Overview

      Zix Corporation operates in a single industry segment, providing solutions that protect, manage and deliver sensitive electronic information. By offering a comprehensive set of products and services, the Company protects organizations from viruses and spam, provides the management tools needed for Web access control and policy-driven email encryption, and provides care delivery solutions for e-prescribing and e-consulting that enable physicians to leverage technology for better patient care.

      In 1998 and prior years, the Company provided systems and solutions for the intelligent transportation, electronic security and other markets. The Company sold all of its operating units in 1998 and began evaluating new Internet-related business opportunities. The Company perceived a need for products and services to bring privacy, security and convenience to Internet communications and since January 1999, the Company has been developing and marketing products and services that bring privacy, security and convenience to Internet users. In the first quarter of 2001, the Company began charging for the use of ZixMail, its initial product in the secure e-messaging space, and began focusing its sales and marketing efforts toward the business market. In 2002 and 2003, the Company significantly expanded its portfolio of commercial products and services, as detailed in Item 1. “Business — Products and Services” above, and rebuilt its sales and marketing work force under new executive leadership. The Company has targeted the healthcare sector, where the legislated mandates of the Health Insurance Portability and Accountability Act, a 1996 law that requires Protected Health Information to be safeguarded over open networks, are driving demand. The privacy regulations for this law took effect in April 2003.

      In July 2003, the Company acquired substantially all of the operating assets and the business of Ohio-based PocketScript, LLC (“PocketScript”), a privately-held development stage enterprise which provides electronic prescription solutions for the healthcare industry. This acquisition enables the Company to expand its services into the e-prescription marketplace, which is expected to grow significantly as more physicians are leveraging technology in delivering care, coupled with the fact that the number of prescriptions written annually in the United States continues to increase. 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. This acquisition enables the Company to add a robust feature set to its anti-spam, anti-virus, and content filtering services while expanding its offerings to include Web filtering. Both PocketScript and Elron Software have incurred operating losses in recent years.

15

Table of Contents

      The foundation of the Company’s business model is centered around the financial leverage expected to be generated by its various subscription and transaction based revenues that are believed to be predominantly recurring in nature and an efficient cost structure for its secure data center operations, the core of which is expected to remain relatively stable. Subscription fees are generally expected to be collected annually at the beginning of the subscription period and are recognized as revenue on a prorated basis over the length of the subscription period.

      Anacom Communications, Inc. (“Anacom”), a privately-held provider of real-time transaction processing services to Internet merchants purchased by the Company in October 1999, ceased operations in June 2001. Anacom was purchased in conjunction with the Company’s development of a potential product, ZixCharge ^TM , which was never commercially released. Operating losses and liquidity have been favorably impacted by Anacom’s shut-down, as Anacom recorded operating losses, excluding non-cash charges, of $1,091,000 for 2001.

      Operating in emerging markets involves risks and uncertainties, and there are no assurances that the Company will be successful in its efforts. Successful growth of an early stage enterprise, particularly Internet-related businesses, is costly and highly competitive. The Company’s growth depends on the timely development and market acceptance of its products and services. In 2002 and 2003, the Company and its recent acquisitions have incurred significant operating losses during their development stage activities and the utilization of cash resources has continued at a substantial level. The Company anticipates further operating losses in 2004.

Results of Operations

      The Company was in the development stage and had no significant revenues in 2001 and 2002. Substantially all of the Company’s revenues in 2001 were generated by Anacom, which ceased operations in June 2001. The Company first began charging for its secure e-messaging products and services in the first quarter of 2001. Revenues from subscription services are recognized as the services are rendered. Subscription fees received from customers in advance are recorded as deferred revenue and recognized as revenues ratably over the subscription period. Revenues for 2002 of $1,672,000 were primarily comprised of the amortization of subscription fees generated from U.S. businesses and $936,000, or 56% of annual revenues, resulting from the pro-rata recognition of the future minimum payments associated with the Company’s Marketing and Distribution Agreement (the “Marketing Agreement”) with Entrust, Inc. (“Entrust”). Additionally, in March 2002, the Company cancelled its agreement with 911 Computer Co., Ltd. (“911”), its exclusive distributor in South Korea, for failure to pay scheduled installment payments when due. As a result, the $100,000 minimum payment previously received from 911 was included in 2002 revenues.

      Revenues increased from $1,672,000 in 2002 to $5,840,000 in 2003 due primarily to an increase of approximately $2,846,000 in amortization of secure e-messaging subscription fees generated from new U.S. corporate customers primarily in the healthcare sector, $288,000 associated with the cancellation of the Company’s Japanese distributor agreement, and $706,000 in email content and Web filtering software sales as well as $544,000 in related maintenance following the acquisition of Elron Software on September 2, 2003. Deferred maintenance revenue acquired in connection with the acquisition of Elron Software was recorded at $776,000, its fair value on the acquisition date in accordance with generally accepted accounting principles, resulting in a 59% reduction in the pre-acquisition balance. Therefore, assuming the affected product maintenance contracts are renewed, reported maintenance revenue should begin to increase quarter over quarter in the near term as the full contract values of such renewal contracts are amortized ratably to revenue. Elron Software products are offered to customers under perpetual license agreements. The Company recognizes revenue on these arrangements after all of the following occur: persuasive evidence that an arrangement exists, the software is delivered, collection is probable, fees are fixed and determinable, and vendor-specific objective evidence of fair value (VSOE) exists to allocate the total fees to the elements of the arrangement. These software licenses are sold as part of a multiple element arrangement that includes

