UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2006

o		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: 0-17995

ZIX CORPORATION

Texas (State of Incorporation)		75-2216818 (I.R.S. Employer Identification Number)

2711 North Haskell Avenue
Suite 2200, LB 36
Dallas, Texas 75204-2960
(Address of Principal Executive Offices)

(214) 370-2000
(Registrant’s Telephone Number, Including Area Code)

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

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 o                    Accelerated filer þ                    Non-accelerated filer o

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

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

Class   Common Stock, par value $.01 per share				Outstanding at November 1, 2006   59,638,839

 

 

INDEX

		Page
		Number
PART — FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets at September 30, 2006 (unaudited) and December 31, 2005 (audited)		ii
Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and 2005		iii
Condensed Consolidated Statement of Stockholders’ Equity for the nine months ended September 30, 2006		iv
Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005		v
Notes to Condensed Consolidated Financial Statements		1
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			20
Item 3. Quantitative and Qualitative Disclosures About Market Risk			38
Item 4. Controls and Procedures			38
PART II-OTHER INFORMATION
Item 1. Legal Proceedings			39
Item 1A. Risk Factors			39
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			45
Item 3. Defaults Upon Senior Securities			45
Item 4. Submission of Matters to a Vote of Security Holders			46
Item 5. Other Information			46
Item 6. Exhibits			46
Sublease
Letter of Agreement
Certification of CEO Pursuant to Section 302
Certification of CFO Pursuant to Section 302
Certification of CEO and CFO Pursuant to Section 906

ZIX CORPORATION

		September 30,				December 31,
		2006				2005
		(Unaudited)				(Audited)
ASSETS
Current assets:
Cash and cash equivalents		$	14,842,000			$	20,240,000
Restricted cash			—				5,100,000
Receivables, net			637,000				149,000
Prepaid and other current assets			1,586,000				1,845,000
Total current assets			17,065,000				27,334,000
Restricted cash			35,000				35,000
Property and equipment, net			2,676,000				3,652,000
Intangible assets, net			93,000				559,000
Goodwill			2,161,000				2,161,000
Deferred financing costs and other assets			96,000				374,000
		$	22,126,000			$	34,115,000
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	1,113,000			$	1,313,000
Accrued expenses			3,076,000				3,749,000
Deferred revenue			7,751,000				7,087,000
Customer deposits			2,024,000				1,000,000
Capital lease obligations			—				165,000
Promissory note payable			2,548,000				—
Short-term note payable			37,000				268,000
Convertible promissory note payable			—				4,404,000
Total current liabilities			16,549,000				17,986,000
Long-term liabilities:
Deferred revenue			1,670,000				1,261,000
Derivative liabilities			2,110,000				—
Customer deposits			—				2,000,000
Promissory note payable			—				2,226,000
Deferred rent			343,000				245,000
Total long-term liabilities			4,123,000				5,732,000
			20,672,000				23,718,000
Contingencies (Note 16)
Stockholders’ equity:
Preferred stock, $1 par value, 10,000,000 shares authorized; none issued and outstanding			—				—
Common stock, $0.01 par value, 175,000,000 shares authorized; 61,966,020 issued and 59,638,839 outstanding in 2006 and 51,932,561 issued and 49,605,380 outstanding in 2005			620,000				519,000
Additional paid-in capital			315,528,000				308,461,000
Treasury stock, at cost; 2,327,181 common shares in 2006 and 2005			(11,507,000	)			(11,507,000	)
Accumulated deficit			(303,187,000	)			(287,076,000	)
Total stockholders’ equity			1,454,000				10,397,000
		$	22,126,000			$	34,115,000

See notes to condensed consolidated financial statements.

ZIX CORPORATION

(Unaudited)

		Three Months Ended September 30,								Nine Months Ended September 30,
		2006				2005				2006				2005
Revenues:
Services		$	4,710,000			$	3,467,000			$	12,814,000			$	9,964,000
Hardware			—				17,000				—				443,000
Software			—				—				—				109,000
Total revenues			4,710,000				3,484,000				12,814,000				10,516,000
Cost of revenues			3,131,000				3,580,000				9,596,000				10,979,000
Gross margin (loss)			1,579,000				(96,000	)			3,218,000				(463,000	)
Operating expenses:
Research and development expenses			1,630,000				1,495,000				4,851,000				5,005,000
Selling, general and administrative expenses			5,210,000				6,192,000				18,351,000				20,253,000
Customer deposit forfeiture			—				—				(1,000,000	)			(960,000	)
(Gain) loss on sale of product lines			(11,000	)			4,649,000				(11,000	)			3,699,000
Asset impairment charge			125,000				—				125,000				—
Total operating expenses			6,954,000				12,336,000				22,316,000				27,997,000
Operating loss			(5,375,000	)			(12,432,000	)			(19,098,000	)			(28,460,000	)
Other (expense) income:
Investment and other income			229,000				178,000				740,000				464,000
Interest expense			(114,000	)			(2,205,000	)			(1,009,000	)			(5,031,000	)
Gain on derivative liabilities			1,120,000				—				4,050,000				—
Loss on extinguishment of convertible debt			—				—				(871,000	)			—
Total other (expense) income			1,235,000				(2,027,000	)			2,910,000				(4,567,000	)
Loss before income taxes			(4,140,000	)			(14,459,000	)			(16,188,000	)			(33,027,000	)
Income tax benefit (expense)			(11,000	)			(22,000	)			77,000				59,000
Net loss		$	(4,151,000	)		$	(14,481,000	)		$	(16,111,000	)		$	(32,968,000	)
Basic and diluted loss per common share		$	(0.07	)		$	(0.40	)		$	(0.29	)		$	(0.98	)
Basic and diluted weighted average common shares outstanding			59,638,839				36,499,291				56,201,207				33,744,143

See notes to condensed consolidated financial statements.

ZIX CORPORATION

(Unaudited)

		Stockholders’ Equity
										Additional												Total
		Common Stock								Paid-In				Treasury				Accumulated				Stockholders’
		Shares				Amount				Capital				Stock				Deficit				Equity
Balance, January 1, 2006			51,932,561			$	519,000			$	308,461,000			$	(11,507,000	)		$	(287,076,000	)		$	10,397,000
Issuance of common stock and related warrants upon private investment (net of issuance costs)			9,930,000				100,000				4,648,000				—				—				4,748,000
Common stock issued to employees for compensation in lieu of cash			82,196				1,000				156,000				—				—				157,000
Common stock issued in lieu of cash for third-party services			21,263				—				30,000				—				—				30,000
Employee share-based compensation costs			—				—				2,008,000				—				—				2,008,000
Valuation of additional warrants issued relating to the convertible promissory notes payable			—				—				50,000				—				—				50,000
Valuation of beneficial conversion feature in convertible promissory note resulting from the private placement of common stock			—				—				459,000				—				—				459,000
Valuation of additional anti-dilutive warrants issued upon private placement of common stock			—				—				74,000				—				—				74,000
Valuation of additional warrants issued upon retirement of convertible promissory note			—				—				6,000				—				—				6,000
Reversal of unamortized valuation of beneficial conversion feature upon retirement of convertible promissory note			—				—				(365,000	)			—				—				(365,000	)
Other			—				—				1,000				—				—				1,000
Net loss			—				—				—				—				(16,111,000	)			(16,111,000	)
Balance, September 30, 2006			61,966,020			$	620,000			$	315,528,000			$	(11,507,000	)		$	(303,187,000	)		$	1,454,000

See notes to condensed consolidated financial statements.

