Packeteer 2006 Annual Report

LETTER FROM THE CEO Dear Fellow Stockholders: 2006 was a successful year for Packeteer and one filled with change both within our company and our market. We reported record revenues of $145 million in 2006, up 28% from 2005. Net income for the year was $4.9 million, which included expenses of $9.2 million, net of tax, as a result of our adoption of the newly required Statement of Financial Accounting Standards No. 123 or SFAS 123. If we had included SFAS 123 expense for 2005 previously disclosed in our footnotes, our net income for the prior year would have been $9.7 million. We generated $20.4 million in cash from operations in 2006 and ended the year with cash and investments of $77 million and no debt. During 2006, Packeteer was recognized by three leading analyst firms as the market leader for WAN Application Delivery products. In May 2006, we acquired Tacit Networks, an industry leader in WAFS technology, which added significantly to our growing market opportunity for WAN Optimization. Tacit Networks was a leader in providing complete branch office infrastructure solutions that deliver best-of-breed CIFS acceleration, Wide Area File Services (WAFS), Gigabyte Data Reduction, and file and bulk data caching, along with Microsoft IT services for a complete solution. This is a very important solution set for any organization pursuing server, storage and resource consolidation to meet cost control, security and regulatory compliance objectives. It is also completely complementary to our PacketShaper solutions. In addition, we released our acceleration module for PacketShaper last summer, bringing TCP and HTTP acceleration to complement our award-winning visibility, QoS and compression platform. We also released the PacketShaper Model 1400, setting a new price performance benchmark for branch office installations. The 1400 has had the most rapid growth rate of any new product we have introduced in recent years. These two product platforms form the basis of a comprehensive solution for ensured application delivery over the wide area network (WAN). At the core of this solution is our patented classification and diagnostic technology, which forms the basis of our “Intelligent” approach to application delivery. By knowing specifically what applications are being delivered on their networks, our customers can use the right tools from Packeteer to deliver the performance their users demand from their applications. Whether their need is to give priority to mission-critical ERP applications, guarantee voice calls, or deliver large files rapidly across the network, the Packeteer solution delivers performance for every application at every location in any customers’ networks. On the sales front, we have significantly expanded and strengthened our resources worldwide. During 2006 and the first two months of 2007, we have added nearly 50% to our sales organization, and have upgraded our leadership throughout the organization, adding three new geographic sales leaders in the Americas, EMEA, and Asia. These changes represent a significant increase in resources and enable the structuring of our sales force and sales processes to meet the needs of a growing global customer base. In addition, we have added to our management depth with Alan Menezes, who joined us in February 2007 as vice president of marketing. He will bring a strong emphasis on positioning Packeteer and our products, as well as increased awareness of our unique solution in the marketplace. We are excited as we enter 2007. The market is awakening to our solutions, and we will be delivering important new products throughout the year. Our sales organization continues to grow as we open new territories for our technology. Our marketing efforts will expand the awareness of Packeteer and our solutions in the marketplace. There are challenges ahead as we face more significant competition, but the growing interest by customers who need to manage all of their applications and the significant value we provide in our intelligent solutions will enable us to uniquely serve these customers worldwide. I want to thank our customers, partners, suppliers, and employees for their significant contributions to our continuing success at Packeteer. Best regards, Dave Côté President and CEO, Packeteer April 13, 2007 Dear Stockholder: This year’s annual meeting of stockholders will be held on Wednesday, May 23, 2007, at 10:00 a.m. local time, at the Cypress Hotel, 10050 South De Anza Boulevard, Cupertino, CA 95014. You are cordially invited to attend. The Notice of Annual Meeting of Stockholders and a Proxy Statement, which describe the formal business to be conducted at the meeting, follow this letter. It is important that you use this opportunity