TARANTELLA INC - 10-Q Quarterly Report

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 ¨ No x

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment ¨

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

The number of shares outstanding of the registrant’s common stock as February 27, 2004 was 26,957,851.

Tarantella, Inc. (the “Company”) is a leading provider of Internet infrastructure software that enables web-based access to enterprise applications from virtually any client device. Headquartered in Santa Cruz, California, Tarantella operates development centers in the United States, the United Kingdom and India with sales representatives in the U.S., U.K., Germany, Canada, France, the Netherlands, Spain and Italy. Tarantella products are sold through an integrated worldwide channel of Tarantella account executives, distributors, value-added resellers, systems integrators and computer and software manufacturers. Tarantella maintains exclusive distribution relationships in Japan as well as distribution and agent relationships in China, Northern and Southeast Asia. In total, Tarantella products are available through resellers in more than 30 countries.

The Company was incorporated in 1979 as a California Corporation under the name The Santa Cruz Operation (“SCO”), Inc. On May 4, 2001, SCO completed the sale of its Server Software and Professional Services Divisions to Caldera Systems, Inc., retaining the Tarantella Division. A new company, Caldera International, was formed which combined the assets acquired from SCO with the assets of Caldera Systems. Upon the completion of the sale, SCO changed its corporate name to Tarantella, Inc.

The Company’s flagship product, Tarantella Enterprise 3, a UNIX/Linux-based application access suite, is installed in corporations and governmental agencies around the world. Tarantella Enterprise 3 was introduced to the marketplace in 2001. Earlier client integration products, which are part of the Vision2K Suite, were introduced in the late 1990s and are currently still available. In June 2003, Tarantella acquired New Moon Systems Inc, and added New Moon Canaveral^™ iQ from Tarantella ^® (“Canaveral iQ”) to its product offering. Canaveral iQ is a Windows-based application access suite, intended for small to mid-sized business customers and departmental deployments with Windows-only infrastructure. In aggregate, Tarantella boasts over 12,000 customer sites including several of the most respected brands in the Fortune Magazine Global 2000.

In the opinion of management, the accompanying unaudited condensed consolidated statements of operations, balance sheets and statements of cash flows include all material adjustments (consisting of normal recurring adjustments) which the Company considers necessary for a fair presentation of its financial condition and results of operations as of and for the interim periods presented. The financial statements include the accounts of the Company and its wholly owned subsidiaries after all material intercompany balances and transactions have been eliminated. These condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s 2003 Annual Report on Form 10-K. The consolidated interim results presented are not necessarily indicative of results to be expected for a full year. The September 30, 2003 balance sheet was derived from audited financial statements, and is included for comparative purposes.

The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X.

The Company’s revenue is derived primarily from two sources, across many industries: (i) product license revenue, derived primarily from product sales to resellers and end users, including large scale enterprises and royalty revenue, derived primarily from initial license fees, ongoing royalties from product sales by source code OEMs, and software updates; and (ii) services and support revenue, derived primarily from support and education and consulting services to end users.

The Company accounts for revenue under the provisions of AICPA Statement of Position (“SOP”) 97-2, Software Revenue Recognition, as amended. Product revenue is recognized upon shipment if evidence of an arrangement exists, the fee is fixed and determinable and collection of resulting receivables is probable. Sales to distributors are recognized upon sale by the distributor to resellers or end users. In certain instances when distributors waive their right to return product, revenue is recognized upon shipment if evidence of an arrangement exists, the fee is fixed and determinable and collection of resulting receivables is probable. Estimated product returns are recorded upon recognition of revenue from customers having rights of return, including exchange rights for unsold products and product upgrades.

Software revenue is recognized using the residual method. Under the residual method, revenue is recognized if vendor-specific objective evidence of fair value exists for all the undelivered elements in an arrangement. Vendor-specific objective evidence of fair value is based on the price when the element is sold separately or, if not sold separately, is established by management. The fair value of services and post-contract support is determined based upon separate sales and renewal rates set forth in the contract, respectively.

The Company recognizes revenue from maintenance fees for ongoing customer support and product updates ratably over the period of the maintenance contract. Payments for maintenance fees are generally made in advance and are non-refundable. For revenue allocated to education and consulting services or derived from the separate sale of such services, the Company recognizes revenue as the related services are performed.

The Company recognizes product revenue from royalty payments upon receipt of quarterly royalty reports from OEMs (original equipment manufacturer) related to their product sales.

Subsequent to the issuance of the Company’s condensed consolidated financial statements for the three months ended December 31, 2002, the Company’s management determined that the accounting treatment initially afforded to certain transactions was not correct. As a result, the accompanying condensed consolidated financial statements have been restated as described below.

The Company announced that it had become aware of business practices in the Company’s Northern European territory that required immediate changes in sales personnel within the region and certain internal controls. After conducting an internal review of certain transactions in the Northern European territory as well as other domestic and international transactions, the Company’s management determined that it was necessary to restate revenues recorded in previous interim periods of fiscal 2003 and the fourth quarter of fiscal 2002.

In the first quarter of fiscal 2003, there were two revenue transactions, totaling $0.2 million, in Europe that did not sell out of the Company’s distributor, as the Company had believed. Since sales to distributors are recognized upon sell out by the distributor to resellers or end users, revenue for these transactions was reversed. One of these transactions sold out of inventory in subsequent quarters and revenue was recognized, and product for the other transaction was returned to the Company.

During the third quarter of fiscal 2003, the Company determined that there was a revenue transaction totaling $0.2 million in the first quarter of fiscal 2003 that should have been recorded when cash was received as the customer’s ability to pay was not certain. This transaction remains unpaid and revenue will be recognized upon receipt of cash.

There were also two additional transactions in the first quarter of fiscal 2003 in the United States totaling $0.2 million where the terms of the original transaction were amended. The amendment requires that the Company recognize such revenue no earlier than receipt of payment, which occurred in the third quarter of fiscal 2003 for both transactions.

As a result of the reversal of these revenues, there was also a reversal of the cost of goods sold, commission expense and cooperative (“COOP”) advertising expense associated with these revenues.

A summary of the significant effects of the restatements on previously reported condensed consolidated financial statements is as follows:

The Company is in contact with the Securities & Exchange Commission in connection with an informal inquiry related to the events leading up to the Company’s restatement.

In January 2003 the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities” and a revised interpretation of FIN No. 46 (“FIN No. 46-R”) in December 2003. FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Should the Company form a variable interest entity, FIN No. 46-R will be effective at that time, but not later than the quarter ending March 31, 2004.

The Company accounts for stock-based compensation arrangements under the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” for its fixed stock option plan and employee stock purchase plan and accordingly, has not recognized compensation cost in the accompanying condensed consolidated statement of operations for options issued at fair value. SFAS No. 123 permits the use of either a fair value based method or the intrinsic value method to measure the expense associated with stock-based compensation arrangements. The Company has recognized stock compensation costs for stock options granted at less than fair value on the date of grant.

In accordance with the interim disclosure provisions of SFAS No. 148, the pro forma effect on the Company’s net income (loss) had compensation expense been recorded for the three months ended December 31, 2003 and 2002, respectively, as determined under the fair value method, is shown below:

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model. The principal determinants of option pricing are fair market value of the Company’s common stock at the date of grant, expected volatility, risk-free interest rate, expected option lives and dividend yields. Weighted average assumptions employed by the Company were: expected volatility of 100% for the three months ended December 31, 2003, 94% for the three months ended December 31, 2002, a risk-free interest rate of 2.99% and 2.75% for the three months ended December 31, 2003 and 2002, respectively and no dividend yield for both periods. In addition, the Company assumed an expected option life of four years for non-executive employees and five years for executive employees.

Basic and diluted loss per share (“EPS”) were calculated as follows for the three months ended December 31, 2003 and 2002 (in thousands, except per share data):

The Company determined that it wanted to reduce the number of European countries in which it had a legal presence. In the first quarter of fiscal 2004, the Company implemented a restructuring which reduced the existing workforce by one employee. This reduction eliminated the Company’s presence in one European country. The Company recorded a charge of $19,000 for this restructuring for severance payments. The remaining balance was paid in the second quarter of fiscal 2004.

On July 24, 2003, the Company announced a restructuring plan, which resulted in a charge of $0.4 million. The Company reduced its spending levels to align its operating expenses with the Company’s lower than expected revenues. The restructuring included a reduction in staffing of 23 employees, and the disposal of fixed assets.