ZIX CORPORATION

(Unaudited)

		Nine Months Ended September 30,
		2006				2005
Operating activities:
Net loss		$	(16,111,000	)		$	(32,968,000	)
Non-cash items in net loss:
Depreciation and amortization			2,195,000				3,246,000
Amortization of debt discount / premium, financing costs and other			797,000				4,053,000
Value of additional warrants issued			10,000				—
Common stock issued to employees and non-employee in lieu of cash			187,000				1,012,000
Loss on extinguishment of convertible debt			871,000				—
Gain on derivative liabilities			(4,050,000	)			—
Employee share-based compensation costs			2,008,000				—
Customer deposit forfeiture			(1,000,000	)			(960,000	)
Changes in deferred taxes			(96,000	)			—
Asset impairment charge			125,000				—
Common stock issued in lieu of cash interest payments			—				608,000
Non-employee stock-based compensation costs			1,000				96,000
(Gain) loss on sale of product lines			(11,000	)			3,699,000
Changes in operating assets and liabilities:
Accounts receivable			(488,000	)			339,000
Other assets			278,000				686,000
Accounts payable			(73,000	)			(549,000	)
Deferred revenue			1,073,000				2,233,000
Accrued and other liabilities			(586,000	)			(679,000	)
Net cash used by operating activities			(14,870,000	)			(19,184,000	)
Investing activities:
Purchases of property and equipment			(1,024,000	)			(1,299,000	)
Sales and maturities of marketable securities			—				16,000,000
Purchase of restricted cash investment			—				(39,000	)
Proceeds from restricted cash investments			5,100,000				—
Proceeds from sale of product lines			11,000				2,809,000
Net cash provided by investing activities			4,087,000				17,471,000
Financing activities:
Proceeds from private placement of common stock			11,817,000				15,016,000
Payment of expenses relating to private placement of common stock			(836,000	)			(333,000	)
Payment of convertible debt			(5,000,000	)			—
Payment of premium on convertible debt			(200,000	)			—
Payment of short-term note payable, capital leases and other			(396,000	)			(401,000	)
Proceeds from exercise of stock options			—				28,000
Proceeds from exercise of warrants			—				1,355,000
Other			—				(28,000	)
Net cash provided by financing activities			5,385,000				15,637,000
(Decrease) increase in cash and cash equivalents			(5,398,000	)			13,924,000
Cash and cash equivalents, beginning of period			20,240,000				3,856,000
Cash and cash equivalents, end of period		$	14,842,000			$	17,780,000

See notes to condensed consolidated financial statements.

ZIX CORPORATION

(Unaudited)

1. Basis of Presentation

     The accompanying condensed consolidated financial statements of Zix Corporation (“ZixCorp” or “the Company”) should be read in conjunction with the audited consolidated financial statements included in the Company’s 2005 Annual Report to Shareholders on Form 10-K. These financial statements are unaudited, but have been prepared in the ordinary course of business for the purpose of providing information with respect to the interim periods. Management of the Company believes that all adjustments necessary for a fair presentation for such periods have been included and are of a normal recurring nature. The results of operations for the three and nine-month periods ended September 30, 2006, are not necessarily indicative of the results to be expected for the full year.

2. Company Overview and Liquidity

     As of January 1, 2006, the Company operates two reporting segments, Email Encryption and e-Prescribing, which provide services that protect, manage and deliver sensitive electronic information and provide electronic prescribing at the point of care.

     Email Encryption is a comprehensive suite of secure messaging services, which allows an enterprise to use policy driven rules to determine which emails need to be sent securely in order to comply with regulations or corporate policy. Email Encryption is commonly referred to as Secure Messaging. e-Prescribing consists of a single product line named PocketScript. PocketScript is an electronic prescribing service that allows physicians to use a handheld device to prescribe drugs and transmit the prescription electronically to any pharmacy. During the prescribing process, the physician is provided with real-time information such as insurance formulary and drug interactions that normally would not be available in a paper prescription format. This allows the physician to leverage technology for better patient care at the point of delivery. The Company’s Email Encryption service is primarily offered as a hosted-service solution, whereby customers pay an annual service subscription. The e-Prescribing service is also offered as a hosted-service solution, however, the end-users’ set-up costs and initial service period are typically paid by a sponsoring health benefits insurance provider (a “payor”). Both Email Encryption and e-Prescribing services require a significant up-front investment to establish service and secure enough subscribers to make the businesses profitable.

     Prior to January 1, 2006, the Company was operated and managed as a single reporting segment.

Company History

     In 1999, the Company began developing and marketing Secure Messaging products and services that brought privacy, security and convenience to Internet users. ZixMail, a desktop solution for encrypting and securely delivering email, was first commercially introduced in the first quarter of 2001. In 2002, the Company began offering additional email encryption products such as:

	•		ZixVPM (Virtual Private Messenger): an e-messaging gateway service that provides company-wide privacy protection for inbound and outbound email communications.
	•		ZixAuditor: an assessment service used to analyze email traffic patterns and monitor compliance with corporate and regulatory policies.
	•		ZixPort: a secure Web-messaging portal.

     In July 2003, the Company acquired substantially all of the operating assets and the business of PocketScript, LLC (“PocketScript”), a privately-held development stage enterprise that provided electronic prescription services for the healthcare industry. This acquisition enabled the Company to expand its services into healthcare delivery solutions, specifically, the e-Prescribing marketplace. PocketScript is the cornerstone offering in the current e-Prescribing product segment.

     In September 2003, the Company acquired substantially all of the operating assets and the business of Elron Software, Inc. (“Elron Software” or “Elron”), a majority-owned subsidiary of Elron Electronic Industries Ltd. and a provider of anti-spam, email content filtering and Web filtering solutions, which enhanced the Company’s Secure Messaging product segment.

     In January 2004, the Company acquired substantially all of the operating assets and the business of MyDocOnline, Inc. (“MyDocOnline”), a subsidiary of Aventis Pharmaceuticals, Inc., the North American pharmaceuticals business of Aventis SA.

     MyDocOnline offered a variety of Internet-based healthcare services and was a provider of secure Web-based communications, disease management, online doctor visits, and laboratory information solutions.

     Also in 2004, Secure Messaging was combined with the Elron products (Message Inspector and Web Inspector or “MI/WI”) and referred to as the eSecure product line and e-Prescribing was combined with the MyDocOnLine product (Dr. Chart) and referred to as the eHealth product line.

     In late 2004, the Company made a strategic decision to focus the Company’s resources and efforts towards the two “core products” of the Secure Messaging and e-Prescribing. Subsequently, on November 4, 2004, the Company announced that it was terminating the Connect service for online doctor visits, which was one of the products acquired in the MyDocOnline acquisition.

     On March 11, 2005, MI/WI product lines, which were acquired in the Elron acquisition, were sold to CyberGuard (see Note 7).

     On September 30, 2005, the Company sold the remaining MyDocOnline product (Dr. Chart) to MITEM (see Note 7).

     In early 2006, the eSecure product line was renamed Email Encryption and the eHealth product line was renamed e-Prescribing to reflect the single product focus in these two remaining core product lines.

     Due to the Company’s history of operating with spending in excess of customer receipts, liquidity is of special importance. To date, the Company’s cash flow from operations has not been sufficient to fund the Company’s on-going operations and the Company has relied on equity and debt financings to fund its operations. Essential to liquidity is the ability of the Company to achieve and retain subscriber bases in both core product offerings to overcome the costs of offering the service and become cash flow positive.

The Company announced in the second quarter of 2006 that it was in the process of reducing its quarterly spending by way of a reduction in workforce and reductions in non-headcount related areas. On August 8, 2006, the Company announced that the targeted cost reductions would be increased to equal approximately a 25% reduction in quarterly spending when compared with the first quarter of 2006. The purpose of these reductions is to streamline the Company’s operating costs in order to strengthen the Company’s liquidity position by more closely matching its cost structure to near-term revenue opportunities. As of November 1, 2006, the Company has substantially completed the headcount reductions.

     For the three-month and nine-month periods ended September 30, 2006, the Company recorded one-time termination expenses of $295,000 and $640,000, respectively. As of September 30, 2006, $79,000 was accrued and is expected to be paid during the remainder of 2006. The total one-time termination expense was recorded to the following line items of the Company’s condensed consolidated statement of operations.