to take part in the affairs of Packeteer by voting on the business to come before this meeting. After reading the Proxy Statement, please promptly mark, sign, date and return the enclosed proxy card in the prepaid envelope or follow the instructions on the proxy card to vote by telephone or electronically through the Internet. Returning your proxy card or voting by telephone or electronically through the Internet will ensure that your shares will be represented if you later decide not to attend the meeting. Regardless of the number of shares you own, your careful consideration of, and vote on, the matters before our stockholders is important. A copy of Packeteer’s Annual Report to Stockholders is also enclosed for your information. At the annual meeting we will review Packeteer’s activities over the past year and our plans for the future. The Board of Directors and management look forward to seeing you at the annual meeting. Sincerely yours, Dave Côté President and Chief Executive Officer PACKETEER, INC. NOTICE OF ANNUAL MEETING OF STOCKHOLDERS To Be Held May 23, 2007 TO THE STOCKHOLDERS: Notice is hereby given that the annual meeting of the stockholders of Packeteer, Inc., a Delaware corporation, will be held on May 23, 2007 at 10:00 a.m. local time, at the Cypress Hotel, 10050 South De Anza Boulevard, Cupertino, CA 95014, for the following purposes: 1. To elect two directors to hold office for a 3-year term and until their respective successors are elected and qualified. 2. To ratify the appointment of KPMG LLP as our independent registered public accounting firm for the fiscal year ending December 31, 2007. 3. To transact such other business as may properly come before the meeting and any adjournment or postponement thereof. Stockholders of record at the close of business on March 30, 2007 are entitled to notice of, and to vote at, this meeting and any adjournment or postponement. For ten days prior to the meeting, a complete list of stockholders entitled to vote at the meeting will be available for examination by any stockholder, for any purpose relating to the meeting, during ordinary business hours at our principal executive offices located at 1021 North De Anza Boulevard, Cupertino, California 95014. All stockholders are cordially invited to attend the meeting in person. However, to assure your representation at the meeting, you are urged to sign and return the enclosed proxy card as promptly as possible in the enclosed selfaddressed envelope. Record holders may also vote electronically via the Internet or telephonically by following the instructions on the proxy card. Our transfer agent, who is tabulating votes cast for the meeting, will count the last vote received from a stockholder, whether delivered by telephone, proxy or ballot or electronically via the Internet. Any stockholder attending the meeting may vote in person even if he or she returned a proxy. However, if a stockholder’s shares are held of record by a broker, bank or other nominee and the stockholder wishes to vote at the meeting, the stockholder must obtain from the broker, bank or other nominee a proxy issued in his or her name. By order of the Board of Directors, David C. Yntema Secretary Cupertino, California April 13, 2007 IMPORTANT: Please fill in, date, sign and promptly mail the enclosed proxy card in the accompanying postagepaid envelope to assure that your shares are represented at the meeting. In the alternative, you may cast your votes by telephone or electronically via the Internet. If you attend the meeting, you may choose to vote in person even if you have previously sent in your proxy card. PACKETEER, INC. 10201 North De Anza Boulevard Cupertino, CA 95014 (408) 873-4400 PROXY STATEMENT 2007 ANNUAL MEETING OF STOCKHOLDERS The accompanying proxy is solicited by the Board of Directors of Packeteer, Inc., a Delaware corporation (“Packeteer,” “Company,” “we,” “us,” and “our”), for use at our annual meeting of stockholders to be held on May 23, 2007, or any adjournment or postponement thereof, for the purposes set forth in the accompanying Notice of Annual Meeting of Stockholders. This Proxy Statement and the enclosed proxy card are being mailed to stockholders on or about April 13, 2007. SOLICITATION AND VOTING Voting Securities. Only stockholders of record as of the close of business on March 30, 2007 will be entitled to vote at the meeting and any adjournment thereof. As of that time, we had 35,976,326 shares of Common Stock outstanding, all of which are entitled to vote with respect to all matters to be acted upon at the annual meeting. Each stockholder of record as of that date is entitled to one vote for each share of Common Stock held by him or her. For purposes of determining the presence of a quorum, abstentions