16

Table of Contents

      Quarterly service revenues from January 2002 through June 30, 2003 included $234,000 per quarter resulting from the pro-rata recognition of certain minimum payments associated with the Marketing Agreement with Entrust. These minimum payments aggregating $3,750,000 were being recognized as revenue ratably over the four year maximum service period ending in December 2005. Entrust paid the Company a $1,000,000 guaranteed minimum payment in January 2003. In July 2003, the Company and Entrust mutually agreed to terminate their Marketing Agreement, because the Marketing Agreement, as structured, no longer served their respective business interests. In connection with the termination of the Marketing Agreement, Entrust paid the Company $700,000 and the scheduled minimum guaranteed payments to have been made in 2004 and 2005, totaling $2,750,000, were cancelled. As a result of the termination of this contract service revenues for the third quarter of 2003 included $296,000, which represents the final revenues to be recognized under this contract. Entrust accounted for 13% of the Company’s revenues in 2003.

      In 2003, the Company organized HealthyEmail, Inc., a nonprofit organization established for the purpose of promoting the responsible use of email in the healthcare sector. HealthyEmail, Inc. and the Company have committed to provide ZixMail licenses at no cost to physicians and two members of their office staff for a two year period to enable the healthcare industry to meet HIPAA privacy requirements, which could potentially have an impact on the Company’s revenue opportunities and overall sales margins.

      The Company’s end-user order backlog as of December 31, 2003, which includes deferred revenue on the Company’s consolidated balance sheet, increased to approximately $13,000,000, which includes approximately $4,900,000 associated with its newly acquired products and services including electronic prescription solutions, email content filtering and Web filtering. The Company’s backlog is comprised mainly of service contracts for product maintenance and support, secure messaging, and electronic prescription solutions. Approximately 65% to 75% of this backlog is expected to be recognized as revenue in 2004, reflecting a mix between single and multi-year service contracts and the anticipated timing of the deployment of e-prescribing services.

      The Company currently generates revenues from the sale of perpetual software licenses, transaction fees associated with providing e-prescription solutions, and service-based contracts for product maintenance, secure messaging, and e-prescription solutions which are amortized to revenue ratably over their respective service periods. Management uses several general metrics to estimate future revenue growth. These metrics include: technology adoption rates in the markets served by the Company, overall order input, renewal rate (customer retention) of service contracts, mix of single or multi-year service contracts and deployment statistics for the Company’s products and services. As the market for e-prescription solutions matures, the deployment of e-prescribing devices to physicians and the prescription volume written by such physicians are important metrics, as the device and its use are a platform for various revenue sources.

      Cost of revenues decreased from $14,996,000 in 2001 to $8,999,000 in 2002 primarily due to a non-recurring, non-cash charge of $3,000,000 for the write-off of digital identification certificates in 2001 and the reduction of $1,969,000 in non-cash charges for depreciation and amortization of property and equipment resulting from certain data center equipment becoming fully depreciated during 2002. The certificates that were written-off did not enter into the sales and marketing plans established by the Company’s then new

17

Table of Contents

      The net decrease in cost of revenues from 2002 to 2003 of $788,000 consists of a $3,367,000 decrease in non-cash expenses offset by an increase of $2,579,000 in cash expenses. The decrease in non-cash expenses to $2,755,000 was primarily due to a reduction in depreciation and amortization of property and equipment of $3,696,000 resulting from certain data center equipment becoming fully depreciated, which was partially offset by $289,000 for amortization of intangible assets associated with the 2003 acquisitions of PocketScript and Elron Software. The 2003 increase in cash expenses is due primarily to personnel additions totaling $1,676,000 which were necessary to expand the Company’s deployment and client services capabilities to support the order growth of the Company’s secure messaging products and services. Additionally, with the Company’s increased volume of business coupled with the 2003 acquisitions of PocketScript and Elron Software, 2003 cash expenses have increased over 2002 by approximately $270,000 in each of the areas of travel, data center maintenance and support and outside consultants, including professional fees associated with the Company obtaining the AICPA SysTrust ^TM certification.

      A significant portion of the Company’s cost of revenues has not been and is not expected to be directly variable to the revenue generated, such as the cost of operating and maintaining the ZixSecure Center which is currently not fully utilized. Accordingly, costs associated with the data center are expected to grow at a much slower pace than revenue. However, cost of revenues also includes the activities of field deployment, professional services and customer service and support, which in the near term are expected to grow at rates substantially equivalent to the Company’s revenue growth rate. Other than the non-cash amortization of the fair value of developed technology acquired with the purchase of Elron Software, cost of revenues related directly to software sales has not been significant.

      Research and development expenses decreased from $9,019,000 in 2001 to $6,180,000 in 2002 primarily due to decreases in third party consulting expenditures totaling $2,333,000 and reduced employee recruitment expenses of $396,000. Non-cash expenses increased $410,000 from $1,435,000 in 2001 to $1,845,000 in 2002 due to a charge of $762,000 for the cost to license certain patents held by Tumbleweed Communications Corp., partially offset by a $352,000 reduction in depreciation and amortization of property and equipment that became fully depreciated during 2002.

      The net decrease in research and development expenses from 2002 to 2003 of $284,000 is due primarily to a $1,469,000 reduction in non-cash expenses consisting primarily of a $737,000 decrease in depreciation and amortization of property and equipment resulting from certain computer equipment becoming fully depreciated and a $762,000 charge in 2002 for the cost to license certain patents held by Tumbleweed Communications Corp. These decreases in non-cash expenses were partially offset by increased cash expenses of $1,185,000, most of which consisted of personnel costs resulting from the acquisitions of PocketScript and Elron Software in the third quarter of 2003.