		Three Months Ended				Nine Months Ended
		September 30, 2006				September 30, 2006
Cost of revenues		$	44,000			$	47,000
Research and development expenses			79,000				92,000
Selling, general and administrative expenses			172,000				501,000
Total one-time termination expense		$	295,000			$	640,000

     The following table summarizes the one-time termination expense impact for the three and nine months ended September 30, 2006, by business segment:

		Three Months Ended				Nine Months Ended
		September 30, 2006				September 30, 2006
Email Encryption		$	128,000			$	157,000
e-Prescribing			112,000				250,000
Corporate			55,000				233,000
Total one-time termination expense		$	295,000			$	640,000

     Based on the Company’s size after the cost reduction actions taken in 2006 and current order and deployment rates as of September 30, 2006, the operating spending plus capital asset purchases for the next twelve months is projected to be $33,000,000 to $34,000,000. Payment of the note payable to Aventis in cash (see Note 12), should the Company choose to pay the note in cash versus

payment in the Company’s common stock as allowed in the note, would increase these projected spending amounts. Using flat year-on-year order rates for Email Encryption, progressive improvements from Email Encryption channels, consistent renewal rates for subscribers, an expectation of cash flow from Payors with whom the Company has a current relationship, and modest success in new Payor Sponsorships as well as selling the Company’s Payor Services, cash receipt projections for the next twelve months are projected to be $26,750,000 to $28,000,000. These cash receipt projections, when combined with $14,842,000 unrestricted cash on hand at September 30, 2006 provide for an estimated $41,592,000 to $42,842,000 in cash available to fund the expected operational spending of $33,000,000 to $34,000,000 for the next twelve months.

     The Company believes it has adequate resources and liquidity to sustain operations for at least the next twelve months and is targeting cash flow improvements through increased cash receipts to augment its liquidity beyond that time. The Company’s belief takes into account the following factors: completion of the recently announced reduction in workforce, relatively low contractual spending commitments over the next twelve months, historically high renewal rates for Email Encryption, continued additions of new customers in the Email Encryption business consistent with levels experienced during the past twelve months, the discretionary nature of the cash spending in excess of cash receipts in the emerging area of e-Prescribing and the general flexibility overall Company spending.

     As contractual cash collections and expected increases in cash sources are not always certain, the Company has some ability to adjust cash spending to react to any shortfalls in actual cash collections or to adjust spending in certain investment areas should cash receipts make that possible or, if warranted and if the terms are acceptable, with additional external financing, receipts from exercised stock options and warrants of the Company’s common stock or strategic partnerships. However, operating in emerging and developing markets involves risk and uncertainties, and there are no assurances that the Company will ultimately achieve or achieve in a timely manner its targeted improvements in operating performance. Beyond the twelve months beginning October 1, 2006, and should business results not improve sufficiently as projected, the Company could have to alter its business plan or further augment its cash flow position through cost reduction measures, sales of assets, additional financings or a combination of these actions. However, there can be no assurance that the Company would be successful in carrying out any of these measures should they become necessary. The Company has expressed a lack of willingness, relative to other alternatives, to raise capital by issuing new shares of common stock given the current price of the Company’s common stock. Accordingly, the extent and timing of success, or lack thereof, in the e-Prescribing market and continued performance in Email Encryption will ultimately be the most significant operational determinants of liquidity.

3. Revenue and Significant Customers

     The Company recognizes revenue in accordance with accounting principles generally accepted in the United States of America, as promulgated by Statement of Position (“SOP”) 97-2, Software Revenue Recognition, SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With respect to Certain Transactions, Emerging Issues Task Force (“EITF”) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, and Securities and Exchange Commission Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements, and other related pronouncements.

     The Company develops, markets, licenses and supports electronic information protection services and related software products. The Company’s services can be placed into several key revenue categories where each category has similar revenue recognition traits: Email Encryption subscription-based services, e-Prescribing service, various transaction fees and related professional services. A majority of the revenues generated by the Company are through direct sales; however, for Email Encryption services the Company employs a network of distributors and resellers. Under all product categories and distribution models, the Company recognizes revenue after all of the following occur: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed and determinable, and collectability is reasonably assured. In the event the arrangement has multiple elements with delivered and undelivered elements, revenue for the delivered elements are recognized under the residual method only when vendor-specific objective evidence of fair value (VSOE) exists to allocate the fair value of the total fees to the undelivered elements of the arrangement. Occasionally, when ZixCorp is engaged in a complex product deployment, customer acceptance may have to occur before the transaction is considered complete. In this situation no revenue is recognized until the customer accepts the product. Discounts provided to customers are recorded as reductions in revenue.

     The Email Encryption services of ZixMail, ZixVPM, ZixPort, and ZixDirect are subscription-based services. In the first nine months of 2005, subscription-based services also included Dr. Chart. Providing these services includes delivering licensed software and providing secure electronic communications and customer support throughout the subscription period. In the case of ZixVPM, typically, as part of the service, an appliance with pre-installed software is installed at the customer site at the beginning of the subscription period. In a subscription service, the customer does not own a perpetual right to a software license, but is instead granted the use of that license during the period of the service subscription. Subscriptions are generally multiple-year contracts that are

irrevocable and non-refundable in nature and require annual, up-front payments. The subscription period begins on the date specified by the parties or when the service is fully functional for the customer which is consequently deemed to be the date of acceptance. Revenues from subscription services are recorded as service revenue as the services are rendered from the date of acceptance over the subscription period. Subscription fees received from customers in advance are recorded as deferred revenue and recognized as revenue ratably over the subscription period.

     On September 30, 2005, the Dr. Chart product line was sold to MITEM. This product line was acquired in January 2004 through the acquisition of MyDocOnline, Inc. For the three and nine-month periods ended September 30, 2005, Dr. Chart product line contributed $135,000 and $330,000 in revenue, respectively (see Note 7).

     e-Prescribing service arrangements contain multiple deliverables including both hardware and services. Due to the lack of VSOE, these elements are combined into a single unit of accounting and, similar to Email Encryption, recognized as service revenue ratably over the longer of the subscription term or expected renewal period. Revenue recognition begins upon installation of the required hardware and commencement of service. Prior to the third quarter 2005, the Company did maintain VSOE for certain service elements of the e-Prescribing service. Accordingly, the residual value assigned to the PocketScript handheld device was recognized as revenue upon installation. The fair value of the undelivered services are being recognized ratably over the period in which those services are delivered.

     In the first quarter 2005, the Company sold anti-spam filtering, email content filtering, and Web filtering solutions under the MI/WI product lines to customers under perpetual licensing arrangements. These perpetual software licenses were normally sold as part of multiple-element arrangements that included annual maintenance and/or subscription, and may have included implementation or training services. Evidence of VSOE for implementation and training services associated with the anti-spam, email content filtering and Web filtering arrangements was based upon standard billing rates and the estimated level of effort for the individuals expected to perform the related services. Installation and training revenues were recognized as the services were rendered. The Company established VSOE for maintenance based upon maintenance that was sold separately. Maintenance revenue was recognized over the term of the maintenance agreement, generally one year.

     On March 11, 2005, the MI/WI product lines were sold to CyberGuard. For the nine months ended September 30, 2005, MI/WI contributed $646,000 in revenue. The product lines contributed no revenue for the three months ended September 30, 2005 (see Note 7).

     Some of the Company’s services incorporate a transaction fee per event occurrence or when predetermined usage levels have been reached. These fees are recognized as revenue when the transaction occurs or when the predetermined usage levels have been achieved, and when the amounts are fixed and determinable.

     The Company does not offer standalone professional services. Further, the Company’s services include various warranty provisions; however, warranty expense was not material to any period presented.

     For the three months ended September 30, 2006 and 2005, Blue Cross and Blue Shield of Massachusetts, Inc., an e-Prescribing customer, accounted for approximately 12% ($545,000) and 13% ($465,000) of total revenues, respectively. No other single customer accounted for 10% or more of the Company’s total revenues for the three months ended September 30, 2006 and 2005. For the nine months ended September 30, 2006 and 2005, Blue Cross and Blue Shield of Massachusetts, Inc. accounted for approximately 10% ($1,329,000) and 18% ($1,850,000) of total revenues, respectively. No other single customer accounted for 10% or more of the Company’s total revenues for the nine months ended September 30, 2006 and 2005.