The expense included a severance charge of $0.4 million for the elimination of 12 positions in the United States and 11 positions in the United Kingdom. The reductions in force affected the product development, support, sales, marketing and general and administrative functions of the Company. There was also a charge of $6,508 for the disposal of fixed assets. As of December 31, 2003, 22 positions had been eliminated. The remaining 1 employee will terminate during the 2nd quarter of fiscal 2004.

On June 5, 2003, the Company announced a restructuring plan, which resulted in a charge of $0.2 million. Also, on June 5, 2003 the Company acquired New Moon Systems, Inc. (“New Moon”). In order to keep spending levels flat with pre-acquisition levels, the Company assessed the overall resource requirements for the combined business and reduced infrastructure accordingly.

The entire restructuring charge of $0.2 million was for severance, related to the elimination of 12 positions. The positions eliminated were 9 in the US, 2 in the UK and 1 in Germany. The reductions in work force affected the product development, sales, marketing and general and administrative functions of the Company. As of September 30, 2003, all 12 employees were terminated.

During the first quarter of fiscal 2003, the Company announced a restructuring plan, which resulted in a charge of $1.1 million. The Company reduced its spending levels to align its operating expenses with the Company’s continued lower than expected revenues.

A severance charge of $0.8 million included the elimination of 10 positions in the United States, 13 positions in the United Kingdom, and 2 positions in Italy. The reductions in work force affected the product development, sales, marketing and general and administrative functions of the Company. As of December 31, 2002, all 25 positions had been eliminated.

A facilities charge of $0.3 million was related to space the Company vacated at two locations in the U.K. This included a non-cash charge of $89,000 related to the write-off of leasehold improvements at the two vacated facilities.

The Company completed all of the cost reduction actions initiated in the first quarter of fiscal year 2003 during the fiscal year. Liabilities remain for lease obligation on one facility in the U.K. The lease for this facility expires at the end of the second quarter of fiscal 2004.

During the first quarter of fiscal 2002, the Company announced a restructuring plan, which resulted in a charge of $1.6 million. The Company reduced its spending levels to align its operating expenses with the Company’s lower than expected revenues. The restructuring included a reduction in staffing of 52 employees, a reserve for unused facilities at the Company’s corporate headquarters, and costs associated with closing several foreign offices.

This included a severance charge of $0.9 million for the elimination of 19 positions in the United States, 23 positions in the United Kingdom, and 10 positions in Japan. The reductions in force affected the product development, support, sales, marketing and general and administrative functions of the Company. As of March 31, 2002, all 52 positions had been eliminated.

Also included was a facilities charge of $0.7 million related to space the Company vacated. The Company had anticipated that it would sub-lease the space by December 31, 2002. As of September 30, 2003, the Company had not secured a sub-lease tenant, so provision adjustments of $0.5 million and $0.6 million were made at the end of fiscal 2003 and fiscal 2002, respectively. The space is now reserved through September 2004. The Company believes it will be able to sub-lease the space by that date. The lease for this building expires on June 30, 2005. In addition, a charge was taken for expenses associated with office closures in Japan and Brazil. There was a non-cash charge of $39,000 related to fixed asset disposals at the Japan subsidiary.

The Company completed the cost reduction actions initiated in fiscal 2002, with the exception of sub-leasing excess space at the Company’s corporate headquarters in Santa Cruz, California.

During the fourth quarter of fiscal 2001, the Company announced a restructuring plan, which resulted in a charge of $0.5 million. The restructuring charge included a reduction in personnel of 10 employees and a planned elimination of offices in Singapore and Australia. Total cash expenditures were $0.4 million.

The severance charge of $0.4 million included the elimination of 4 positions in the United States and 6 positions in the United Kingdom. The reductions in work force affected the sales, marketing and general and administrative functions of the Company. At September 30, 2001, all 10 positions had been eliminated. A provision adjustment of $64,000 was made to release excess restructuring reserve, which resulted from the fact that the Company had not anticipated that the Australian office would be sub-leased. The provision adjustment of $8,453 in the fourth quarter of fiscal 2003 was for the final costs associated with closing the Australian office.

During the second quarter of fiscal 2001, the Company announced a restructuring plan which resulted in a charge of $1.6 million, which when taken with a provision adjustment to a previously established restructuring reserve for severance related to the sale of divisions to Caldera, resulted in a net charge for the period of $1.1 million. The restructuring charge included a reduction in personnel of 28 employees and a reserve for unused facilities. Total cash expenditures were $1.6 million.

The $1.6 million restructuring charge included a severance charge of $1.5 million for the elimination of 16 positions in the United States, 4 positions in the United Kingdom, and 8 positions in various other geographies. The reduction in work force affected the sales, marketing and general and administrative functions of the Company. As of September 30, 2001, all 28 positions had been eliminated. The Company vacated additional space within its Santa Cruz, California office in the first quarter of fiscal 2002, and an additional charge of $81,000 was recorded for estimated payments on the lease for an additional 12 months. In the fourth quarter of fiscal 2002, an additional charge of $85,000 was recorded and in the fourth quarter of fiscal 2003, an additional charge of $64,000 was recorded because the facility was not yet sub-leased. The facility was not sub-leased as of September 30, 2003 and the restructuring reserve at the end of the fourth quarter of fiscal 2003 covers rents through September 30, 2004. The Company believes it will be able to sub-lease the space by that date. The lease for this building expires on June 30, 2005.

The following table presents information on revenue and long-lived assets by geography. Revenue is allocated based on the location from which the sale is satisfied and long-lived asset information is based on the physical location of the asset.

At December 31, 2003, the Company held 505,767 shares of Rainmaker stock. The Company accounts for this investment as available-for-sale, and accordingly, records it at fair market value based on quoted market prices. Any unrealized gains or losses are included as part of accumulated other comprehensive income. The fair market value of the investment at December 31, 2003 was $708,074 and the cost was $170,830 resulting in an unrealized gain of $537,244. Rainmaker’s common stock is traded on the Nasdaq under the symbol “RMKR”.

On November 14, 2002, the Board of Directors unanimously adopted resolutions approving and recommending to the shareholders for their approval a series of amendments to the Company’s Amended and Restated Articles of Incorporation to effect a reverse stock split of the Company’s Common Stock at a ratio to be determined by the Company’s Board of Directors. On February 27, 2003, the stockholders approved amendments to the Company’s Amended and Restated Articles of Incorporation to effect a reverse stock split. On May 19, 2003, the Board of Directors unanimously approved the implementation of a reverse split with a ratio of one for five. On June 6, 2003, the Company implemented a one-for-five reverse split and the Company’s outstanding common shares were reduced from 49.7 million shares to approximately 9.9 million shares. The reverse stock split has been retroactively reflected in the accompanying condensed consolidated financial statements and notes thereto for all periods presented.

On June 5, 2003, Tarantella completed the acquisition of New Moon Systems, Inc., a privately held California corporation (“New Moon “) pursuant to an Agreement and Plan of Reorganization (the “Agreement”), dated May 29, 2003. New Moon, headquartered in San Jose, CA, develops software to simply and cost-effectively manage and deploy Windows-based applications to end-user desktops in small and medium-sized businesses, as well as enterprise departmental customers. New Moon Canaveral ^™ iQ from Tarantella ^® (“Canaveral iQ”) extends the capabilities of Microsoft’s Windows Terminal Services and answers the demand for a simple and intelligent means of centrally managing remote applications.

Pursuant to the Agreement, Tarantella issued a total of 1,592,000 shares of Tarantella common stock valued at $3.6 million in exchange for all of the outstanding shares of New Moon and to satisfy its obligations to the former employees of New Moon. The fair value of the Company’s common stock was determined based on the average closing price per share of the Company’s common stock over the five day period including the two days before and after the terms of the acquisition were agreed to and announced. The New Moon shareholders shall also receive a minimum cash earnout of approximately $1.7 million over a period from January 1, 2004 to December 31, 2006 based on a royalty of 30% of New Moon product revenues, net of direct costs. After the shareholders have been paid the minimum earnout, they would be entitled to an additional royalty of 15% of New Moon product revenues, net of direct costs, during this period. In the event the minimum earnout is not achieved by the conclusion of the quarter ending December 31, 2006, Tarantella shall pay along with the final earnout payment an amount equal to the minimum earnout less all aggregate earnouts paid to date, less any off-sets and any escrow claim deficiencies. The Company also incurred approximately $0.3 million of direct merger costs, for a total purchase price of approximately $5.7 million.