      Selling, general and administrative expenses decreased from $29,892,000 in 2001 to $19,335,000 in 2002, but increased slightly to $19,907,000 in 2003.

      The net decrease in selling, general and administrative expenses from 2001 to 2002 amounted to $10,557,000. Expenses, excluding non-cash expenses, decreased $4,859,000 in 2002 primarily due to reduced discretionary advertising expenditures of $3,453,000 resulting from the Company’s participation in fewer trade shows in 2002 and the April 2002 cancellation of the Yahoo! Inc. advertising commitment initiated in 2000, all part of the Company’s efforts to re-evaluate and redirect its advertising and marketing efforts. Also contributing to the decrease between years were Anacom expenditures of $532,000 that were eliminated in 2002 following cessation of Anacom’s operations in June 2001 and decreased employee recruitment expenditures of $333,000. In the third quarter of 2002, the Company established an office in Ottawa, Ontario, Canada, as a result of hiring available talent in the region to expand the Company’s sales and professional

18

Table of Contents

      The net increase in selling, general and administrative expenses from 2002 to 2003 amounted to $572,000. Expenses, excluding non-cash expenses, increased $3,633,000 in 2003 primarily due to increased personnel costs of approximately $2,900,000 consisting of $1,359,000 resulting from the acquisitions of PocketScript and Elron Software in the third quarter of 2003 and $1,541,000 associated with the Company’s expansion of its sales organization which began in late 2002. In 2003, due to increased sales activity, headcount increases and the acquisitions of PocketScript and Elron Software, additional cost increases were incurred for travel, facility costs and advertising and promotion totaling $732,000, $509,000 and $403,000, respectively, including expenditures associated with the Company’s HealthyEmail initiative. The Company’s legal professional services decreased by $873,000 in 2003 primarily due to the elimination of outside legal fees associated with the Company’s lawsuit with Visa U.S.A., Inc. and Visa International Service Association, which was concluded in 2002. Non-cash charges between 2002 and 2003 decreased by $3,061,000, to $1,580,000, primarily due to a $1,937,000 decrease in stock-based compensation related to stock option grants for employees and third party service providers and $1,935,000 for non-recurring costs recorded in 2002 related to the Yahoo! Inc. advertising arrangement, partially offset by $159,000 for amortization of intangible assets associated with the 2003 acquisitions of PocketScript and Elron Software and $484,000 in non-cash compensation expense resulting from the Company implementing a program in the third quarter of 2003 whereby non-executive employees were paid certain compensation, such as sales commissions, with the Company’s common stock rather than cash.

      Investment income decreased from $2,187,000 in 2001 to $319,000 in 2002 and further decreased to $138,000 in 2003. The continual decrease between years is primarily due to the decrease in invested cash and marketable securities and lower interest rates.

      Interest expense incurred in 2002 totaled $2,141,000 resulting from the issuance of $8,000,000 in Convertible Notes. Due to a significant issuance discount on the Convertible Notes, primarily due to the fair value of associated warrants totaling $1,148,000 using the Black-Scholes option pricing model, the Company recorded a non-recurring, non-cash charge of $1,698,000 representing the beneficial conversion feature resulting from the Convertible Notes being convertible into 2,116,402 shares of common stock at an effective price less than the fair market value of the common stock on the date the Convertible Notes were issued. In the fourth quarter of 2002, the noteholders converted the Convertible Notes and related accrued interest into 2,141,811 shares of the Company’s common stock.

      Realized and unrealized losses on investments in 2001 primarily represents an impairment write-off of the Company’s $5,000,000 related party investment in Maptuit Corporation (“Maptuit”). In October 2002, in connection with the requirements of a $6,000,000 financing package executed by Maptuit, the Company exchanged its $5,000,000 debt and equity position in Maptuit for $154,000 in cash, a non-interest bearing $900,000 subordinated promissory note due in 2006 and two million shares of common stock of Maptuit. In June 2003, the Company exchanged the $900,000 subordinated promissory note and one million shares of common stock of Maptuit for $530,000 in cash and, in January 2004, the Company exchanged the remaining one million shares of Maptuit’s common stock for $70,000 in cash.

19

Table of Contents

      Income taxes on the loss from continuing operations in 2001, 2002 and 2003 is different from the U.S. statutory rate of 34%, primarily due to unbenefitted U.S. losses. The Company’s income tax expense for 2003 of $148,000 represents non-U.S. taxes payable resulting from the operations of the Company’s Canadian subsidiary established in late 2002. The $269,000 current tax benefit recorded in 2002 resulted from legislative changes extending the net operating loss carry-back period from two years to five years. The Company has fully reserved its U.S. net deferred tax assets in 2001, 2002 and 2003 due to the uncertainty of future taxable income. There may be limitations on our ability to fully utilize our substantial net operating loss carryforwards against any future taxable income, including potential limitations due to ownership changes as defined in Section 382 of the Internal Revenue Code.

      As a result of the foregoing, the Company experienced losses from continuing operations of $56,794,000 in 2001, $34,299,000 in 2002 and $27,667,000 in 2003.

      The Company sold all of its remaining operating businesses during 1998 realizing follow-on gains of $48,000, $862,000 and $89,000 in 2001, 2002 and 2003, respectively.