and “broker non-votes” will be counted by the Company as present at the meeting. Abstentions will also be counted by the Company in determining the total number of votes cast with respect to a proposal (other than the election of directors). Broker non-votes will not be counted in determining the number of votes cast with respect to a proposal. Broker Non-Votes. A broker non-vote occurs when a broker submits a proxy card with respect to shares held in a fiduciary capacity (typically referred to as being held in “street name”) but declines to vote on a particular matter because the broker has not received voting instructions from the beneficial owner. Under the rules that govern brokers who are voting with respect to shares held in street name, brokers have the discretion to vote such shares on routine matters, but not on non-routine matters. Routine matters include the election of directors, increases in authorized Common Stock for general corporate purposes and ratification of auditors. Non-routine matters include amendments to stock plans. Solicitation of Proxies. We will bear the cost of soliciting proxies. In addition to soliciting stockholders by mail through our employees, we will request banks, brokers and other custodians, nominees and fiduciaries to solicit customers for whom they hold our stock and will reimburse them for their reasonable, out-of-pocket costs. We may use the services of our officers, directors and others to solicit proxies, personally or by telephone, without additional compensation. In addition, we have retained MacKenzie Partners, a proxy solicitation firm, for assistance in connection with the annual meeting at a cost of approximately $4,000 plus reasonable out-of-pocket expenses. Voting of Proxies. All valid proxies received before the meeting will be exercised. All shares represented by a proxy will be voted, and where a proxy specifies a stockholder’s choice with respect to any matter to be acted upon, the shares will be voted in accordance with that specification. If no choice is indicated on the proxy, the shares will be voted in favor of the proposal. A stockholder whose shares are registered in their own name has the power to revoke his or her proxy at any time before it is exercised by delivering to Packeteer (attention: David C. Yntema, Secretary) at our principal executive offices a written instrument revoking the proxy or a duly executed proxy with a later date, or by attending the meeting and voting in person. If you hold shares in street name, through a bank, broker or other nominee, please contact the bank, broker or other nominee to revoke your proxy. Stockholders whose shares are registered in their own names may vote (1) by returning a proxy card, (2) electronically via the Internet or (3) by telephone. Specific instructions to be followed by any registered stockholder interested in voting electronically via the Internet or by telephone are set forth on the enclosed proxy card. The Internet and telephone voting procedures are designed to authenticate the stockholder’s identity and to allow the stockholders to vote his or her shares and confirm that his or her voting instructions have been properly recorded. If you do not wish to vote electronically via the Internet or telephone, please complete, sign and return the proxy card in the self-addressed, postage paid envelope provided. PROPOSAL NO. 1 ELECTION OF DIRECTORS We have a classified Board of Directors consisting of three classes, who will serve until the annual meetings of stockholders to be held in 2007, 2008 and 2009, respectively, and until their respective successors are duly elected and qualified. At each annual meeting of stockholders, directors are elected for a term of three years to succeed those directors whose terms expire at the annual meeting dates. The terms of Dave Côté and Gregory E. Myers will expire on the date of the upcoming annual meeting. Accordingly, two persons are to be elected to serve on the Board of Directors at the meeting. Management’s nominees for election by the stockholders to those two positions are Messrs. Côté and Myers. If elected, the nominees will serve as directors until our annual meeting of stockholders in 2010 and until their successors are elected and qualified. If any of the nominees declines to serve or becomes unavailable for any reason, or if a vacancy occurs before the election (although we know of no reason to anticipate that this will occur), the proxies may be voted for such substitute nominees as we may designate. Vote Required and Recommendation of the Board Directors are elected by a plurality of the votes present in person or represented by proxy and entitled to vote, which means that if the quorum requirements are met, the two nominees receiving the highest number of votes will be elected as directors. Abstentions and broker non-votes have no effect on the vote. The Board of Directors recommends a vote “FOR” the nominees Dave Côté and Gregory E. Myers. The following table sets forth, for our current directors, including the nominees to be elected at this meeting, information with respect to their ages and background. Name Age Director Since Directors nominated for election at the 2007 Annual Meeting of Stockholders: Dave Côté . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gregory E. Myers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Directors whose terms expire at the 2008 Annual Meeting of Stockholders: Steven J. Campbell . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Craig W. Elliot . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Joseph A. Graziano . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Directors whose terms expire at the 2009 Annual Meeting of Stockholders: L. William Krause. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bernard F. (Bud) Mathaisel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Peter Van Camp . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Directors whose terms expire at the 2007 Annual Meeting of Stockholders 52 56 65 46 63 64 62 51 2002 2006 1996 1996 1996 2001 2004 2001 Dave Côté has served as our President, Chief Executive Officer and as a director since October 2002. From April 1997 to October 2002, Mr. Côté served as Vice President of Worldwide Marketing and Communication ASSPs (Application-Specific Standard Products) for Integrated Device Technology, Inc., a semiconductor company. From January 1995 to November 1996, Mr. Côté served as Vice President of Marketing and Customer Support for ZeitNet Inc., which was acquired by Cabletron in 1996. From 1979 to 1995, he served in various marketing and sales positions, most recently as Director of Marketing at SynOptics, Inc. (now Nortel Networks). Mr. Côté holds an M.B.A. from California State University at Sacramento and a B.S. from the University of California at Davis. Gregory E. Myers has served as a director since July 2006. From January 1999 to December 2005, Mr. Myers served as Vice President of Finance and Chief Financial Officer of Symantec Corporation, a provider of Internet security technology. Prior to his role as Symantec’s Chief Financial Officer, Mr. Myers served Symantec in various senior finance positions, beginning in September 1993. Mr. Myers served as a member of Maxtor Corporation’s 2 Board of Directors from August 2003 until its sale to Seagate Technology in May 2006. He also served on the Board of Directors of Inktomi Corporation, an Internet software company, before it was acquired by Yahoo! Inc. in March 2003. Currently, Mr. Myers is a private investor and sits on the Board of Directors and heads the audit committee for WebRoot Corporation, a privately held Internet Security company. Mr. Myers holds an undergraduate degree from Cal-State University, Hayward and holds an M.B.A. from Santa Clara University. Directors whose terms expire at the 2008 Annual Meeting of Stockholders Steven J. Campbell has served as Chairman of the Board of Directors since our inception in January 1996 and served as our Chief Executive Officer from January 1996 through April 1996. Mr. Campbell was a founder of StrataCom, Inc., a network switching equipment company which was acquired by Cisco Systems in July 1992. At StrataCom, Mr. Campbell was employed from January 1986 to June 1986 as Chief Executive Officer, and then from June 1986 to 1990 as Vice President of Engineering and Operations. He headed the PBX development at Rolm Communications, Inc., a telecommunications company, from 1978 through 1983 and held various positions at Intel Corporation from 1972 through 1978. Mr. Campbell holds a B.S. in electrical engineering from Oregon State University and an M.S. in electrical engineering from Santa Clara University. Craig W. Elliott has served as a director since April 1996. From April 1996 until his retirement in May 2002, Mr. Elliott served as President and Chief Executive Officer of Packeteer. Prior to joining Packeteer, Mr. Elliott served as International General Manager of Apple, Inc.’s Online Internet Division from January 1991 to March 1996. From November 1987 to May 1990, Mr. Elliott served as Apple’s Product Business Manager in charge of Networking and Communication Products. Mr. Elliott holds a B.S. from Iowa State University. Joseph A. Graziano has served as a director since February 1996. From June 1989 to December 1995, Mr. Graziano was Executive Vice President and Chief Financial Officer of Apple, Inc. and served as a director of Apple from June 1993 until October 1995. From May 1987 to June 