The residual purchase price of $2.4 million was recorded as goodwill. Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, goodwill relating to the New Moon acquisition is not being amortized and will be carried at cost and tested for impairment annually and whenever events indicate that an impairment may have occurred. As of December 31, 2003, the Company has incurred acquisition costs of $331,000. This increased by $4,000 from September 30, 2003 since the Company incurred further legal costs related to the acquisition. The allocation of the purchase price to goodwill is subject to change as more information becomes available related to legal costs incurred for the acquisition.

The Company licenses its software and services pursuant to a software license agreement, in which the Company agrees to indemnify, hold harmless and defend the customer against damages arising out of claims filed by third parties that the Company’s products infringe any copyright or other intellectual property right. The term of the indemnification is generally perpetual, limited by applicable statutes of limitations. The license agreement generally limits the scope of the remedies for such indemnification obligation, including but not limited to certain product usage limitations and the right to replace an infringing product or modify it to make it non-infringing. If the Company cannot address the infringement by replacing or repairing the product, the Company is allowed to cancel the license and return the fees paid by the customer. The Company has never incurred expense under such indemnification provisions. The Company believes the estimated fair value of these indemnification agreements is minimal.

As permitted under California law, the Company has agreements whereby it indemnifies its officers and directors for certain events while the officer or director is, or was serving at the Company’s request in such capacity. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a Director’s and Officer’s insurance policy that limits the Company’s exposure and enables it to recover at least a portion of any future amounts paid. As a result of its insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is minimal.

The Company generally warrants for a period of 90 days that its software products will perform substantially in accordance with its published specifications, that the reproduction of the software on the media material provided by the Company is correct and that the documentation is correctly printed. In the event of any non-conformance, the Company agrees to repair, replace or accept return of the non-conforming product and refund any fees paid by the customer for said non-conforming product. The Company has never incurred significant expense under its product warranties. The Company believes the estimated fair value of these warranty agreements is immaterial.

On March 29, 2004 the Company announced the acquisition of privately held Caststream, Inc. (“Caststream”), developer of cast:stream Enterprise e-learning and presentation broadcasting software. Cast:stream incorporates real-time streaming audio and video, instant messaging synchronized with interactive, immersive, rich media. This creates advanced collaboration, learning and training presentations available via any Internet connection. As a result of the acquisition, Caststream will relocate its operations from its headquarters in Saratoga, California to Tarantella’s corporate headquarters in Santa Cruz, California. Steve Bannerman, Founder and CEO of Caststream, Inc. will continue as Tarantella’s Vice President of Corporate Marketing, a post he has held since December 2003. In addition to Mr. Bannerman, other Caststream employees have joined Tarantella in various technical, marketing and sales positions.

Under the terms of the transaction, Tarantella purchased all of the outstanding Caststream capital stock in exchange for a total of 200,000 shares of Tarantella common stock and warrants. In addition, Tarantella agreed to assume certain liabilities estimated to be approximately $40,000. The Tarantella stock and warrants are to be deposited into escrow for a one year period to fund Caststream’s indemnification obligations. Tarantella has agreed to register the common stock and warrants being issued to Caststream’s stockholders as soon as practicable once the Company has complied with its reporting obligations under the Securities Exchange Act of 1934, as amended. The acquisition is considered a related party transaction under applicable securities laws because certain Tarantella executive officers held a direct interest in Caststream prior to the transaction.

On January 6, 2004, the Company announced the appointment of John M. Greeley as Chief Financial Officer (CFO), reporting directly to Frank Wilde, the Company’s Chief Executive Officer. Mr. Greeley assumed the CFO responsibilities from Mr. Mohan, who had been serving as acting CFO since September 8, 2003.

On February 23, 2004, the Company announced the completion of a private placement of common stock and warrants to various investors. In the private placement, the investors purchased 11,678,580 shares of Tarantella common stock at a price of $1.40 per share for gross proceeds of $16,350,000. The investors also acquired warrants to purchase up to an additional 2,335,714 shares at an

exercise price of $1.70 per share. The warrants are exercisable for five years. If the warrants are fully exercised, the Company would receive additional gross proceeds of approximately $3,970,714. The Company also has agreed to register the shares of common stock issued to the investors as well as the shares issuable upon exercise of the warrants for resale once the Company has complied with its reporting obligations under the Securities Exchange Act of 1934, as amended. In connection with the financing, the Company will pay fees in the amount of $1,074,000 and issue warrants to purchase 142,500 shares at $1.54 per share and 180,000 shares at $1.70 per share. The warrants have lives of three and five years, respectively.

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s condensed consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q, as well as the Management’s Discussion and Analysis of Financial Condition and Result of Operations included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2003. In addition to historical information contained herein, this Discussion and Analysis contains forward-looking statements. These statements involve risks and uncertainties and can be identified by the use of forward-looking terminology such as “estimates,” “projects,” “anticipates,” “plans,” “future,” “may,” “will,” “should,” “predicts,” “potential,” “continue,” “expects,” “intends,” “believes,” and similar expressions. Examples of forward-looking statements include those relating to financial risk management activities and the adequacy of financial resources for operations. These and other forward-looking statements are only estimates and predictions. While the Company (also referred to as “Tarantella”) believes that the expectations reflected in the forward-looking statements are reasonable, the Company’s actual results could differ materially. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s expectations only as of the date hereof.

Tarantella is a leading provider of Internet infrastructure software that enables web-based access to enterprise applications.

Tarantella products provide managed and secure web access to enterprise mainframe, Windows, AS/400, Linux, and UNIX applications. It leverages existing IT assets to provide cost savings, improved productivity, and the flexibility to accommodate the rapid changes in today’s organizations.

Subsequent to the issuance of the Company’s condensed consolidated financial statements for the three months ended December 31, 2002 the Company’s management determined that the accounting treatment initially afforded to certain transactions was not correct. As a result, the accompanying condensed consolidated financial statements for the quarter ended December 31, 2002 have been restated.

The effects of the restatement are presented in Note 2 to the condensed consolidated financial statements and have been reflected in management’s discussion and analysis of financial condition and results of operations.

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts reported in the Company’s consolidated financial statements and the accompanying notes. Note 3 to the consolidated financial statements in our Annual Report on Form 10-K for the fiscal year ended September 30, 2003 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements for the three fiscal years in the period ended September 30, 2003. The amounts of assets and liabilities reported on the Company’s balance sheets and the amounts of revenues and expenses reported for each of our fiscal periods are affected by estimates and assumptions which are used for, but not limited to, the accounting for revenue, bad debts, product returns, certain accrued expenses, restructuring and liabilities and a valuation allowance for deferred tax assets. Actual results could differ from these estimates. The following critical accounting policies are significantly affected by judgments, assumptions and estimates used in the preparation of the condensed consolidated financial statements.

The Company’s revenue is derived primarily from two sources, across many industries: (i) products license revenue, derived primarily from product sales to resellers and end users, including large scale enterprises and royalty revenue, derived primarily from initial license fees, ongoing royalties from product sales by source code OEMs, and software updates; and (ii) services and support revenue, derived primarily from support and education and consulting services to end users.

The Company accounts for revenue under the provisions of AICPA Statement of Position (“SOP”) 97-2, Software Revenue Recognition, as amended. Product revenue is recognized upon shipment if evidence of an arrangement exists, the fee is fixed and determinable and collection of resulting receivables is probable. Sales to distributors, are recognized upon sale by the distributor to resellers or end users. In certain instances when distributors waive their right to return product, revenue is recognized upon shipment if evidence of an arrangement exists, the fee is fixed and determinable and collection of resulting receivables is probable. Estimated product returns are recorded upon recognition of revenue from customers having rights of return, including exchange rights for unsold products and product upgrades.

Software revenue is recognized using the residual method. Under the residual method revenue is recognized if vendor-specific objective evidence of fair value exists for all the undelivered elements in an arrangement. Vendor-specific objective evidence of fair value is based on the price when the element is sold separately or, if not sold separately, is established by management. The fair value of services and post contract support is determined based upon separate sales and renewal rates set forth in the contract, respectively.

The Company recognizes product revenue from royalty payments upon receipt of quarterly royalty reports from OEMs (original equipment manufacturer) related to their product sales.

The Company performs ongoing credit evaluations of its customers’ financial condition and does not require collateral. The Company maintains allowances for potential credit losses and such losses have been within management’s expectations.

The Company records a provision for product returns for related sales in the same period as the related revenues are recorded. These estimates are based on historical sales returns, analysis of credit memo data and other known factors. If the historical data the Company uses to calculate these estimates do not properly reflect future returns, revenue could be affected.