Liquidity and Capital Resources

      Net cash used by continuing operations was $18,745,000 in 2003 compared to $19,759,000 in 2002. The improvement in operating cash flows in 2003 was primarily due to a 19% reduction in the Company’s loss from continuing operations totaling $6,632,000, a decrease in receivables resulting from the January 2003 collection of $1,000,000 from Entrust, Inc. and an increase in non-acquired deferred revenue of approximately $2,985,000 as a result of increased sales of prepaid service contracts. Substantially offsetting these increases was a $10,548,000 reduction in 2003 non-cash operating expenses in the areas of depreciation and amortization, stock-based compensation, vendor obligations paid in common stock and certain non-cash charges for interest expense associated with the Company’s convertible note outstanding during 2002. Depreciation expense has continued to decrease as the Company’s data center equipment becomes fully depreciated. Net cash used by operating activities in 2003 was funded primarily by existing cash resources and financing activities described below.

      Net cash flows used in investing activities during 2003 of $779,000 were attributable to purchases of property and equipment totaling $2,252,000 partially offset by non-recurring cash flows of $1,000,000 acquired in the purchase of Elron Software and $530,000 received as partial recovery of the Company’s investment in Maptuit Corporation. The recent trend for a reduced level of additions for property and equipment reversed in 2003, as expected, as the Company upgraded certain computer hardware in its data center and acquired computer equipment to satisfy customer orders for the Company’s products and services, primarily ZixVPM and ZixWorks.

      Net cash provided by financing activities in 2003 was comprised of $5,608,000 from a mid-year private placement of common stock and warrants, and proceeds of $12,965,000 from the exercise of stock options and warrants to purchase 2,358,968 shares of the Company’s common stock at an average price per share of $5.50. Separately, on September 30, 2003, the Company elected to convert the remaining $4,925,000 of Series A and Series B convertible preferred stock and related accrued dividends into 1,270,585 shares of the Company’s common stock at $4.07 and $3.76 per share, respectively. Additionally, in 2003, the Company used equity securities valued at $8,719,000 to acquire substantially all of the assets and businesses of PocketScript and Elron Software.

      The Company’s cash requirements consist principally of funding the Company’s operating losses as it pursues a leadership position in the emerging markets in which it operates and capital expenditures, primarily for data center expansion and refurbishment and for computer equipment to support new customer orders. The

20

Table of Contents

      At December 31, 2003, the Company had cash and marketable securities totaling $13,852,000, no debt and total liabilities, excluding deferred revenue, of $3,738,000. Subsequent to year end, through March 9, 2004, as a result of the exercise of stock options and warrants, the Company’s liquidity improved as it received proceeds of $10,318,000 in exchange for 1,262,023 shares of the Company’s common stock. On March 9, 2004, there are currently exercisable warrants and stock options, with an exercise price per share of $10.00 or less, to acquire approximately 4,100,000 shares of the Company’s common stock, at an average price of approximately $5.35 per share, which if exercised would result in a significant level of additional new funding for the Company. Additionally on January 30, 2004, in connection with the acquisition of MyDocOnline, the Company received $7,000,000 in cash from Aventis, Inc., a former affiliate of MyDocOnline. Aventis loaned the Company $3,000,000, due March 2007, which is payable in either cash or shares of common stock at the option of the Company and may be prepaid by the Company anytime without penalty. Additionally, Aventis entered into a three-year service contract with the Company for a minimum commitment of $4,000,000 for the performance by the Company of various services pursuant to a Master Services Agreement. At Aventis’ discretion, the loan may be paid in the form of additional services provided to Aventis by the Company in accordance with the Master Services Agreement. The loan and the Company’s obligations associated with the Master Services Agreement are secured by a lien on the Company’s accounts receivables and property and equipment. On March 9, 2004, the total of the Company’s cash and marketable securities was approximately $25,800,000.

      The amount of the Company’s future cash requirements depend primarily on the market acceptance of its products and services and the timing and magnitude of cash flows generated from new customer orders. Cash flows will also be impacted by capital expenditure requirements, resources devoted to the additional development of our products and services and resources devoted to sales and marketing including discretionary advertising initiatives. The Company expects the market for its products and services to expand as the business community recognizes the importance of privacy and security for their electronic communications and as electronic prescription initiatives mature in the marketplace. In the future the Company may need to raise additional funds to sustain its operations or initiate reductions in operating expenses, or both. The Company will continue to consider various capital funding alternatives to strengthen its financial position. These capital funding alternatives could involve one or more types of equity securities, including convertible debt, common or convertible preferred stock and warrants to acquire common or preferred stock. Such equity securities could be issued at or below the then-prevailing market price for shares of the Company’s common stock. The Company currently has no existing credit facilities. There can be no assurances that the Company will be able to raise additional capital on satisfactory terms if and when needed.

Off-Balance Sheet Arrangements, Contractual Obligations, and Contingent Liabilities and Commitments

      The following table aggregates the Company’s material contractual cash obligations as of December 31, 2003:

21

Table of Contents

      The Company has severance agreements with certain employees which would require the Company to pay approximately $3,275,000 if all such employees separated from employment with the Company following a change of control, as defined in the severance agreements.

Critical Accounting Policies and Estimates

      The Company’s significant accounting policies are described in Note 1 to the consolidated financial statements. The preparation of financial statements and related disclosures in accordance with accounting principles generally accepted in the United States requires the Company’s management to make estimates and assumptions that affect the amounts reported in the Company’s consolidated financial statements and accompanying notes. Actual results could differ from these estimates and assumptions. Critical accounting policies and estimates are defined as those that are both most important to the portrayal of the Company’s financial condition and results and require management’s most subjective judgments. The Company’s most critical accounting policies and estimates are described below.