4. Segment Information

     As of January 1, 2006, the Company began to manage its business in two reportable segments: Email Encryption and e-Prescribing as discussed in Note 2.

     The Company’s Chief Executive Officer is the chief operating decisions maker (“CODM”) in assessing the performance of each segment and determining the related allocation of resources.

     To determine the allocation of resources the CODM generally assesses the performance of each segment based on revenue, gross margin, and direct expenses which include research and development expenses and selling and marketing expenses that are directly attributable to the segments. Most assets and most corporate costs are not allocated to the segments and are not used to determine

resource allocation. Any transactions that are considered a one-time occurrence or not likely to be repeated in future periods are excluded from the CODM’s assessments. The accounting policies of the reportable segments are the same as those applied to the condensed consolidated financial statements.

     “Corporate” includes charges such as corporate management, compliance and other non-operational activities that cannot be directly attributed to a reporting segment. In addition, Corporate also includes the revenues and direct costs of products that have been sold or otherwise discontinued by the Company. In 2005, the Company sold two product lines: MI/WI and Dr. Chart (see Note 7). These products contributed $135,000 and $976,000 of revenue in the three and nine months ended September 30, 2005, respectively.

     Prior to January 1, 2006, the Company was operated and managed as a single reporting unit. Amounts shown below for any period prior to January 1, 2006, are estimations prepared for comparative purposes only.

		Three Months Ended September 30, 2006																Three Months Ended September 30, 2005
		Email				e-												Email				e-
		Encryption				Prescribing				Corporate				Total				Encryption				Prescribing				Corporate				Total
Revenues		$	3,585,000			$	1,125,000			$	—			$	4,710,000			$	2,687,000			$	662,000			$	135,000			$	3,484,000
Cost of revenues			1,297,000				1,834,000				—				3,131,000				1,284,000				1,894,000				402,000				3,580,000
Gross margin (loss)			2,288,000				(709,000	)			—				1,579,000				1,403,000				(1,232,000	)			(267,000	)			(96,000	)
Direct expenses			2,703,000				2,452,000				—				5,155,000				3,021,000				2,267,000				225,000				5,513,000
Segment loss			(415,000	)			(3,161,000	)			—				(3,576,000	)			(1,618,000	)			(3,499,000	)			(492,000	)			(5,609,000	)
Unallocated (expense) / income:
Marketing, general and administrative expense			—				—				(1,685,000	)			(1,685,000	)			—				—				(2,174,000	)			(2,174,000	)
Gain (loss) on sale of product line			—				—				11,000				11,000				—				—				(4,649,000	)			(4,649,000	)
Asset impairment charge			—				—				(125,000	)			(125,000	)			—				—				—				—
Customer deposit forfeiture			—				—				—				—				—				—				—				—
Gain on derivatives			—				—				1,120,000				1,120,000				—				—				—				—
Loss on extinguishment of debt			—				—				—				—				—				—				—				—
Investment and other income			—				—				229,000				229,000				—				—				178,000				178,000
Interest expense			—				—				(114,000	)			(114,000	)			—				—				(2,205,000	)			(2,205,000	)
Total unallocated			—				—				(564,000	)			(564,000	)			—				—				(8,850,000	)			(8,850,000	)
Loss before income taxes		$	(415,000	)		$	(3,161,000	)		$	(564,000	)		$	(4,140,000	)		$	(1,618,000	)		$	(3,499,000	)		$	(9,342,000	)		$	(14,459,000	)

		Nine Months Ended September 30, 2006																Nine Months Ended September 30, 2005
		Email				e-												Email				e-
		Encryption				Prescribing				Corporate				Total				Encryption				Prescribing				Corporate				Total
Revenues		$	10,287,000			$	2,527,000			$	—			$	12,814,000			$	7,164,000			$	2,376,000			$	976,000			$	10,516,000
Cost of revenues			4,082,000				5,514,000				—				9,596,000				3,948,000				5,425,000				1,606,000				10,979,000
Gross margin (loss)			6,205,000				(2,987,000	)			—				3,218,000				3,216,000				(3,049,000	)			(630,000	)			(463,000	)
Direct expenses			8,426,000				7,920,000				—				16,346,000				9,136,000				7,199,000				1,175,000				17,510,000
Segment loss			(2,221,000	)			(10,907,000	)			—				(13,128,000	)			(5,920,000	)			(10,248,000	)			(1,805,000	)			(17,973,000	)
Unallocated (expense) / income:
Marketing, general and administrative expense			—				—				(6,856,000	)			(6,856,000	)			—				—				(7,748,000	)			(7,748,000	)
Gain (loss) on sales of product line			—				—				11,000				11,000				—				—				(3,699,000	)			(3,699,000	)
Asset impairment charge			—				—				(125,000	)			(125,000	)			—				—				—				—
Customer deposit forfeiture			—				—				1,000,000				1,000,000				—				—				960,000				960,000
Gain on derivatives			—				—				4,050,000				4,050,000				—				—				—				—
Loss on extinguishment of debt			—				—				(871,000	)			(871,000	)			—				—				—				—
Investment and other income			—				—				740,000				740,000				—				—				464,000				464,000
Interest expense			—				—				(1,009,000	)			(1,009,000	)			—				—				(5,031,000	)			(5,031,000	)
Total unallocated			—				—				(3,060,000	)			(3,060,000	)			—				—				(15,054,000	)			(15,054,000	)
Loss before income taxes		$	(2,221,000	)		$	(10,907,000	)		$	(3,060,000	)		$	(16,188,000	)		$	(5,920,000	)		$	(10,248,000	)		$	(16,859,000	)		$	(33,027,000	)

     Revenues from international customers and long-lived assets located outside of the United States are not material to the condensed consolidated financial statements.

     As mentioned above, the Company does not allocate resources based on assets; however, for disclosure purposes total assets by segment are shown below. Assets reported under each segment include only those that provide a direct and exclusive benefit to that segment. Assets assigned to each segment include accounts receivable and related allowances, prepaid and other assets, certain property and equipment and related accumulated depreciation, goodwill, and intangible assets and related accumulated amortization. All other corporate and shared assets are recorded under “Corporate.”

		September 30, 2006																December 31, 2005
		Email				e-												Email				e-
		Encryption				Prescribing				Corporate				Total				Encryption				Prescribing				Corporate				Total
Total assets		$	3,321,000			$	1,339,000			$	17,466,000			$	22,126,000			$	3,969,000			$	1,436,000			$	28,710,000			$	34,115,000

5. Stock Options and Stock-based Employee Compensation

     Below is a summary of common stock options outstanding at September 30, 2006:

		Authorized				Options				Options				Available
		Shares				Outstanding				Vested				for Grant
Employee and Director Stock Option Plans:
1990 Stock Option Plan			345,045				2,500				2,500				—
1992 Stock Option Plan			450,000				65,666				65,666				—
1995 Long-term Incentive Plan			1,825,000				1,286,875				958,125				—
1996 Director’s Stock Option Plan			225,000				60,000				60,000				—
1999 Director’s Stock Option Plan			975,000				826,153				770,625				—
2001 Stock Option Plan			2,525,000				1,836,258				965,966				222,832
2001 Employee Stock Option Plan			300,000				192,382				171,571				64,071
2003 New Employee Stock Option Plan			500,000				431,267				359,950				68,733
2004 Stock Option Plan			3,200,000				1,648,911				673,786				1,551,089
2004 Director’s Stock Option Plan			300,000				270,833				181,667				29,167
2006 Director’s Stock Option Plan			750,000				194,190				32,365				555,810
Total employee and director stock option plans			11,395,045				6,815,035				4,242,221				2,491,702
Executive Stock Option Agreements:
John A. Ryan, former Chairman and CEO			1,000,000				1,000,000				1,000,000				—
Richard D. Spurr, Chairman, President and CEO			650,000				650,000				561,364				—
Other executive stock option agreements			450,000				125,000				125,000				—
Total executive stock option agreements			2,100,000				1,775,000				1,686,364				—
Other stock option agreements			70,000				70,000				70,000				—
Total			13,565,045				8,660,035				5,998,585				2,491,702

     Under all of the Company’s stock option plans, new shares are issued when options are exercised.