Payments from customers are continuously monitored and allowances are maintained for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. When evaluating the adequacy of allowances for doubtful accounts, various factors are taken into account, including accounts receivable aging, customer credit-worthiness, historical bad debts, and geographic and political risk. If the financial condition of customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. As of December 31, 2003, the Company’s net accounts receivable balance was $2.9 million.

Tarantella has operations in many countries other than the United States. Transfer prices for services provided between the United States and these countries have been documented as reasonable, however, tax authorities could challenge these transfer prices and assess additional taxes on prior period transactions. Any such assessment could require the Company to record an additional tax provision in its statement of operations.

Income tax assets and liabilities are determined by taxable jurisdiction. The Company evaluates net deferred tax assets in each tax jurisdiction by estimating the likelihood of the Company generating future profits to realize these assets. The Company has assumed that it will not generate sufficient future taxable income to realize these assets and has created valuation reserves to reduce the net deferred tax asset values to zero.

During fiscal 2004 and fiscal 2003, the Company recorded several reserves in connection with restructuring programs. These reserves include estimates for employee severance, facility redundancies and disposal of fixed assets. Actual costs have not differed materially from these estimates.

Intangible assets have been recorded in connection with the acquisition on New Moon Systems Inc. The cost of the acquisition was allocated to the assets and liabilities acquired, including identifiable intangible assets, with the remaining amount being classified as goodwill. Certain identifiable intangible assets such as purchased technology and customer lists are amortized to operating expense over time. Under current accounting guidelines adopted on July 1, 2002, goodwill will not be amortized to expense but rather periodically assessed for impairment. Accordingly, the allocation of the acquisition cost to identifiable intangible assets and goodwill has a significant impact on our future operating results. The allocation process requires extensive use of estimates and assumptions,

including estimates of future cash flows expected to be generated by the acquired assets. Further, when impairment indicators are identified with respect to previously recorded intangible assets, the values of the assets are determined using valuation techniques that require significant management judgment. Should conditions be different than management’s current assessment, material write-downs of intangible assets may be required. The Company will perform the annual goodwill impairment test as of July 1, 2004 to determine if there is any goodwill impairment. Under SFAS 142, goodwill and intangible assets of a reporting unit shall be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The Company believes that there has been no event as of December 31, 2003, that reduced the fair value of our reporting unit below the goodwill and intangible assets carrying amounts. The Company will perform evaluations more frequently if business conditions indicate an assessment in an interim period is warranted. The Company will periodically review the estimated remaining useful lives of other intangible assets. A reduction in estimate of remaining useful lives could result in increased amortization expense in future periods.

Certain prior period amounts have been reclassified to conform to current period presentation. These reclassifications had no significant impact on the financial statements for the periods presented.

On October 20, 2003, the Company announced that it had received notification from the Nasdaq Listing Qualifications Panel that the Company’s stock would discontinue trading on the Nasdaq SmallCap Market effective with the open of business on Tuesday, October 21, 2003.

This action followed Tarantella’s appeal to Nasdaq for a listing extension after not meeting the stated time requirements to file SEC Form 10-Q for the Company’s third fiscal quarter. The Nasdaq Panel determination to delist the Company’s stock was based on the Company’s filing delinquency, public interest concerns, and the nature of the ongoing internal revenue investigation. On December 8, 2003, the Company filed an appeal to reverse that portion of the Nasdaq Panel’s decision relating to its public interest concerns. On February 27, 2004, the Nasdaq advised the Company that its appeal had been denied.

Tarantella’s common stock is not currently eligible to trade on the OTC Bulletin Board but is eligible for quotation on the OTC Pink Sheets. The Company’s trading symbol has changed to TTLA.PK. Regaining SEC compliance may allow the Company’s shares to be eligible for trading on the OTC Bulletin Board. If the Company resumes compliance with the periodic reporting requirements of the 1934 Exchange Act, it will attempt to meet the listing requirements for the Nasdaq SmallCap Market, however some requirements such as minimum bid price and market capitalization are outside of the Company’s control.

The Company’s net revenues are derived from software licenses and fees for services.

Net revenues for the three months ended December 31, 2003 increased 18% to $3.5 million from $2.9 million in the same period in fiscal 2003. The increase in revenue performance, broken out geographically, was a $0.3 million increase in the United States, $0.3 million increase in Europe and $0.2 million increase in Canada and Latin America. The increase in these regions was partially offset by a $0.3 million decrease in Asia Pacific. The reason for the decrease in revenue in the Asia Pacific region was that there was a prepaid royalty of $0.3 for a large customer in Japan in the first quarter of fiscal 2003 that did not repeat in the first quarter of fiscal 2004. The increase in net revenues was mainly due to increased service revenues.

License revenues for the three months ended December 31, 2003 were $2.4 million. This is flat with the $2.4 million of license revenues for the three months ended December 31, 2002.

Service revenues increased to $1.1 million for the three months ended December 31, 2003, from $0.6 million in the same period in fiscal 2003, an increase of 89%. Service revenue was 32% of the total revenue for the first fiscal quarter of 2004, compared to 20% for the same period in the prior year. The increase in service revenues was a result of increased maintenance revenue for the US government and a large professional services contract in Spain.

International revenues were 63% of total revenues for the first fiscal quarter of 2004 and 67% for the same period in the prior year.

For the three months ended December 31, 2003, Clarity Technology, the Company’s U.K. distributor, accounted for 16% of the Company’s net revenues. For the three months ended December 31, 2002, Tomen Cyber Business Corporation, the Company’s Japanese distributor, accounted for 19% of the Company’s net revenues.

Cost of license revenues for the three months ended December 31, 2003 were $0.2 million compared to $0.1 million in the same period of fiscal 2003. The reason for the increase in cost of license revenues in fiscal 2004 was that the first quarter of fiscal 2004 included amortization for technology acquired from New Moon in the amount of $118,000. The first quarter of fiscal 2003 did not include any amortization for New Moon technology since the acquisition occurred during the third quarter of fiscal 2003.

Cost of service revenues for the three months ended December 31, 2003 were $0.3 million, flat compared to the same period in fiscal 2003. Although actual cost of service revenues remained flat, they declined as a percentage of service revenue, increasing gross margin from 56% in the first quarter of fiscal 2003, to 70% in the first quarter of fiscal 2004. The improvement in the services gross margin is a result of a higher percentage of the services revenue from maintenance contracts. Maintenance revenue has a higher margin than professional services revenue since there is very little labor involved.

Total cost of revenues as a percentage of net revenues increased to 14% in the first quarter of fiscal 2004 from 11% for the same period in fiscal 2003. Cost of revenues as a percentage of net revenue were higher because cost of revenues for the first quarter of fiscal 2004 included amortization for technology acquired from New Moon in the amount of $118,000. The first quarter of fiscal 2003 did not include any amortization for New Moon technology since the acquisition occurred during the third quarter of fiscal 2003.

Research and development expenses were basically flat at $1.0 million in the first quarter of fiscal 2004 compared to $1.0 million in the comparable quarter of fiscal 2003, and as a percentage of net revenues were 28% and 34%, respectively. The decrease in research and development as a percentage of net revenues is due to increased revenues.

Selling, general and administrative expenses increased 25% to $4.6 million in the first quarter of fiscal 2004 from $3.7 million for the comparable quarter of the prior year. The significant increase in expenses is due to increased legal and audit fees, which resulted from the revenue investigation. The Company incurred expenses of $0.9 million in the first quarter of fiscal 2004 for the revenue investigation and the subsequent audit. Over the past three quarters the Company has spent a total of $1.5 million on the revenue investigation and the subsequent audit. There was also an increase due to severance costs of $0.3 million, for one employee, paid in accordance with the Company’s change in control agreement, which was triggered by the private placement that was completed during the first quarter of fiscal 2004. For more information on the Company’s change in control agreements see Item 11 and Exhibit 10.35 in the Company’s 2003 Annual Report on Form 10-K. The increase in audit and legal fees and severance costs was partially offset by lower labor costs of $0.7 million. The lower labor costs were due to a headcount reduction from 77 employees down to 64. Selling, general and administrative expenses as a percentage of net revenues were 132% in the first quarter of fiscal 2004 and 124% in the same period in fiscal 2003.

Restructuring charges for the three months ended December 31, 2003 were $19,000, compared to $1.1 million for the three months ended December 31, 2002. The Company has substantially completed these plans as of December 31, 2003. See Note 5 for more details on restructuring charges.