      The Company’s long-lived assets, comprised of intangibles and property and equipment aggregating $6,740,000 or 26% of total assets at December 31, 2003, are periodically reviewed for impairment, by comparing the carrying value of the asset with its estimated fair value. The potential impairment is measured based on a projected discounted cashflow method, using a discount rate that is considered to be commensurate with the risk inherent in the Company’s current business model. Assumptions are made with respect to future net cash flows expected to be generated by the related asset. An impairment charge would be recorded for an amount by which the carrying value of the asset exceeded the discounted projected net cash flows.

      Goodwill, totaling $4,321,000, represents the cost in excess of fair value of net assets acquired in the September 2003 acquisition of Elron Software. The Company will evaluate its goodwill for impairment annually as of October 1, beginning in 2004, or when there is reason to believe that the value has been diminished or impaired. Evaluations for possible impairment are based upon a comparison of the estimated fair value of the business unit to which the goodwill relates to the sum of the carrying value of the assets and liabilities of that unit. The fair values used in this evaluation are estimated based upon discounted future cash flow projections for the unit and market values of comparable businesses where available. An impairment is deemed to exist if the net book value of the unit exceeds its estimated fair value. There has been no change to the carrying amount of goodwill since its origination in September 2003.

      Future changes made to the current estimates or assumptions, including such factors as order volumes and price levels, life spans of purchased technology, continuity of acquired customers, alternative uses for property and equipment and levels of operating expenses, could result in an unanticipated impairment charge from the write-down of the Company’s long-lived assets or goodwill.

      As required by Statement of Financial Accounting Standards No. 109, the Company recognizes deferred tax assets on its consolidated balance sheet if it is “more likely than not” that the subject net operating loss carry forwards and unused tax credits will be realized on future federal income tax returns. At December 31, 2003, the Company continued to provide a full valuation allowance against accumulated U.S. deferred tax assets of $69,822,000, reflecting the Company’s historical losses and the uncertainty of future taxable income. If the Company begins to generate U.S. taxable income in a future period or if the facts and circumstances on which its estimates and assumptions are based were to change, thereby impacting the likelihood of realizing the deferred tax assets, judgment would have to be applied in determining the amount of valuation allowance no longer required. Reversal of all or a part of this valuation allowance could have a significant positive impact on operating results in the period that it becomes more likely than not that certain of the Company’s deferred tax assets will be realized.

22

Table of Contents

      General. The Company develops, markets, licenses and supports computer software products and services. Certain of the Company’s products and services, such as ZixMail, ZixVPM, ZixPort, ZixWorks and its newly acquired electronic subscription solutions are offered on a subscription basis. The Company’s subscription service includes delivering licensed software and providing customer support and secure email solutions throughout the subscription period. The customer generally is provided an appliance with pre-installed software or contractually subscribes to data center resident service capability and capacity. Subscriptions to date have generally been annual non-refundable contracts with no automatic renewal provisions. The subscription period begins on the date specified by the parties. Revenues from subscription services are recorded as the services are rendered. Subscription fees received from customers in advance are recorded as deferred revenue and recognized as revenues ratably over the subscription period. Transaction fees associated with the electronic prescription service are recognized as revenue when the transaction occurs.

      The Company also sells anti-spam and Web filtering products to customers under perpetual license agreements. The Company recognizes revenue on these arrangements after all of the following occur: persuasive evidence that an arrangement exists, the software is delivered, collection is probable, fees are fixed and determinable, and vendor-specific objective evidence of fair value (VSOE) exists to allocate the total fees to the elements of the arrangement. These software licenses are sold as part of a multiple element arrangement that includes annual maintenance, and often times implementation or training services. Where VSOE has not been established for certain elements, revenue for all elements is deferred until those elements have been delivered or their fair values have been determined. However, if VSOE is determinable for all of the undelivered elements, and the undelivered elements are not essential to the delivered elements, the Company will defer recognition of the full fair value related to the undelivered elements and recognize as revenue the remaining portion of the arrangement value through application of the residual method. Evidence of VSOE for implementation and training services is based upon standard billing rates and the estimated level of effort for the individuals expected to perform the related services. Installation and training revenues are recognized as the services are rendered. The Company establishes VSOE for maintenance based upon current contract renewal rates. The Company recognizes maintenance revenue over the term of the maintenance agreement, generally one year.

      Multiple element arrangements. In the near term, the Company expects that a larger percentage of its revenues will be derived from customers purchasing a combination of software under perpetual license agreements and related services including product maintenance and secure messaging services. The Company determines the fair value of each of the contract deliverables using VSOE which requires significant judgment when selling and pricing products and services in emerging markets where increasing competition and technology changes are commonplace. VSOE for each element is based on the price for which the Company will sell the element on a stand-alone basis. If the Company determines that it does not have VSOE on an undelivered service element of an arrangement, the Company will delay revenue recognition from the software sale and amortize it to revenue ratably over the service period of the related service deliverable. This occurrence could materially impact our future financial results depending on the significance of software sales to our mix of total revenues.

      During 2003, the Company completed two acquisitions using the purchase method of accounting. The amounts assigned to the identifiable assets and liabilities acquired in connection with these acquisitions were based on estimated fair values as of the date of the acquisition, with the remainder recorded as goodwill. The fair values were determined by management, generally based upon information supplied by the management of the acquired entities and in one instance a valuation prepared by independent appraisal experts. The fair values have been based primarily upon future cash flow projections for the acquired assets, discounted to present value using a risk-adjusted discount rate. In connection with these acquisitions, we have recorded a significant amount of intangible assets and goodwill.

23

Table of Contents

Recent Accounting Pronouncements

      In July 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). This statement nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”. SFAS 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of commitment to an exit or disposal plan. This statement is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 did not have an effect on the Company’s results of operations or its financial position.