Employee and Director Stock Option Plans

     The Company has non-qualified stock options outstanding to employees, directors, and third parties under various stock option plans. The exercise price of options granted under these plans are generally not less than the fair market value at the date of grant and, subject to termination of employment, generally expire ten years from the date of grant. Employee options generally vest in installments over three years. Option grants to employees, officers and directors frequently contain accelerated vesting provisions upon the occurrence of a change of control, as defined in the applicable option agreements. At September 30, 2006, 2,491,702 shares of common stock were available for future grants under the Company’s stock option plans.

Executive Stock Option Agreements:

     John A. Ryan — In November 2001, Mr. John A. Ryan was appointed chairman, president and chief executive officer of the Company. Mr. Ryan received options to acquire 1,000,000 shares of ZixCorp common stock at an exercise price of $5.24 per share that became fully vested in November 2003, and all were still outstanding on September 30, 2006. Mr. Ryan resigned as Chief Executive Officer and Chairman of the Board in February and October 2005, respectively.

     Richard D. Spurr — In January 2004, Mr. Richard D. Spurr was appointed president and chief operating officer of the Company. Mr. Spurr received options to acquire 650,000 shares of ZixCorp common stock at an exercise price of $10.80 per share. These options vested 25% in April 2004 and the remaining balance vests quarterly through January 2007 on a pro rata basis. The options automatically vest 100% in the event of a change in control of the Company. At September 30, 2006, all 650,000 options were still outstanding. Mr. Spurr was appointed Chief Executive Officer in March 2005, and Chairman of the Board in February 2006.

     Other Executive Stock Option Agreements - In 2001 and 2002, options to purchase 450,000 shares of common stock were granted to key Company executives, which became fully vested in March 2005. At September 30, 2006, 125,000 options remain outstanding with an exercise price of $5.25 per share.

Other Stock Option Agreements:

     From time to time the Company may grant stock options to consultants, contractors and other third parties for services provided to the Company. These options are expensed based on their fair values as calculated by using the Black-Scholes Option Pricing Model (“BSOPM”). At September 30, 2006, options outstanding to non-employees were 285,000, of which 215,000 were granted from employee or director stock option plans and the remaining 70,000 issued under other stock option agreements.

Accounting Treatment

     On January 1, 2006, the Company adopted SFAS No. 123(R), Share-Based Payment, and has elected to use the modified prospective method, which requires the application of the accounting standard to all share-based awards issued on or after January 1, 2006 and any outstanding share-based awards that were issued but not vested as of January 1, 2006. Accordingly, the condensed consolidated financial statements as of September 30, 2005, and for the three and nine months then ended have not been restated to reflect the impact of SFAS 123(R).

     For the three and nine months ended September 30, 2006, the adoption of FAS 123(R) resulted in incremental stock-based compensation expense of $568,000 and $2,008,000, respectively. This amount includes (i) compensation expense related to stock options granted prior to January 1, 2006, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the pro-forma provisions of SFAS 123, and (ii) compensation expense for stock options granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). The incremental stock-based compensation expense caused loss before taxes and net loss to increase by $568,000 and $2,008,000 and the basic and diluted net loss per share to increase by $0.01 and $0.04 per share for the three and nine months ended September 30, 2006, respectively.

     For the three and nine months ended September 30, 2006, the total stock-based compensation expense was recorded to the following line items of the Company’s condensed consolidated statement of operations:

		Three Months Ended				Nine Months Ended
		September 30, 2006				September 30, 2006
Cost of revenues		$	33,000			$	96,000
Research and development expenses			30,000				88,000
Selling, general and administrative expenses			505,000				1,824,000
Stock-based compensation expense		$	568,000			$	2,008,000

     There were no stock option exercises for the nine months ended September 30, 2006; therefore, no excess tax benefits were recorded. A deferred tax asset totaling $763,000, resulting from stock-based compensation expense recognized in the first nine months of 2006, was recorded and $719,000 of that total, which relates to stock option compensation costs for U.S. employees, was fully reserved as of September 30, 2006, because of the Company’s historical net losses for its United States operations. The difference of $44,000, which relates to stock option compensation costs for Canadian employees, was recognized as an income tax benefit in the statement of operations for the period.

     SFAS 123(R) requires the Company to calculate the pool of excess tax benefits, or the additional paid-in capital (“APIC”) pool, available as of January 1, 2006, to absorb tax deficiencies recognized in subsequent periods, assuming the Company had applied the provisions of the standard in prior periods. Pursuant to the provisions of FASB Staff Position 123R-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards, the Company adopted the alternative method for determining the tax effects of share-based compensation, which among other things, provides a simplified method for estimating the beginning APIC pool balance.

     Prior to the adoption of SFAS 123(R), the Company applied Accounting Principles Board (“APB”) No. 25 to account for its stock-based awards. The following table details the effect on the Company’s net loss and loss per common share had compensation expense for employee stock-based awards been recorded in the three and nine-month periods ended September 30, 2005, based on the fair value method under SFAS 123(R):

		Three Months Ended				Nine Months Ended
		September 30, 2005				September 30, 2005
Net loss, as reported		$	(14,481,000	)		$	(32,968,000	)
Deduct pro forma stock compensation expense computed under the fair value method			(1,383,000	)			(4,745,000	)
Pro forma net loss		$	(15,864,000	)		$	(37,713,000	)
Basic and diluted loss per common share:
As reported		$	(0.40	)		$	(0.98	)
Pro forma		$	(0.43	)		$	(1.12	)

     During the first quarter of 2006 and with shareholder approval, the Company extended the contract life of 306,143 options held by one former director. As a result of this modification, the Company recognized an additional compensation expense of $34,000 in the period.

     As of September 30, 2006, there was $2,409,000 of total unrecognized stock based compensation related to non-vested share-based compensation awards granted under the stock option plans. This cost is expected to be recognized over a weighted average period of 1.10 years.

     The Company used the BSOPM to determine the fair value of option grants made during the first three quarters of 2006 and 2005. The Company estimated the average holding period of vested options to be two years from the vesting period (1.6 – 1.8 years) for options granted before 2006, but used the “simplified” method per SEC Staff Accounting Bulletin No. 107, Share Based Payment, to calculate the estimated life of options granted to employees subsequent to December 31, 2005. The expected stock price volatility was calculated by averaging the historical volatility of the Company’s common stock over a term equal to the expected life of the options. The following weighted average assumptions were applied in determining the fair value of options granted during the respective periods:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Risk-free interest rate			4.91	%			4.01	%			4.63	%			3.29	%
Expected option life		5.9 years				3.8 years				5.8 years				3.6 years
Expected stock price volatility			92.36	%			91.02	%			95.49	%			96.68	%
Expected dividend yield			—				—				—				—
Fair value of options granted		$	0.57			$	2.04			$	1.22			$	2.43

Stock Option Activity

     The following is a summary of all stock option transactions for the nine months ended September 30, 2006:

										Weighted
						Weighted				Average
						Average				Remaining				Aggregate
						Exercise				Contractual				Intrinsic
		Shares				Price				Term				Value
Outstanding at January 1, 2006			7,595,415			$	7.03
Granted at market price			15,000			$	1.93
Granted above market price			2,265,410			$	2.84
Cancelled or expired			(1,215,790	)		$	5.67
Exercised			—			$	—
Outstanding at September 30, 2006			8,660,035			$	6.11				6.46			$	—
Options exercisable at September 30, 2006			5,998,585			$	7.14				5.74			$	—

     At September 30, 2006, the Company had no stock options outstanding in which the exercise price was lower than the market value of the Company’s common stock. Therefore, the intrinsic value is zero on all options.