Interest expense, net was $7,000 for the first quarter of fiscal 2004 compared to interest income, net of $32,000 for the same period in fiscal 2003. The decrease in interest income is due to lower interest-earning balance and greater interest bearing obligations in the first quarter of fiscal 2004.

Other expense, net was $50,000 in the first quarter of fiscal 2004, compared to $14,000 for the same period of fiscal 2003. The increase in other expense primarily relates to greater foreign exchange translation differences.

Income tax expense was $98,000 for the first quarter of fiscal 2004 compared to $60,000 for the same period in fiscal year 2003. The tax provisions for the first quarters of fiscal 2004 and fiscal 2003 reflect foreign taxes.

Net loss for the first quarter of fiscal 2004 was $2.8 million compared to net loss of $3.2 million for the same quarter of fiscal 2003. The decrease in net loss is primarily due to higher revenues and lower operating expenses.

The Company has financed its operations through cash flow from operations, private offerings of the Company’s common stock and bank borrowings. As of December 31, 2003, the Company’s principal source of liquidity included cash and cash equivalents of $3.9 million, representing 30% of total assets and an available bank line of credit under which the Company had no outstanding borrowings.

The credit agreement provides that the Company may borrow up to $1.5 million at 2.5% per month based on 75% of eligible accounts receivable. The line of credit has no financial covenants and is secured by the assets of the Company. The increase in cash and short-term investments of $0.7 million in the first quarter of fiscal 2004 is due to the completion of a private placement of common stock and warrants which resulted in net proceeds to the Company of approximately $2.5 million. The increase in cash due to proceeds from the private placement was partially offset by cash used for operating activities of $1.5 million and a reduction in borrowings on the line of credit of $0.3 million.

The Company’s operating activities used cash of $1.5 million during the first quarter of fiscal 2004, compared to $2.2 million used for operating activities in the first quarter of fiscal 2003. The decrease in the cash used for operating activities is due to a $0.6 million decrease in operating loss from the first quarter of fiscal 2003 to the first quarter of fiscal 2004. The operating loss was $2.6 million in the first quarter of fiscal 2004 compared to $3.2 million in the first quarter of fiscal 2003. Cash used in investing activities was $12,000 in the first quarter of fiscal 2004 compared to $127,000 in the first quarter of fiscal 2003. Cash provided by financing activities was $2.2 million in the first quarter of fiscal 2004 compared with cash used in financing activities of $2,000 for the same quarter of fiscal 2003. Cash provided by financing activities in the first quarter of fiscal 2004 includes proceeds from a private placement of $2.5 million, partially offset by a reduction of borrowing on the line of credit of $0.3 million.

The Company’s days sales outstanding (DSO) at December 31, 2003 was 75, an increase of 8 days from 67 days at December 31, 2002. DSO increased because the accounts receivable over 60 days increased from $12,000 to $220,000.

On December 26, 2003, the Company completed a private placement of common stock and warrants to the following investors: Special Situations Technology Funds, Starlight Digital Technologies, LLC, an investment group in which Mr. Wilde acts as Managing Director, and an additional private investor, resulting in gross proceeds to the Company of approximately $2,750,000. In connection with the financing, the Company paid placement fees in the amount of $232,303.

Subsequent to the end of the first quarter of fiscal 2004, the Company announced the completion of a private placement of common stock and warrants to various investors. In the private placement, which closed on February 23, 2004, the investors purchased 11,678,580 shares of Tarantella common stock at a price of $1.40 per share for gross proceeds of $16,350,000. The investors also acquired warrants to purchase up to an additional 2,335,714 shares at an exercise price of $1.70 per share. The warrants are exercisable for five years. If the warrants are fully exercised, the Company would receive additional gross proceeds of approximately $3,970,714. The Company also has agreed to register the shares of common stock issued to the investors as well as the shares issuable upon exercise of the warrants for resale once the Company has complied with its reporting obligations under the Securities Exchange Act of 1934, as amended. In connection with the financing, the Company will pay fees in the amount of $1,074,000 and issue warrants to purchase 142,500 shares at $1.54 per share and 180,000 shares at $1.70 per share. The warrants have lives of three and five years, respectively.

The Company has capital lease commitments of $32,000 in fiscal 2004. There are no capital lease commitments beyond fiscal 2004. The Company has operating lease commitments of $1.3 million in fiscal 2004. The Company’s various operating lease commitments extend to 2020.

The Company’s management believes that, based on the Company’s current plans, its existing cash and cash equivalents, short-term investments, cash received from private placements and funds generated from operations will be sufficient to meet its operating requirements for the next twelve months.

Set forth below and elsewhere in this filing and in other documents the Company files with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements in this filing.

The results of operations for any quarter or fiscal year are not necessarily indicative of the results to be expected in future periods. The Company’s operating results have in the past been, and will continue to be, subject to quarterly and annual fluctuations as a result of a number of factors, including but not limited to:

As a consequence, operating results for a particular future period are difficult to predict.

Any significant downturn in the Company’s customers’ markets, or domestic and global conditions, which result in a decline in demand for their software and services could harm the Company’s business. The state of the economy has had a negative impact on the software industry. This could result in customers continuing to delay or cancel orders for software. Any of these occurrences could have a significant impact on the Company’s operating results, revenues and costs and may cause the market price of the Company’s common stock to decline or become more volatile.

The Company’s future operating results may be affected by various uncertain trends and factors that are beyond the Company’s control. These include adverse changes in general economic conditions and rapid or unexpected changes in the technologies affecting the Company’s products. The process of developing new high technology products is complex and uncertain and requires accurate anticipation of customer needs and technological trends.

The Company depends on the development and acceptance of new products in a rapidly changing market.

The market for the Company’s products is characterized by rapidly changing technology, evolution of new industry standards, and frequent introductions of new products and product enhancements. The Company’s success will depend upon its continued ability to enhance its existing products, to introduce new products on a timely and cost-effective basis to meet evolving customer requirements, to achieve market acceptance for new product offerings, and to respond to emerging industry standards and other technological changes. There can be no assurance that the Company will be successful in developing new products or enhancing its existing products or that such new or enhanced products will receive market acceptance. The Company’s success also depends upon its ability to license from third parties and to incorporate into its products new technologies that become industry standards. There can be no assurance that the Company will continue to obtain such licenses on favorable terms or that it will successfully incorporate such third-party technologies into its own products.

The Company anticipates new releases of products in the fiscal year ending September 30, 2004. There can be no assurance that such new releases will not be affected by technical problems or “bugs”, as is common in the software industry. Furthermore, there can be no assurance that these or other future product introductions will not be delayed. Delays in the availability, or a lack of market acceptance, of new or enhanced products could have an adverse effect on the Company’s business. There can be no assurance that product introductions in the future will not disrupt product revenues and adversely affect operating results.

The Company competes in the highly competitive Internet infrastructure market.

The industry has become increasingly competitive and, accordingly, the Company’s results may also be adversely affected by the actions of existing or future competitors, including the development of new technologies, the introduction of new products, and the reduction of prices by such competitors to gain or retain market share. The Company’s results of operations could be adversely affected if it were required to lower its prices significantly.

The Company participates in a highly dynamic industry and future results could be subject to significant volatility, particularly on a quarterly basis. The Company’s revenues and operating results may be unpredictable due to the Company’s shipment patterns. The Company operates with little backlog of orders because its products are generally shipped as orders are received. In general, a substantial portion of the Company’s revenues have been booked and shipped in the third month of the quarter, with a concentration of

these revenues in the latter half of that third month. In addition, the timing of closing of large license contracts and the release of new products and product upgrades increase the risk of quarter to quarter fluctuations and the uncertainty of quarterly operating results. The Company’s staffing and operating expense levels are based on an operating plan and are relatively fixed throughout the quarter. As a result, if revenues are not realized in the quarter as expected, the Company’s expected operating results and cash balances could be adversely affected, and such effect could be substantial and could result in an operating loss and depletion of the Company’s cash balances.

Although the Company’s current business plan does not foresee the need for further financing activities to fund the Company’s operations for the foreseeable future, due to risks and uncertainties in the market place, the Company may need to raise additional capital. The Company may raise additional funds through public or private financing, strategic relationships or other arrangements. The Company cannot be certain that the funding, if needed, will be available on attractive terms, or at all. Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require the Company to relinquish its rights to certain of its technologies or products. If the Company fails to raise capital when needed, the business will be negatively affected, which could cause the stock price to decline.