Risks and Uncertainties

      Since 1999, we have been developing and marketing products and services that bring privacy, security and convenience to Internet users, with a particular focus in the healthcare sector. Our businesses operate in emerging markets, and developing these businesses is costly and the market is highly competitive. Emerging market businesses involve risks and uncertainties, and there are no assurances that we will be successful in our efforts. We have experienced significant operating losses in recent years and utilization of cash resources continues at a substantial level. ZixCorp anticipates further losses in 2004.

      In July 2003, we acquired substantially all of the assets of PocketScript, a provider of electronic prescription solutions for the healthcare industry; in September 2003, we acquired substantially all of the assets of Elron Software, a provider of anti-spam, email content filtering and Web filtering solutions; and in late January 2004, we acquired substantially all of the assets of MyDocOnline, a provider of secure Web-based communications and laboratory information solutions. PocketScript and MyDocOnline are start-up ventures in emerging markets. While Elron has been in business for a number of years, its revenues have declined in recent years. PocketScript, Elron, and MyDocOnline have incurred operating losses in recent years. The ability to increase the companies’ revenues in the near future is largely dependent upon, in Elron’s case, whether our efforts to bring enhanced and new products to market are successful, and in the case of PocketScript and MyDocOnline, whether we are able to develop the market for their products and services. Our challenge is to make these new subsidiaries profitable. To do so may require us to invest significant resources, including significant amounts of cash, and there are no assurances that these subsidiaries will become profitable in the near term.

      We must be able to achieve broad market acceptance for our products and services in order to operate profitably. We have not yet been able to do this. To our knowledge, there are currently no secure e-messaging protection and transaction businesses similar to our Zix branded business that currently operates at the scale that we would require, at our current expenditure levels and pricing, to become profitable. As previously noted, PocketScript and MyDocOnline are start-up ventures in emerging markets. There is no assurance that our products and services will become generally accepted or that they will be compatible with any standards that become generally accepted, nor is there any assurance that enough paying users will ultimately be obtained to enable us to operate profitably.

      Our Zix branded solutions are targeted to the secure e-messaging protection and transaction services market. Elron’s product solutions have enabled us to enhance our Zix branded protection management

24

Table of Contents

      Although there are many large, well-funded participants in the information technology security industry, few currently participate in the secure e-messaging protection and transaction services market in which our Zix branded solutions compete. Most other product-only solutions in this market require extensive increases in overhead to implement and deploy them. In addition, our Zix branded solutions can be made operational in a very short period of time compared to the longer procurement and deployment cycles common with the solutions of many of our competitors. Our service and product offerings are focused on the secure communications market, including secure e-messaging and protection management. Companies that compete with our Zix branded secure e-messaging and protection business include content management and secure delivery companies, such as Authentica, Inc., Certified Mail, Sigaba Corporation and Tumbleweed Communications Corp., and other messaging/spam protection participants such as BrightMail Incorporated, CipherTrust, Inc., ClearSwift Limited, FrontBridge Technologies, Inc., MessageLabs, Postini, Inc., NetIQ Corp. and SurfControl Incorporated.

      Our Zix branded products and Elron products also compete with several product companies that deliver anti-virus solutions that may also contain limited email messaging/spam protection capabilities, including Network Associates, Inc. (McAfee), Sophos, Inc., Symantec Corporation and Trend Micro, Inc. We also compete with companies that offer Web filtering products, such as Secure Computing Corporation, SurfControl Incorporated, Websense, Inc. and NetIQ Corp.

      In addition, we face competition from vendors of Internet server appliances, operating systems, networking hardware, network management solutions and security software, many of which now, or may in the future, develop or bundle secure e-messaging, messaging/spam protection and/or Web filtering capabilities into their products.

      We may face increased competition as these competitors partner with others or develop new product and service offerings to expand the functionality that they can offer to their customers. We believe that the secure e-messaging protection and transaction services market is immature, and, for the most part, unpenetrated, unlike many segments of the information technology security industry — which are saturated. We have spent several years on infrastructure development and product development. Our competitors may, over time, develop new technologies that are perceived as being more secure, effective or cost efficient than our own. If we are not successful in exploiting the technology advantage we believe we currently hold, these competitors could successfully garner a significant share of the market, to the exclusion of our company. Furthermore, increased competition could result in pricing pressures, reduced margins or the failure of our business to achieve or maintain market acceptance, any of which could harm our business.

      Our PocketScript electronic prescription management services allow health care payors to effectively deliver drug information to physicians at the point of care, enabling providers to work more effectively within established formularies. Our PocketScript services, targeted to the e-prescription marketplace, are expected to grow as more physicians are leveraging technology in delivering healthcare services, coupled with the fact that the number of prescriptions written annually in the United States continues to increase. Participants in the e-prescribing space include AllScripts Healthcare Solutions, Ramp Corporation, Dr. First, Inc. and iScribe (a division of AdvancePCS).

      Our recently acquired MyDocOnline business offers a variety of Internet-based healthcare services. MyDocOnline Connect is a subscription-based Web service that allows patients and physicians to securely communicate online. Connect helps patients become more active, informed participants in their own health. Communication features offered by the service cover the spectrum of patient needs and include: online doctor visits, administrative questions, appointment requests, billing questions, prescription requests, and referral requests. The service also offers a host of educational, interactive content features that deliver condition-

25

Table of Contents

      Dr. Chart, also a Web-based communication tool, connects healthcare providers and laboratories by allowing doctors to initiate lab orders, check medical necessity compliance and view results rapidly and accurately using a secure Internet connection. Dr. Chart also automatically integrates patient information, customizes requisition formats for individual practices, automatically prints specimen labels, automatically checks Medicare compliance and provides an up-front Advanced Beneficiary Notification (ABN) at point of order and allows labs to enhance reporting with historical analyses, trending, and graphing. Dr. Chart seamlessly integrates into labs’ current systems and is fully customizable. Competitors include: 4Medica, Inc., Cerner Corporation and Misys plc. All of the competitors offer the same basic services that Dr. Chart offers, although we believe that Dr. Chart is superior to services offered by its competitors because of the flexibility of the product, expertise in interfacing to other systems, and duration and breadth of experience delivering Internet-based orders and solutions to labs nationwide. Nevertheless, we expect to face increasing competition in this arena and our competitors may develop products and services that are perceived to be better than ours.