     The weighted average grant-date fair value of options granted during the three and nine months ended September 30, 2006, was $0.57 and $1.22, respectively. The weighted average grant-date fair value of options granted during the three and nine months ended September 30, 2005 was $2.04 and $2.43, respectively. A significant factor in the difference between the 2006 and 2005 valuations is the Company’s 2006 practice of granting options with exercise prices in excess of the market price of the Company’s common stock on the date of grant. The total intrinsic value of options exercised during the three and nine months ended September 30, 2006, and 2005, was not material in either period.

Common Stock Issued in Lieu of Cash

     In the third quarter of 2003, the Company implemented a program whereby non-executive employees were paid certain incentive compensation, such as commissions, with Company common stock rather than cash. This program was authorized to grant 600,000 shares in-lieu of compensation. In May 2005, shareholders approved an additional 500,000 shares for this program, which was expanded to include executive incentive pay as well. In June 2006, shareholders approved an additional 500,000 shares for this program bringing the total to 1,600,000 shares. At September 30, 2006, a total of 980,328 shares of common stock had been granted under the program. During the three months ended September 30, 2006, the Company granted no unrestricted shares of common stock under this program. For the nine months ended September 30, 2006 the Company granted 103,459 shares of common stock under this program. The common stock granted under this program had a weighted average fair value of $1.78 per share for the nine months ended September 30, 2006. The Company valued this stock at the fair value on the date of grant. For the three and nine months ended September 30, 2006 and 2005, the Company incurred non-cash expense relating to common stock issue in lieu of cash consisting of the following:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2006				2005				2006				2005
Common stock issued to employees for compensation in lieu of cash		$	—			$	769,000			$	157,000			$	1,012,000
Stock granted to third parties			—				—				30,000				—
Total		$	—			$	769,000			$	187,000			$	1,012,000

6. Supplemental Cash Flow Information

     Supplemental cash flow information relating to interest, taxes and noncash activities:

		Nine Months Ended September 30,
		2006				2005
Cash paid for interest		$	263,000			$	307,000
Cash (refunded) paid for income tax		$	(21,000	)		$	321,000
Noncash investing and financing activities:
Accrued expenses relating to purchase of fixed asset		$	127,000			$	—
Assets sold to customers as part of their subscription service		$	19,000			$	—
Accrued expenses related to private placement of common stock (Note 13)		$	72,000			$	(74,000	)
Value of additional warrants issued (Note 12)		$	130,000			$	—
Valuation of beneficial conversion, net of subsequent reversal (Note 12)		$	94,000			$	2,518,000
Assets acquired on capital lease		$	—			$	160,000
Issuance of note receivable relating to the sale of Message Inspector and Web Inspector product lines (Note 7)		$	—			$	1,434,000
Stock redemption of convertible promissory notes payable (Note 12)		$	—			$	2,332,000
Revaluation of warrants resulting from restructure of convertible promissory notes payable (Note 12)		$	—			$	(375,000	)
Insurance premiums financed by short-term note payable		$	—			$	84,000

7. Business Sales and Acquisitions

Sale of Dr. Chart, a product of MyDocOnline

     On September 30, 2005, the Company sold the remaining MyDocOnline product (Dr. Chart) to MITEM. As consideration, the Company received $150,000 in cash paid immediately after closing, a promissory note with a principal amount of $550,000 payable by mid-August 2007, and a warrant exercisable for 400,000 shares of MITEM common stock. Additionally, subject to the conditions and limitations provided in the Asset Purchase Agreement, MITEM assumed all Dr. Chart customer contracts and obligations upon close of the sale, including net deferred revenues of approximately $739,000. Subsequent to the closing of the transaction, the promissory note was adjusted to a principal amount of $540,000 pursuant to the terms of the sales agreement. The note principal was due in six equal quarterly payments of $90,000 beginning May 15, 2006, and bore interest at a rate of 10% per annum. The promissory note was recorded as a note receivable and fully reserved at the time of the sale as the note’s collectability was not assured and no value was assigned to the warrants received.

     In September 2006, MITEM and Zix Corporation restructured the note receivable. The restructured note includes monthly payments, inclusive of interest, of $25,000 through December 2006. The monthly payments increase to $30,000 in 2007 and the final monthly installment is $140,000 in January 2008. The interest rate is unchanged at 10% and the restructured note receivable remains fully reserved.

     MITEM paid the required September 2006 payment of $25,000 and the Company recognized a gain on the payment of $11,000 as the note was fully reserved. The gain was recorded as a gain on the sale of the product line and reduced the overall loss on the sale of Dr. Chart to $4,740,000. Future gains will be recorded if MITEM continues to make their monthly payments.

     The following summarizes the carrying amount of assets and liabilities that were sold to or assumed by MITEM upon the close of the transaction, the allocation of the goodwill to the Dr. Chart product, and resulting loss from the sale:

Net assets sold (liabilities transferred):
Accounts receivable, net		$	34,000
Equipment, net			37,000
Intangibles, net			575,000
Deferred revenue			(739,000	)
Net			(93,000	)
Goodwill			4,797,000
Net proceeds:
Cash receivable			150,000
Note receivable, net			—
Service obligation			(30,000	)
Transaction fees			(150,000	)
Net proceeds			(47,000	)
Initial loss on sale of product line			(4,734,000	)
Additional transaction fees recorded in fourth quarter 2005			(17,000	)
Loss on sale of product line as of December 31, 2005			(4,751,000	)
Payment received on fully reserved note receivable			11,000
Loss on sale of product line		$	(4,740,000	)

     Revenues for the Dr. Chart product line were $135,000 and $330,000 for the three and nine months ended September 30, 2005. Dr. Chart did not represent a separate component of the Company as its operations and cash flows were not sufficiently separated from the rest of the Company; consequently, its results of operations are included in the Company’s consolidated statements of operations for the respective periods.

     The Company also agreed to provide customary indemnification to MITEM for breaches of representations and warranties, covenants and other specified matters. The Company has evaluated this indemnification and determined that no accrual is necessary.

Sale of Web Inspector and Message Inspector Product Lines

     On March 11, 2005, the Web Inspector and Message Inspector product lines, which were acquired in the Elron acquisition, were sold to CyberGuard Corporation for $3,244,000 net of transactions fees of $317,000, consisting of $2,126,000 in cash and a $1,500,000 note receivable with no stated interest rate. The note receivable was recorded at its present value of $1,435,000 using an imputed interest rate of 9%. This is estimated to approximate the rate which would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions. The resulting discount was amortized into interest income over the term of the note. CyberGuard paid the note in full in 2005.

     The following summarizes the carrying amount of assets and liabilities that were sold to or assumed by CyberGuard upon the close of the transaction, the allocation of the goodwill associated with the portion of the email encryption reporting unit being sold, and the resulting gain from the sale:

Net assets sold (liabilities transferred):
Equipment, net		$	15,000
Prepaid expenses			165,000
Intangibles, net			1,499,000
Initial deferred revenue			(1,546,000	)
Subsequent additional transfer of deferred revenue, net			(85,000	)
Net			48,000
Goodwill			2,161,000
Net proceeds:
Cash			2,126,000
Note receivable, net			1,435,000
Transaction fees			(317,000	)
Net proceeds			3,244,000
Gain on sale of product lines		$	1,035,000

     On the initial sales of the MI/WI product lines a gain of $950,000 was recognized in the quarter ended June 30, 2005. However, in the quarter ended September 30, 2005, the Company agreed to transfer an additional $85,000 of deferred revenue to CyberGuard resulting in a total gain on the sale of MI/WI of $1,035,000 for the year ended December 31, 2005.

     Revenues for the MI/WI product lines were $646,000 for the nine months ended September 30, 2005. MI/WI did not represent a separate component of the Company as its operations and cash flows were not sufficiently separated from the rest of the Company; consequently, its results of operations are included in the Company’s consolidated statements of operations for the respective periods.

     The Company also agreed to provide customary indemnification to CyberGuard for breaches of representations and warranties, covenants and other specified matters. The Company has evaluated this indemnification and determined that no accrual is necessary.