The Company’s revenues may be affected by the seasonality of revenues in the European and government markets.

The Company experiences seasonality of revenues for both the European and the U.S. federal government markets. European revenues during the quarter ending June 30 are historically lower or relatively flat compared to the prior quarter. This reflects a reduction of customer purchases in anticipation of reduced selling activity during the summer months. Sales to the U.S. federal government generally increase during the quarter ending September 30. This seasonal increase is primarily attributable to increased purchasing activity by the U.S. federal government prior to the close of its fiscal year. Additionally, net revenues for the first quarter of the fiscal year are typically lower or relatively flat compared to net revenues of the prior quarter.

Cost of revenues may be affected by changes in the mix of products and services.

The overall cost of revenues may be affected by changes in the mix of net revenue contribution between licenses and services, geographical regions and channels of distribution, as the costs associated with these revenues may have substantially different characteristics. The Company may also experience a change in margin as net revenues increase or decrease since technology costs and services costs are fixed within certain volume ranges.

The Company’s results of operations could be adversely affected if it were to lower its prices significantly. In the event the Company reduced its prices, the Company’s standard terms for selected distributors would be to provide credit for inventory ordered in the previous 180 days, such credits to be applied against future purchases. The Company, as a matter of policy, does not allow product returns for a refund, unless the product is covered under the 90 day warranty period, the product is non-conformant and the Company cannot repair or replace the product. Product returns are generally allowances for stock balancing and are accompanied by compensating and offsetting orders. Revenues are net of a provision for estimated future stock balancing and excess quantities above levels the Company believes are appropriate in its distribution channels. The Company monitors the quantity and mix of its product sales.

If the Company fails to manage the distribution of its products and services properly, or if the Company’s distributors’ financial condition or operations weaken, the Company’s revenue could suffer.

The Company markets products directly and through resellers and distributors. Since direct sales may compete with the sales made by resellers and distributors, these resellers and distributors may elect to use other suppliers that do not directly sell their own products. Any increase in our commitment to direct sales could cause conflict with some of our channel partners. Further, some of the Company’s resellers and distributors may have insufficient financial resources and may not be able to withstand changes in business conditions, including economic weakness and industry consolidation. Revenue from indirect sales could suffer if the Company’s distributors’ and resellers’ financial condition weakens.

The Company is dependent upon information received from third parties in order to determine reserves for product returns.

The Company depends on information received from external sources in evaluating the inventory levels at distribution partners in the determination of reserves for the return of materials not sold, stock rotation and price protection. Significant effort has gone into developing systems and procedures for determining the appropriate reserve level. In the event information is not received timely or accurately, the Company’s ability to monitor the inventory levels will be affected and may negatively impact the Company’s business.

The Company’s business depends upon its proprietary rights and there is a risk that such rights will be infringed.

The Company attempts to protect its software with a combination of patent, copyright, trademark, and trade secret laws, employee and third party nondisclosure agreements, license agreements, and other methods of protection. Despite these precautions, it may be possible for unauthorized third parties to copy certain portions of the Company’s products or reverse engineer or obtain and use information the Company regards as proprietary. While the Company’s competitive position may be affected by its ability to protect its intellectual property rights, the Company believes that trademark and copyright protections are less significant to the Company’s success than other factors, such as the knowledge, ability, and experience of the Company’s personnel, name recognition, and ongoing product development and support. Further, certain provisions of the Company’s licenses, including provisions protecting against unauthorized use, copying, transfer, and disclosure of the licensed product, may be unenforceable under the laws of certain jurisdictions. In addition, the laws of some foreign countries do not protect the Company’s intellectual property rights to the same extent as do the laws of the U.S.

Risks of claims from third parties for intellectual property infringement could adversely affect the business.

As the number of software products in the industry increases and the functionality of these products further overlaps, the Company believes that software products will increasingly become subject to infringement claims. There can be no assurance that third parties will not assert infringement claims against the Company and/or against the Company’s suppliers of technology. In general, the Company’s suppliers have agreed to indemnify the Company in the event any such claim involves supplier-provided software or technology, but any such claim, whether or not involving a supplier, could require the Company to enter into royalty arrangements or result in costly litigation.

The Company’s business may be adversely affected by events outside the Company’s control.

While the Company has not been the target of software viruses specifically designed to impede the performance of the Company’s products, such viruses could be created and deployed against the Company’s products in the future. Similarly, experienced computer programmers or hackers could attempt to penetrate the Company’s network security or the security of the Company’s web sites. A hacker who penetrates the Company’s network or web sites could misappropriate proprietary information or cause interruptions of services. The Company might be required to expend significant capital and resources to protect against, or to alleviate, problems caused by virus creators and/or hackers. In addition, war, power shortage, natural disasters, acts of terror, and regional and global health risks could impact the Company’s ability to conduct business in certain regions. Any of these events could have an adverse effect on the Company’s business, results of operations, and financial condition.

The Company’s results of operations may be affected by fluctuations in foreign currency exchange rates.

Although the Company’s revenues are predominantly in U.S. dollars, substantial portions of the Company’s revenues are derived from sales to customers outside the United States. Trade sales to international customers represented 53%, 44% and 52% of total revenues for fiscal 2003, 2002 and 2001 respectively. The Company’s revenues can be affected by general economic conditions in the United States, Europe and other international markets. Also, portions of the Company’s operating expenses are transacted in foreign currencies. The Company’s operating strategy and pricing take into account changes in exchange rates over time. However, the Company’s results of operations may be significantly affected in the short term by fluctuations in foreign currency exchange rates.

The Company’s results of operations may be affected by the assessment of additional taxes.

The Company’s success largely depends upon its ability to retain and recruit key personnel.

The Company’s continued success depends to a significant extent on senior management and other key employees. None of these individuals is subject to a long-term employment contract or a non-competition agreement. The Company has historically used stock options and other forms of equity-related compensation as a key component to its employee compensation program in order to align employees’ interests with the interests of shareholders, encourage employee retention, and provide competitive compensation packages. In recent periods, a majority of the Company’s employee stock options have had exercise prices in excess of the Company’s stock price, which could affect the Company’s ability to retain or attract present and prospective employees. In addition, the Financial

Accounting Standards Board and other agencies have proposed, and are currently considering, changes to United States generally accepted accounting principles that would require the Company and other companies to record a charge to earnings for employee stock option grants and other equity incentives. These and other developments in the provision of equity compensation to employees could make it more difficult to attract, retain and motivate employees and result in additional expense to the Company. The loss of one or more key employees or the Company’s inability to attract and retain other key employees could have a material adverse effect on the Company.

Following the Company’s divestiture of its server software and professional services divisions in May 2001, the Company has not achieved profitability, and may never generate sufficient revenues to achieve profitability.

The Company is in contact with the Securities and Exchange Commission in connection with an informal inquiry related to the events leading up to the Company’s restatement. The Company cannot predict the outcome of this inquiry.

If the Company is unable to effectively integrate and develop the operations of New Moon Systems, Inc. (“New Moon”), the business may suffer.

The Company acquired New Moon in June 2003. The Company intends to integrate the operations, certain employees, products and technology of New Moon into its own, and faces various risks as a result of this acquisition including, but not limited to:

If the Company is not able to successfully integrate and develop New Moon’s business, the Company’s business may be negatively affected in future periods, which may cause the stock price to decline. In addition, if the value of intangible assets and goodwill acquired becomes impaired, the Company will be required to write down the value of the assets, which would negatively affect financial results. The Company may incur liabilities from New Moon including liabilities for IP infringement or indemnification of New Moon’s customers for similar claims, which could materially and adversely affect the business.

The Company may make future acquisitions that may result in additional risks.

The Company may continue to make investments in complementary companies, products or technologies. If the Company buys a company or a division of a company, they may experience difficulty integrating that company or division’s personnel and operations, which could negatively affect operating results. In addition:

In connection with future acquisitions, the Company may be required to assume the liabilities of the acquired companies. By assuming the liabilities, the Company may incur liabilities, including liabilities for IP infringement or indemnification of customers of acquired businesses for similar claims, which could materially and adversely affect the business. The Company may have to incur debt or issue equity securities to pay for any future acquisition, the issuance of which may involve restrictive covenants or be dilutive to existing shareholders.

The Company’s stock is subject to substantial price and volume fluctuations due to a number of factors, many of which are beyond its control, and those fluctuations may prevent shareholders from reselling their common stock at a profit.