      The emerging nature of the secure e-messaging protection and transaction services business and its rapid evolution, require us continually to develop and introduce new products and services and to improve the performance, features and reliability of our existing products and services, particularly in response to competitive offerings. Our Elron business, while having a significant customer base and meaningful revenues, has not been profitable in recent years under its prior ownership.

      We also have under development new feature sets for our current Zix branded product line and service offerings and are considering new secure e-messaging products and services. By adding Elron’s product line to our current service offerings, we will be able to accelerate the development time we would have otherwise needed to build additional feature sets into our Zix branded product and service offerings. The success of new or enhanced products and services depends on several factors — primarily, market acceptance. We may not succeed in developing and marketing new or enhanced products and services that respond to competitive and technological developments and changing customer needs. This could harm our business.

      The market for secure electronic communications is a developing market. Continued growth of the secure e-messaging protection and transaction services market will depend to a large extent on the market recognizing the need for secure electronic communications, such as email encryption and e-prescribing. Failure of this market to grow would harm our business.

      Our PocketScript electronic prescription management services and our MyDocOnline services are targeted to the emerging market for providing secure communications among healthcare providers to deliver information in an efficient, economical manner. These are emerging markets, and the success of our

26

Table of Contents

      While we have ample through-put capacity to handle our customers’ requirements for the medium term, at some point we may be required to expand and upgrade our technology and network hardware and software. We may not be able to accurately project the rate of increase in usage on our network, particularly since we have significantly expanded our potential customer base by our recent acquisition of PocketScript and MyDocOnline, whose service offerings will be supported by our ZixSecure Center, once we transition the data center operations of PocketScript and MyDocOnline to this facility. In addition, we may not be able to expand and upgrade, in a timely manner, our systems and network hardware and software capabilities to accommodate increased traffic on our network. If we do not timely and appropriately expand and upgrade our systems and network hardware and software, we may lose customers and revenues.

      Our business depends on the uninterrupted operation of our centers — currently, our ZixSecure Center located in Dallas, Texas; the Austin, Texas data center used for fail-over and staging of new customers of our Zix branded services; the Dallas, Texas co-location facility that supports the operations of our recently acquired MyDocOnline business; and the data center that supports the PocketScript operations. We must protect these centers from loss, damage or interruption caused by fire, power loss, telecommunications failure or other events beyond our control. Any damage or failure that causes interruptions in our data centers’ operations could materially harm our business, financial condition and results of operations.

      In addition, our ability to issue digitally-signed certified time-stamps and public encryption codes in connection with our Zix branded products and services and to support PocketScript’s e-prescribing services and MyDocOnline’s services depends on the efficient operation of the Internet connections between customers and our data centers. We depend on Internet service providers efficiently operating these connections. These providers have experienced periodic operational problems or outages in the past. Any of these problems or outages could adversely affect customer satisfaction.

      Furthermore, it is critical that our facilities and infrastructure remain secure and the market perceives them to be secure. Despite our implementation of network security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, attacks by hackers and similar disruptions from unauthorized tampering with our computer systems. In addition, we are vulnerable to coordinated attempts to overload our systems with data, resulting in denial or reduction of service to some or all of our users for a period of time. We do not carry insurance to compensate us for losses that may occur as a result of any of these events; therefore, it is possible that we may have to use additional resources to address these problems.

      Secure messages sent through our ZixPort and ZixMessage Center messaging portals, in connection with the operation of our secure e-messaging protection and transaction services, will reside, for a user-specified period of time, in our secure data center network; individual prescription histories transmitted through our PocketScript system will reside in our secure data center network; and the personal healthcare information transmitted through our MyDocOnline system will reside in our secure data center network. Any physical or electronic break-ins or other security breaches or compromises of this information could expose us to significant liability, and customers could be reluctant to use our Internet-related products and services.

27

Table of Contents

      We may have to defend our intellectual property rights or defend against claims that we are infringing the rights of others. Intellectual property litigation and controversies are disruptive and expensive. Infringement claims could require us to develop non-infringing products or enter into royalty or licensing arrangements. Royalty or licensing arrangements, if required, may not be obtainable on terms acceptable to us. Our business could be significantly harmed if we are not able to develop or license the necessary technology. Furthermore, it is possible that others may independently develop substantially equivalent intellectual property, thus enabling them to effectively compete against us.

      We subject our Zix branded products and services to quality assurance testing prior to product release. There is no assurance that the quality and assurance testing previously conducted by the businesses we recently acquired on their current products and services conform to our standards for quality assurance testing. Regardless of the level of quality assurance testing, any of our products and services could contain undetected defects or errors. This could result in loss of or delay in revenues, failure to achieve market acceptance, diversion of development resources, injury to our reputation, litigation claims, increased insurance costs or increased service and warranty costs. Any of these could prevent us from implementing our business model and achieving the revenues we need to operate profitably.