8. Restricted Cash

     Current and noncurrent restricted cash of $5,135,000 at December 31, 2005, relates primarily to a debt covenant on the convertible promissory note payable requiring the Company to maintain a minimum of $5,000,000 on deposit. This note was retired in June 2006 using the restricted cash balance (see Note 12). The remaining noncurrent restricted cash balance at September 30, 2006, of $35,000 relates to a Letter of Credit given as a security deposit on one of the Company’s office leases.

9. Accounts Receivable

		September 30,				December 31,
		2006				2005
Gross trade accounts receivable		$	4,732,000			$	3,136,000
Allowance for returns and doubtful accounts			(139,000	)			(35,000	)
Billed but unpaid portion of deferred revenue			(4,161,000	)			(2,969,000	)
Trade receivables, net			432,000				132,000
Taxes receivable			198,000				—
Other receivable			7,000				17,000
Total receivables, net		$	637,000			$	149,000

     The above “Billed but unpaid portion of deferred revenue” is a reduction for future customer service or maintenance obligations which are invoiced but unpaid as of the respective balance sheet dates. Deferred revenue in current and long-term liabilities represents future customer service or maintenance obligations which have been billed and collected as of the respective balance sheet dates.

     No single customer accounted for 10% or more of gross trade accounts receivable at September 30, 2006 or December 31, 2005.

10. Intangible Assets and Goodwill

     At September 30, 2006, the Company’s intangible assets, all of which are subject to amortization, were comprised of developed technology, which resulted from the third quarter 2003 acquisition of PocketScript.

		September 30, 2006												December 31, 2005
						Accumulated												Accumulated
		Cost				Amortization				Net				Cost				Amortization				Net
Developed technology		$	2,034,000			$	1,941,000			$	93,000			$	2,034,000			$	1,475,000			$	559,000

     The weighted average useful life for developed technology is three years as of September 30, 2006 and 2005. Amortization expense relating to intangible assets totaled $106,000 and $466,000 for the three and nine months ended September 30, 2006, and $288,000 and $1,020,000 for the three and nine months ended September 30, 2005, respectively.

     The expected future intangible amortization expense is as follows:

Three months ended December 31, 2006		$	70,000
2007			23,000
Total		$	93,000

     At September 30, 2006, and December 31, 2005, the Company had recorded goodwill totaling $2,161,000 which was originally recorded with the acquisition of Elron Software in the third quarter 2003 and is assigned to the Email Encryption segment. Goodwill of $2,161,000 was included in the carrying value of assets sold to CyberGuard in the sale of the Message Inspector and Web Inspector product lines (see Note 7). Goodwill of $4,797,000 was included in the carrying value of assets sold to MITEM in the sale of the MyDocOnline product line (see Note 7). The Company evaluates its goodwill for impairment annually in the fourth quarter, or when there is reason to believe that the value has been diminished or impaired. There has been no impairment indicators to the goodwill recorded as of September 30, 2006.

11. Customer Deposit

     A Master Services Agreement was entered into with Sanofi-Aventis, Inc. (“Sanofi-Aventis”) for $4,000,000 in January 2004 for the Company’s performance of various future services in conjunction with the MyDocOnline acquisition. The services were to be delivered in minimum amounts of $1,000,000, $1,000,000 and $2,000,000 prior to April 11, 2005, January 30, 2006, and January 30, 2007, respectively. The services will be defined on an ongoing basis over the life of the agreement and valued in accordance with pricing for similar services rendered by the Company to other customers. Sanofi-Aventis paid the $4,000,000 upon execution of the Master Services Agreement.

     Since the Company’s services to be provided to Sanofi-Aventis were not fully defined, the $4,000,000 payment was recorded as a customer deposit. As the services are defined and priced in individual project agreements, the value of the defined element will be reclassified to deferred revenues and then recognized as revenue in accordance with applicable revenue recognition criteria. If the services are not requested by Sanofi-Aventis by the dates outlined above, the deposit will be forfeited on an annual basis and ZixCorp will recognize the forfeiture as a reduction of operating expenses. The Company is required to return to Sanofi-Aventis any unused portion of the deposit only in the event of material breach of the contract by the Company; in the event the Company or a party employed or engaged by the Company is debarred pursuant to the Generic Drug Enforcement Act of 1992 or similar state, local or foreign law; in the event the Company files for bankruptcy; or in the event of force majeure. The Company believes that it is unlikely any of these events will occur. The Company’s obligations associated with the Master Services Agreement are secured by a first priority lien on the Company’s property and equipment and accounts receivable. As of September 30, 2006, the Company has provided $40,000 of services to Sanofi-Aventis under this Master Services Agreement which was recognized as revenue in 2004.

     Sanofi-Aventis has not requested any additional services through September 30, 2006, other than the $40,000 noted above. As such, $960,000 was forfeited by Sanofi-Aventis in the second quarter of 2005 and an additional $1,000,000 was forfeited in the first quarter of 2006. Both forfeitures are reported as customer deposit forfeitures and reduced non-cash operating expenses in the respective quarters. The Company believes that the forfeitures of deposit are most likely associated with a change in strategic direction that came about as a result of the merger between Sanofi and Aventis and the resulting change in personnel. The eventual disposition of the remaining customer deposit, $2,000,000 required to be used before January 30, 2007, is not known at this time.

12. Notes Payable

     Total notes payable at September 30, 2006, are as follows:

																		Additional
																		Discount
																		from
																		Warrants
														December 31,				and				Discount								September 30,
		Stated				Effective								2005,				Beneficial				Amortization /								2006,
		Interest				Interest								Net				Conversion				Reversal /				Payments				Net
		Rate				Rate				Term				Book Value				Feature				Write-off				Made				Book Value
Convertible promissory note payable			8.22	%			37.41	%		NA				$	4,404,000			$	(573,000	)		$	1,169,000			$	(5,000,000	)		$	—
Promissory note payable			4.50	%			11.00	%			2007				2,226,000				—				322,000				—				2,548,000
Short-term promissory notes			6.99	%			6.99	%			2006				268,000				—				—				(231,000	)			37,000
Total notes payable														$	6,898,000			$	(573,000	)		$	1,491,000			$	(5,231,000	)		$	2,585,000

Convertible Promissory Notes Payable

     On November 2, 2004, the Company entered into purchase agreements with Omicron Master Trust (“Omicron”) and Amulet Limited (“Amulet”, together with Omicron, the “Investors”), in which the Company issued and sold to the Investors $20,000,000 aggregate principal amount of secured, convertible notes and warrants to purchase 1,000,000 shares of the Company’s common stock at an exercise price of $6.00 a share. The warrants are all exercisable and expire November 2, 2009. At the time the notes were issued, the Company’s common stock had a fair value of $4.88 per share.

     The Company incurred approximately $1,598,000 of financing costs associated with the original issuance of the convertible notes payable. This amount was deferred and amortized over the life of the notes using the effective interest method.

     In April 2005, the Company entered into amendments with the Investors to restructure the original purchase agreements signed in November 2004.

     Accounting treatment of the amended convertible promissory notes payable - The amended convertible promissory notes payable were valued by an independent third party who reassessed the value of the 1,000,000 initial warrants issued with the notes at $2,225,000 using a binomial model calculation.

     The Company accounted for the notes and related warrants using the provisions of EITF Issue No. 00-19 Accounting for Derivative Financial instruments Indexed to, and Potentially Settled in a Company’s Own Stock and APB No. 14 Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants. Under the provisions of EITF 00-19 the notes were recorded as a liability as they do not meet the requirements of being accounted for as equity. Under the provisions of APB No. 14, the proceeds received from the notes were allocated between the notes and the warrants based on their relative fair values at the time of issuance. Based on relative fair values at the time the notes were amended, the total discount on the convertible notes payable as of April 2005, was $2,086,000. This balance was amortized to interest expense using the effective interest method over the then-remaining term of the notes.