The stock market in general, and the market for shares of technology companies in particular, has experienced extreme price and volume fluctuations, which have often been unrelated to the operating performance of the affected companies. Strategic factors such as new product introductions, acquisitions or restructurings by the Company or its competitors may have a significant impact on the market price of the Company’s common stock. Furthermore, quarter-to-quarter fluctuations in operating results may have a significant impact on the market price of the stock. These conditions, as well as factors that generally affect the market for stocks of high technology companies, could cause the price of the Company’s stock to fluctuate substantially over short periods.

The Company’s stock was de-listed by the Nasdaq on October 21, 2003, and is now quoted on the Over-the-Counter (“OTC”) Pink Sheets. Trading the Company’s stock may be more difficult due to the limited trading activity on the OTC market. This could cause a further decline in the Company’s stock price. Declines in the market price of the Company’s stock could greatly impair the Company’s ability to raise capital through equity or debt financing.

Former New Moon shareholders will have the ability to sell a large number of shares of Tarantella common stock, which may cause the trading price of the Company’s common stock to decline.

In connection with the acquisition of New Moon, the Company issued approximately 1,592,000 shares (calculated after the 1-for-5 reverse stock split which was implemented on June 6, 2003) of the Company’s common stock to former New Moon shareholders. During the one year period following the closing of the acquisition, the aggregate number of shares of common stock sold in any calendar quarter by each of the former New Moon shareholders shall not exceed 25% of the aggregate number of shares of common stock issued to such former New Moon shareholders pursuant to the acquisition; provided, however, that the percentage tradable in any calendar quarter shall be increased by an amount proportionate to the amount by which the trading volume of common stock exceeds 15,000,000 shares in the prior quarter. Furthermore, if the Company grants registration rights or issues shares of capital stock as part of a subsequent acquisition of the stock or assets of another company, and the sale of such stock is not subject to volume restrictions, then the 25% limitation described in the previous sentence will no longer be in effect. With the exception of the limitations set forth in this paragraph, the Company does not have any control over the timing of any sales by the former New Moon shareholders. As a result, the market price of the Company’s common stock may fall if a large portion of those shares is sold in the public market.

Reference is made to part II, Item 7A, Quantitative and Qualitative Disclosures about Market Risk, in the Company’s Annual Report on Form 10-K for the year ended September 30, 2003.

The events cited in this report are the subject of the restatement that resulted from material weaknesses in the Company’s system of internal controls and operations. The Company has taken and intends to continue to take measures to cure these weaknesses, which include changes in senior management and tightening internal policies and procedures.

The Company has carried out an evaluation, under the supervision and with the participation of its management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. It should be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. Based upon their evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that disclosure controls and procedures are effective to ensure that material information required to be disclosed in the Company reports that are filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, except as noted below with respect to the restatement.

Due to the matters that caused the restatement of the audited consolidated financial statements and related notes for the three and twelve months ended September 30, 2002 and the unaudited condensed consolidated financial statements and related notes for the three months ended December 31, 2002 and three and six months ended March 31, 2003, the Company has taken a number of steps to improve the effectiveness of internal controls, including the following:

The Company now requires extensive sales certifications from all sales representatives and systems engineers to be provided to the Company’s finance department.

The Company now requires proof of an end user purchase order when fulfilling transactions over $25,000.

The Company now requires all distributors to submit sales out reports and inventory reports prior to the closing of a financial period.

The Company drafted a revenue recognition handbook and distributed to all sales personnel. Each person in sales has certified they have read and understand the handbook.

We believe that these efforts have addressed the material weaknesses and significant deficiencies that affected our internal controls in 2002 and 2003. The Company continues to improve and refine its internal controls. This process is ongoing, and the Company seeks to foster an exemplary internal control environment.

Other than as summarized above, there has been no change in the Company’s internal control over financial reporting that occurred during the most recent fiscal quarter that has materially affected or is reasonably likely to materially affect the Company’s internal control over financial reporting. The Company will continue to assess disclosure controls and procedures and will take any further actions that are deemed necessary.

On August 28, 2003, a former Tarantella sales representative filed an action against Tarantella, Inc. and Tarantella International, Inc., a wholly owned subsidiary of Tarantella, (collectively, “Tarantella”) in the California Superior Court in Santa Clara County, California. The complaint purports to state claims for breach of contract, negligent and intentional misrepresentation, fraud, and deceit. The complaint alleges that the plaintiff is owed commissions on certain sales of Tarantella products, and seeks an unspecified amount of damages, correction of the purported contract, prejudgment interest, punitive damages and costs. On September 25, 2003, Tarantella filed a response denying the claims and asserting affirmative defenses. The case is presently in the discovery stage.

Tarantella believes the allegations contained in the complaint are without merit and intends to defend the action vigorously. Should the plaintiff’s claims succeed, however, Tarantella could be required to pay monetary damages, which could have a material adverse effect on Tarantella’s business, financial position and results of operations.

No other material legal proceedings are pending to which the Company is a party.

On December 26, 2003, the Company completed a private placement of common stock and warrants resulting in gross proceeds to the Company of approximately $2,750,000. In connection with the financing, the Company paid fees in the amount of $232,303. In the private placement, the investors purchased 2,750,000 shares of Tarantella common stock at a price of $1.00 per share. The investors also acquired warrants to purchase up to an additional 550,000 shares at an exercise price of $1.39 per share. The warrants are exercisable for five years. The Company also has agreed to register the shares of common stock issued to the investors as well as the shares issuable upon exercise of the warrants for resale once the Company has complied with its reporting obligations under the Securities Exchange Act of 1934, as amended and is permitted to register its securities under the securities laws. In connection with the investment, the Company also amended its existing shareholder rights plan such that Special Situations shall be permitted to acquire up to 30% beneficial ownership of the outstanding stock of the Company without triggering the Company’s shareholder rights plan, provided that for purposes of determining Special Situations’ beneficial ownership, neither the warrants nor any future exercises of warrants will be considered.

The Company filed the following Report on Form 8-K during the quarter ended December 31, 2003.

On December 11, 2003, Tarantella, Inc. filed a Report on Form 8-K announcing that the Board of Directors of the Company had appointed Frank Wilde as the President, CEO and Director of the Company, replacing Doug Michels. The Company further announced that it had signed definitive agreements for a private placement of common stock and warrants with a group of investors.

On October 21, 2003, Tarantella, Inc. filed a Report on Form 8-K announcing that the Company had received notification from the Nasdaq Listing Qualifications Panel that the Company’s stock would discontinue trading on the Nasdaq SmallCap market at commencement of business on October 21, 2003.

On October 2, 2003, Tarantella, Inc. filed a Report on Form 8-K announcing that the Company had entered into a Purchase Agreement dated September 29, 2003, by and among Tarantella, Inc. and certain investors named therein (the “Agreement”). Pursuant to the Agreement, Special Situations Funds purchased 1,462,500 shares and Vertical Ventures purchased 487,500 shares of the Company’s common stock at the average closing bid price per share for the last five trading days, or $1.156 per share. The transactions contemplated in the Agreement closed on September 30, 2003. The Agreement also includes accompanying warrants to purchase an aggregate of 1,950,000 shares (at equal numbers of shares purchased by each investor) at a price of $1.395 per share.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


TARANTELLA, INC.

		/s/ JOHN M. GREELEY
		John M. Greeley Vice President, Chief Financial Officer April 2, 2004

		/s/ JENNY TWADDLE
		Jenny Twaddle Vice President, Corporate Controller April 2, 2004


425 Encinal Street, Santa Cruz, California		95060
(Address of principal executive office)		(Zip Code)


			Page
*Part I.*	*Financial Information*

	Item 1.	Financial Statements

		a) Condensed Consolidated Statements of Operations for the three months ended December 31, 2003 and 2002 (restated)	3

		b) Condensed Consolidated Balance Sheets, as of December 31, 2003 and September 30, 2003	4

		c) Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2003 and 2002 (restated)	5

		d) Notes to Condensed Consolidated Financial Statements	7

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21

	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	31

	Item 4.	Controls and Procedures	31

*Part II.*	*Other Information*

	Item 1.	Legal Proceedings	32

	Item 2.	Changes in Securities and Use of Proceeds	32

	Item 3.	Defaults Upon Senior Securities	32

	Item 4.	Submission of Matters to a Vote of Security Holders	32

	Item 5.	Other Information	32

	Item 6.	Exhibits and Reports on Form 8-K	33

	*Signatures and certifications*		34


	Three Months Ended December 31,
	2003			2002 (As restated, see Note 2)
	(Unaudited)
Net revenues:
Licenses	$	2,366		$	2,362
Services		1,102			583