      Our Zix branded products and services, the PocketScript e-prescription service and the MyDocOnline businesses employ, and future products and services may employ, public key cryptography technology. With public key cryptography technology, a public key and a private key are used to encrypt and decrypt messages. The security afforded by this technology depends, in large measure, on the integrity of the private key, which is dependent, in part, on the application of certain mathematical principles. The integrity of the private key is predicated on the assumption that it is difficult to mathematically derive the private key from the related public key. Should methods be developed that make it easier to derive the private key, the security of encryption products using public key cryptography technology would be reduced or eliminated and such products could become unmarketable. This could require us to make significant changes to our products, which could damage our reputation and otherwise hurt our business. Moreover, there have been public reports of the successful decryption of certain encrypted messages. This, or related, publicity could adversely affect public perception of the security afforded by public key cryptography technology, which could harm our business.

      We depend on the performance of our senior management team — including our chairman and chief executive officer, John A. Ryan; our president and chief operating officer, Richard Spurr and their direct reports and other key employees, particularly highly skilled technical personnel. Our success depends on our ability to attract, retain and motivate these individuals. There are no binding agreements with any of our employees which prevent them from leaving our company at any time. There is competition for these personnel. In addition, we do not maintain key person life insurance on any of our personnel. The loss of the services of any of our key employees or our failure to attract, retain and motivate key employees could harm our business.

      Exports of software products using encryption technology, such as our Zix branded products and services, are generally restricted by the U.S. government. Although we have obtained U.S. government approval to export our products to almost all countries in the world, the list of countries to which our products cannot be exported could be revised in the future. Furthermore, some foreign countries impose restrictions on the use of

28

Table of Contents

      Furthermore, boards of pharmacy in the various states in which our PocketScript and MyDocOnline businesses operate regulate the process by which physicians write prescriptions. While regulations in the states in which these businesses currently generally operate permit the electronic writing of prescriptions, such regulations could be revised in the future. Moreover, regulations in states in which these businesses do not currently operate may not be as favorable and may impede our ability to develop business in these states. Furthermore, future state or federal regulation could mandate standards for the electronic writing of prescriptions or for the secure electronic transmittal of personal health information through the Internet that our technology and systems do not comply with, which would require us to modify our technology and systems.

      The market price of our common stock has fluctuated significantly in the past and is likely to fluctuate in the future. Our stock price may decrease as a result of the dilutive effect caused by the additional number of shares that may become available in the market due to the issuances of our common stock in connection with the capital funding and acquisition transactions we completed over the last year. As of February 13, 2004, there was a short position in our common stock of 6,836,222 shares.

      Our directors and executive officers beneficially own shares of our securities that represent approximately 17.6% of the combined voting power eligible to vote on matters brought before our shareholders, including securities and associated warrants beneficially owned by Antonio R. Sanchez, Jr., a former director and father of a current director (Antonio R. Sanchez III), and current beneficial owner of approximately 8.7% of our outstanding common stock, and John A. Ryan, our chairman and chief executive officer. Therefore, our directors and executive officers, if they acted together, could exert substantial influence over matters requiring approval by our shareholders. These matters would include the election of directors. This concentration of ownership and voting power may discourage or prevent someone from acquiring our business.

      George W. Haywood, a private investor, beneficially owns approximately 16.0% of our outstanding common stock. Therefore, Mr. Haywood could exert substantial influence over all matters requiring approval by our shareholders, including the election of directors. Mr. Haywood’s interests may not be aligned with the interests of our other shareholders. This concentration of ownership and voting power may discourage or prevent someone from acquiring our business.

      At some point in the future we may determine to seek additional capital funding or to acquire additional businesses. These events could involve the issuance of one or more types of equity securities, including convertible debt, common or convertible preferred stock and warrants to acquire common or preferred stock. Such equity securities could be issued at or below the then-prevailing market price for our common stock. In addition, we incentivize employees and attract new employees by issuing options to purchase our shares of common stock. Therefore, the interest of our existing shareholders could be diluted by future stock option grants to employees and any equity securities issued in capital funding financings or business acquisitions.

29

Table of Contents

      We disposed of our previous operating businesses in 1998 and 1997. In selling those businesses, we agreed to provide customary indemnification to the purchasers of those businesses for breaches of representations and warranties, covenants and other specified matters. Although we believe that we have adequately provided for future costs associated with these indemnification obligations, indemnifiable claims could exceed our estimates.

      There are no assurances that we will be successful or that we will not encounter other, and even unanticipated, risks. We discuss other operating, financial or legal risks or uncertainties in our periodic filings with the SEC. We are, of course, also subject to general economic risks.

NOTE ON FORWARD-LOOKING STATEMENTS AND RISK FACTORS

      This document contains “forward-looking statements” within the meaning of Section 27A of the Act and Section 21E of the Exchange Act. All statements other than statements of historical fact are “forward-looking statements” for purposes of federal and state securities laws, including: any projections of future business, market share, earnings, revenues or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning proposed new products, services or developments; any statements regarding future economic conditions or performance; any statements of belief; and any statements of assumptions underlying any of the foregoing. Forward-looking statements may include the words “may,” “will,” “predict,” “plan,” “should,” “goal,” “estimate,” “intend,” “continue,” “believe,” “expect,” “anticipate” and other similar words. Such forward-looking statements may be contained in the “Risks and Uncertainties” section above, among other places.

      Although we believe that the expectations reflected in any of our forward-looking statements are reasonable, actual results could differ materially from those projected or assumed in any of our forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to change and to inherent risks and uncertainties, such as those disclosed in this document. We do not intend, and undertake no obligation, to update any forward-looking statement.