     The amended notes also contained a “beneficial conversion feature” resulting from the stock redemption being valued at the daily volume weighted average price less 10%. Per EITF Issue No. 98-5 Accounting for Convertible Securities with Beneficial Conversion Features of Contingently Adjustable Conversion Features and EITF Issue No. 00-27 Application of Issue No. 98-5 to Certain Convertible Instruments, the beneficial conversion feature is valued using the intrinsic value method based on the net book value of the amended notes after all discounts are taken into effect. Using this approach, the intrinsic value of the beneficial conversion feature was calculated to be $2,518,000. This amount was allocated to the discount against the notes and additional paid-in capital in 2005. This balance was fully amortized to interest expense using the effective interest method through December 31, 2005, the date of the last payment to which the beneficial conversion feature was applicable.

     The Company incurred approximately $287,000 of costs in relation to the amendments to the convertible promissory notes. These costs were recorded as a period expense in the first quarter of 2005. However, the remaining unamortized balance of the financing costs incurred in relation to the issuance of the initial notes on November 2, 2004, continued to be reported as a deferred financing cost asset and amortized over the then-remaining life of the amended notes using the effective interest method.

     2005 payment activity on the convertible promissory notes payable: Through a series of transactions beginning in May 2005, the Company made all required note payments ($10,000,000) using a combination of common stock ($8,409,000) and cash ($1,951,000). In accordance with the terms of the amended agreement, the Company issued 145,032 warrants equaling 70% of the common stock that would be issued to the investor to retire that portion of the principal paid in cash at $5.38 per share. These warrants were valued at $47,000 using the Black-Scholes Option Pricing Model.

     On December 30, 2005, the Company transacted an early extinguishment of 50% of the remaining outstanding balance of the convertible promissory notes payable ($5,000,000). As part of the partial debt extinguishment the Company paid the 5% early payment premium and all accrued interest. Additionally, per the amended terms of the notes, 650,558 warrants were issued equaling 70% of the common stock that would be issued to the investor to retire that portion of the principal paid in cash at $5.38 per share. These warrants were valued at $100,000 using the BSOPM.

     After all payments were made on the convertible promissory notes payable, the principal balance of the remaining note was $5,000,000, excluding any unamortized discounts, as of December 31, 2005.

     2005 and first quarter 2006 adjustments to the stock conversion price and warrant exercise price — The amended convertible promissory notes payable had certain weighted average anti-dilution clauses that adjust the debt conversion and warrant exercise price if the Company issued common stock below $6.00 per share. In the third quarter of 2005, the Company raised net proceeds of $24,201,000 through a private placement of common stock. As a result of this action, the number of warrants originally granted under the convertible promissory notes on November 2, 2004, increased from 1,000,000 to 1,115,244 and the exercise price of those warrants decreased from $6.00 per share to $5.38 per share. The conversion price of the convertible promissory note payable was also adjusted from $6.00 per share to $5.38 per share. The 115,244 additional warrants were valued at $153,000 using the BSOPM and recorded as additional discount on the convertible promissory note payable in 2005.

     In the first quarter 2006, the Company issued under the anti-dilution clauses of the amended notes an additional 51,053 warrants valued at $50,000 using the BSOPM and the exercise price on the warrants declined from $5.38 to $5.24. This action also caused the conversion price on the existing note payable to decrease from $5.38 to $5.24. Of the $50,000 value of the warrants, $10,000 was recorded as interest expense as 21,257 of the warrants related to 2005 payment activity. The remaining $40,000 was recorded as additional discount on the convertible promissory note, interest expense and additional paid-in capital.

     Of the 51,053 additional warrants issued in the first quarter of 2006, 12,550 were allocated to the various warrant tranches that were re-priced during 2005 based on the terms of the amended notes.

     Second quarter 2006 convertible promissory note payable and related warrant activity — As discussed further in Note 13, in April 2006, the Company issued 9,930,000 shares of its common stock and 5,958,000 warrants to purchase the Company’s common stock to various investors in a private placement transaction. Additional warrants for the purchase of 198,600 shares of common stock were issued to the underwriters of the private placement. The private placement had the following impacts on the warrants relating to the convertible promissory notes payable:

	•		Per anti-dilution terms included in the amended convertible promissory notes payable, the Company issued additional warrants to purchases 264,718 shares of common stock. These warrants expire on the following schedule: 22% in November 2006 and 2007, 10% in November 2008 and 46% in November 2009. The additional warrants were valued at $74,000 using the BSOPM and recorded as discount against the outstanding note and amortized to interest expense using the effective interest method.
	•		The exercise prices of the warrants relating to the convertible promissory notes payable were reduced from a range of $1.44 to $5.24 to a range of $1.42 to $4.47.
	•		The conversion price of the outstanding convertible promissory notes payable was reduced from $5.24 per share to $4.47 per share. The reduced conversion price caused the Company to record the intrinsic value of a beneficial conversion feature as the adjusted conversion price was reset to a price below the market price of the Company’s stock on the date the notes were originally issued (November 2, 2004). The intrinsic value of the adjusted conversion price is $459,000 and was recorded as additional discount on the remaining convertible promissory note payable and was amortized to interest expense using the effective interest method.

     On June 23, 2006, the Company and the remaining note holder agreed on terms for early extinguishment of the remaining $5,000,000 convertible promissory note payable. Based on the terms of the early extinguishment agreement the following actions were taken:

	•		The Company retired the full $5,000,000 using restricted cash and paid a $200,000 early payment premium plus accrued interest for a total payoff amount of $5,259,000.
	•		In accordance with the terms of the note, the Company issued warrants to the note holder to purchase an additional 782,998 shares of common stock at $4.47 per share. 50% of these warrants expire in November 2006 and 50% expire in November 2007. These warrants were valued at $6,000 using the BSOPM.

     Upon repayment of the convertible promissory note payable the Company wrote-off all unamortized discounts and deferred financing costs against the loss on extinguishment of debt. The total loss on extinguishment of debt was $871,000 and consisted of the following:

Early payment premium		$	200,000
Write-off of unamortized discount			449,000
Write-off of unamortized financing costs			216,000
Value of warrants issued upon extinguishment			6,000
Loss on extinguishment of debt		$	871,000

     The unamortized portion of the beneficial conversion feature recorded as a result of the April 2006 private placement of common stock was $365,000 on June 23, 2006. As the beneficial conversion feature could no longer be exercised at the time the convertible promissory note was repaid, the remaining $365,000 balance was reversed out of additional paid-in capital and discount on notes payable.

     Below is a summary of the outstanding warrants relating to the convertible promissory notes payable on September 30, 2006 (this table is not a summary of all warrants outstanding as of September 30, 2006, only those associated with the convertible promissory notes payable):

										Activity during Nine
										Months Ended September
		December 31, 2005								30, 2006								September 30, 2006
										Additional												Adjusted
		Warrants				Exercise				Warrants				Exercise				Warrants				Exercise
Warrant Grants:		Outstanding				Price				Issued				Price Adjustment				Outstanding				Price
Convertible promissory notes payable, initial warrants			450,422			$	5.38				241,120			$	(0.91	)			691,542			$	4.47
Re-pricing of initial warrants, Sept 23, 2005			118,672				2.15				11,640				(0.16	)			130,312				1.99
Re-pricing of initial warrants, Oct 28, 2005			87,442				1.82				6,600				(0.10	)			94,042				1.72
Re-pricing of initial warrants, Dec 1, 2005			125,914				1.69				8,950				(0.07	)			134,864				1.62
Re-pricing of initial warrants, Dec 9, 2005			217,550				1.44				8,958				(0.02	)			226,508				1.42
Additional warrants issued due to repricing for 2005 Private Placement			115,244				5.38				17,246				(0.91	)			132,490				4.47
Additional warrants issued due to 2005 cash payments on convertible promissory notes payable			795,590				5.38				21,257				(0.91	)			816,847				4.47
Additional warrants issued due to 2006 cash payments on convertible promissory notes payable			—				—				782,998				—				782,998				4.47
Warrants issued to the broker in conjunction with the note issuance			166,667				6.00				—				—				166,667				6.00
Total			2,077,501								1,098,769								3,176,270