Total net revenues		3,468			2,945

Cost of revenues:
Licenses		168			56
Services		330			258

Total cost of revenues		498			314

Gross margin		2,970			2,631

Operating expenses:
Research and development		961			987
Selling, general and administrative		4,585			3,661
Restructuring charge		19			1,147

Total operating expenses		5,565			5,795

Operating loss		(2,595	)		(3,164	)

Other income (expense):
Interest income (expense), net		(7	)		32
Other expense, net		(50	)		(14	)

Total other income (expense)		(57	)		18

Loss before income taxes		(2,652	)		(3,146	)

Income tax expense		98			60

Net loss		(2,750	)		(3,206	)

Other comprehensive income:
Unrealized gain on available for sale securities		75			283
Foreign currency translation adjustment		69			(4	)

Total other comprehensive income		144			279

Comprehensive loss	$	(2,606	)	$	(2,927	)

Net Loss per share:
Basic and diluted	$	(0.22	)	$	(0.39	)
Shares used in net loss per share calculation:
Basic and diluted		12,689			8,206


*(In thousands)*	December 31, 2003			September 30, 2003
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	3,850		$	3,151
Available-for-sale equity securities		708			632
Trade receivables, net of allowances of $0.4 million at December 31, 2003 and $0.5 million at September 30, 2003		2,894			2,980
Other receivables		179			175
Prepaids and other current assets		630			720

Total current assets		8,261			7,658

Property and equipment, net		612			734
Acquired intangible assets, net		1,144			1,262
Goodwill		2,395			2,391
Other assets		427			343

Total assets	$	12,839		$	12,388

Liabilities and shareholders’ equity
Current liabilities:
Trade payables	$	745		$	1,043
Line of credit		—			319
Royalties payable		—			22
Royalties payable - former New Moon shareholders		1,723			1,725
Income taxes payable		546			549
Accrued restructuring charges		631			854
Accrued expenses and other current liabilities		4,204			3,615
Deferred revenues		2,116			1,757

Total current liabilities		9,965			9,884

Long-term deferred revenues		472			36

Total long-term liabilities		472			36

Shareholders’ equity:
Preferred stock, authorized 20,000 shares; no shares issued and outstanding		—			—
Common stock, no par value, authorized 100,000 shares; issued and outstanding 15,279 at December 31, 2003 and 11,959 shares at September 30, 2003		129,819			126,749
Deferred stock compensation		(530	)		—
Accumulated other comprehensive income		697			553
Accumulated deficit		(127,584	)		(124,834	)

Total shareholders’ equity		2,402			2,468

Total liabilities and shareholders’ equity	$	12,839		$	12,388


	Three Months Ended December 31,
*(In thousands)*	2003			2002 (As restated, see note 2)
	(Unaudited)
Cash flows from operating activities:
Net loss	$	(2,750	)	$	(3,206	)
Adjustments to reconcile net loss to net cash used for operating activities:
Depreciation and amortization		270			212
Foreign currency exchange loss (gain)		43			(6	)
Loss on disposal of property and equipment		1			79
Stock compensation expense		22			—
Changes in operating assets and liabilities, net of New Moon acquisition:
Trade receivables		85			507
Other receivables		(4	)		—
Prepaids and other current assets		90			102
Other assets		(84	)		262
Trade payables		(298	)		(189	)
Royalties payable		(22	)		(53	)
Income taxes payable		(3	)		222
Accrued restructuring expenses		(223	)		446
Accrued expenses and other current liabilities		607			(606	)
Deferred revenues		795			3

Net cash used in operating activities		(1,471	)		(2,227	)

Cash flows from investing activities:
Purchases of property and equipment		(6	)		(127	)
Additional New Moon purchase acquisition costs		(4	)		—
Change in royalties payable - former New Moon shareholders		(2	)		—

Net cash used in investing activities		(12	)		(127	)

Cash flows from financing activities:
Payments on capital lease obligations		(18	)		(2	)
Line of credit payments		(319	)		—
Net proceeds from issuance of common stock and warrants		2,518			—

Net cash provided by (used in) financing activities		2,181			(2	)

Effects of exchange rate changes on cash and cash equivalents		1			2

Increase (decrease) in cash and cash equivalents		699			(2,354	)
Cash and cash equivalents at beginning of period		3,151			7,055

Cash and cash equivalents at end of period	$	3,850		$	4,701

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	Three Months Ended December 31, 2002 (Unaudited)
	As Previously Reported *			Restated
License revenues	$	3,002		$	2,362
Cost of license revenues		69			56
Research and development		979			987
Selling, general and administrative		3,723			3,661
Net loss		(2,633	)		(3,206	)

Loss per share:
Basic and diluted	$	(0.32	)	$	(0.39	)
Shares used in loss per share calculation:
Basic and diluted		8,206			8,206


	Three Months Ended December 31,
	2003			2002
	(In thousands, except per share data)

Net income (loss), as reported	$	(2,750	)	$	(3,206	)

Add: Stock-based employee compensation expense included in reported net loss		22			—

Less: Total stock-based employee compensation expense determined under fair value based method for all awards		(1,125	)		(1,386	)


Pro forma net loss	$	(3,853	)	$	(4,592	)

Net loss per share as reported
Basic and diluted	$	(0.22	)	$	(0.39	)

Pro forma net loss per share
Basic and diluted	$	(0.30	)	$	(0.56	)


*(In Thousands)*	Reduction in Force			Total
Restructuring charge accrued	$	19		$	19
Payments/utilization of the accrual		(15	)		(15	)

Accrual at December 31, 2003		4			4


*(In Thousands)*	Reduction in Force			Disposal of Fixed Assets			Total
Restructuring charge accrued	$	442		$	6		$	448
Payments/utilization of the accrual		(393	)		(6	)		(399	)

Accrual at September 30, 2003		49			—			49

Payments/utilization of the accrual		(24	)		—			(24	)
Provision Adjustment		—			—			—

Accrual at December 31, 2003	$	25		$	—		$	25


*(In Thousands)*	Reduction in Force			Facilities			Disposal of Fixed Assets			Total
Restructuring charge accrued	$	820		$	238		$	89		$	1,147
Payments/utilization of the accrual		(408	)		(24	)		(89	)		(521	)

Accrual at December 31, 2002		412			214			—			626

Payments/utilization of the accrual		(240	)		(74	)		—			(314	)

Accrual at March 31, 2003		172			140			—			312

Payments/utilization of the accrual		(113	)		(33	)		—			(146	)
Provision Adjustment		(59	)		—			—			(59	)

Accrual at June 30, 2003		—			107			—			107

Payments/utilization of the accrual		—			(34	)		—			(34	)

Accrual at September 30, 2003		—			73			—			73

Payments/utilization of the accrual		—			(23	)		—			(23	)

Accrual at December 31, 2003	$	—		$	50		$	—		$	50


	Three Months Ended December 31,
	2003		2002
	*(In thousands)*
Net revenues:
United States	$	1,278	$	963
Canada and Latin America		320		177
EMEIA (1)		1,534		1,186
Asia Pacific		336		602
Corporate adjustments		—		17

Total net revenues	$	3,468	$	2,945


	December 31, 2003		September 30, 2003
	*(In thousands)*
Long-lived assets:
United States	$	4,242		4,381
EMEIA (1)		336		349

Total long-lived assets	$	4,578	$	4,730


	December 31, 2003
	Gross Carrying Amount		Estimated Useful Lives	Accumulated Amortization		Intangible Assets, Net
	*(In thousands)*		*(In years)*
Amortized intangible assets
Technology	$	500	3	$	97	$	403
Patents		700	3		136		564
Trademarks		200	3		39		161
Other		20	3		4		16

Total	$	1,420		$	276	$	1,144

Aggregate amortization expense:

For three months ended December 31, 2002	$	0

For three months ended December 31, 2003	$	118

Estimated remaining amortization expense:

For year ending September 30, 2004	$	355

For year ending September 30, 2005		473

For year ending September 30, 2006		316

	$	1,144


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

31.2		Certification of Chief Financial Officer Pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as Adopted Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer Pursuant To 18 U.S.C. Section 1350, as Adopted Pursuant To Section 906 Of the Sarbanes-Oxley Act of 2002

32.2		Certification of Chief Financial Officer Pursuant To 18 U.S.C. Section 1350, as Adopted Pursuant To Section 906 Of the Sarbanes-Oxley Act of 2002