1989, Mr. Graziano served as Chief Financial Officer of Sun Microsystems, Inc. From October 1981 to May 1985, he was Chief Financial Officer of Apple Computer, Inc. Mr. Graziano holds a B.S. in accounting, received an honorary doctorate of business from Merrimack College and is a certified public accountant. Directors whose terms expire at the 2009 Annual Meeting of Stockholders L. William Krause has served as a director since March 2001. Mr. Krause has been President of LWK Ventures, a private investment firm, since 1991. In addition, Mr. Krause served as Chairman of the Board of Caspian Networks, Inc., an IP networking systems provider, from April 2002 to September 2006 and as CEO from April 2002 until June 2004. From September 2001 to February 2002, Mr. Krause was Chairman and Chief Executive Officer of Exodus Communications, Inc., which he guided through Chapter 11 Bankruptcy to a sale of assets. He also served as President and Chief Executive Officer of 3Com Corporation, a global data networking company, from 1981 to 1990, and as its Chairman from 1987 to 1993 when he retired. Mr. Krause currently serves as a director of Brocade Communication Systems, Inc., Core-Mark Holding, Inc., Sybase, Inc., and Trizetto Group, Inc. Mr. Krause holds a B.S. degree in electrical engineering and received an honorary doctorate of science from The Citadel. Bernard F. (Bud) Mathaisel has served as a director since December 2004. From August 1999 through September 2006, Mr. Mathaisel was Chief Information Officer of Solectron Corporation where he also held the title of Corporate Vice President from 1999 to 2004 and Senior Vice President from 2004 to 2006, and where he was responsible for global information technology, facilities, environmental health and safety, and all business continuity. Prior to joining Solectron, Mr. Mathaisel served as CIO of Ford Motor Company, where he had world-wide responsibility for IT, e-commerce and Ford’s process-leadership group. Prior to Ford, Mr. Mathaisel was a national partner at Ernst & Young LLP where he founded and directed their Center for Business Innovation in Boston, Massachusetts. Mr. Mathaisel has also held executive positions at Walt Disney Company and Temple, Barker and Sloane, Inc. Mr. Mathaisel holds a B.S. in aeronautics and astronautics and an M.S. in Operations Research from Massachusetts Institute of Technology. Peter Van Camp has served as a director since May 2001. Mr. Van Camp serves as the Executive Chairman of Equinix, Inc., an Internet infrastructure services company, where he also served as Chief Executive Officer from May 2000 through April 2007. Prior to joining Equinix in May 2000, he served as President, Americas Region for 3 UUNet, an Internet services company and a division of WorldCom, Inc., beginning in January 1997. From October 1982 until January 1997, Mr. Van Camp served as Vice President of Sales and subsequently President of CompuServe Network Services, the corporate data networking division of CompuServe, Inc., a network services company. Mr. Van Camp holds a B.S. in accounting with a concentration in computer science from Boston College. CORPORATE GOVERNANCE Director Independence The Board of Directors has determined that, other than Mr. Côté, our current President and Chief Executive Officer, each of the members of the Board of Directors is an independent director for purposes of applicable Nasdaq rules. The Board of Directors has an Audit Committee, a Compensation Committee and a Corporate Governance and Nominating Committee. Our Board of Directors has determined that each member of the Audit Committee satisfies the additional independence requirements for audit committee members set forth in applicable Nasdaq and SEC rules. Our Board of Directors has also determined that each member of the Compensation Committee satisfies the additional independence requirements for our Compensation Committee members set forth in the charter of the Compensation Committee posted on our website at http://www.packeteer.com/company/investors/corpgov.cfm. Director Attendance at Meetings The Board of Directors held nine meetings during 2006. Each of the standing committees of the Board of Directors held the number of meetings indicated below. Each of our directors attended at least 75% of the total number of meetings of the Board of Directors and all of the committees of the Board of Directors on which such director served during 2006. The following table sets forth the members of each of the standing committees during 2006 and the number of meetings held by each such committee: Committees of the Board of Directors Name of Director Dave Côté . . . . . . . . . . . . . Steven J. Campbell . . . . . . Craig W. Elliott . . . . . . . . . Joseph A. Graziano . . . . . . L. William Krause . . . . . . . Bernard F. (Bud) Mathaisel . . . . . . . . . . . . Gregory E. Myers . . . . . . . Peter Van Camp. . . . . . . . . Number of Meetings: Audit Compensation Nominating and Corporate Governance Member Member during 2006(1) Chairman and Financial Expert Chairman Member Member (2) 6 Member 7 5 Member Chairman (1) Mr. Elliott resigned as a member of the Compensation Committee on January 4, 2007. (2) Mr. Myers became a member of the Board of Directors and the Audit Committee on July 18, 2006. Director Attendance at Annual Meetings of Stockholders We make every effort to schedule our annual meeting of stockholders at a time and date to maximize attendance by our directors taking into account their schedules. All of our directors are expected to make every effort to attend our annual meeting of stockholders absent an unavoidable and irreconcilable conflict. Messrs. Côté, Elliott, and Mathaisel attended our 2006 annual meeting of stockholders. 4 Board Committees Audit Committee. The Audit Committee functions under a charter that is available on our website at: http://www.packeteer.com/company/investors/corpgov.cfm. The primary functions of the Audit Committee include: (i) overseeing our accounting and financial reporting processes and the audits of our financial statements, including monitoring the adequacy of our system of financial reporting and internal accounting controls and procedures; (ii) reviewing the qualifications, independence and performance, and approving the terms of engagement, of our independent registered public accounting firm; (iii) reviewing and pre-approving any audit and permissible nonaudit services that may be performed by our independent registered public accounting firm; (iv) reviewing and approving any related party transactions; (v) reviewing with our management and the independent registered public accounting firm our interim and year-end operating results; (vi) reviewing our critical accounting policies and the application of accounting principles; and (vii) preparing any reports required under SEC rules. The Board of Directors has determined that all of the members of the Audit Committee possess the level of financial literacy required by applicable Nasdaq and SEC rules and that Mr. Graziano is an audit committee financial expert as defined by SEC rules. In addition, each of the members of the Audit Committee, including Mr. Graziano, satisfies the independence requirements for audit committee members set forth in applicable Nasdaq and SEC rules. Additional information regarding the Audit Committee is set forth in the Report of the Audit Committee immediately following Proposal No. 2. Compensation Committee. The Compensation Committee functions under a charter that is available on our website at: http://www.packeteer.com/company/investors/corpgov.cfm. The purpose of the Compensation Committee is to assist the Board of Directors in carrying out its responsibilities with respect to: (i) reviewing and approving the compensation of our executive officers, including the Chief Executive Officer; (ii) reviewing director compensation; (iii) administering our equity incentive plans; and (iv) preparing any reports required under SEC rules. More specifically, the Compensation Committee’s scope and authority with respect to executive officer compensation include: (i) review and approval of all compensation for the Chief Executive Officer, including incentive compensation, in consultation with the Board of Directors; (ii) review and approval of annual performance goals and objectives relevant to Chief Executive Officer compensation and review of his performance in light of these goals and objectives; (iii) the making of recommendations to the Board of Directors regarding incentive-based and equity-based compensation plans in which executive officers participate; (iv) review and approval of salaries, incentive-based awards and equity-based awards for our executive officers; (v) oversight of the evaluation of management; (vi) administration of our incentive-based or equity-based compensation plans consistent with the provisions of such plans; (vii) approval of all employment, severance or change in control agreements, or other supplemental benefits applicable to executive officers; (viii) periodic review of and rendering of advice to the Board of Directors concerning regional and industry-wide compensation practices and trends to assess the adequacy and competitiveness of our director and executive officer compensation; and (ix) periodic review of changes to director compensation and recommendation of such changes to the Board of Directors. The Compensation Committee charter provides for delegation of any of our Compensation Committee’s duties or responsibilities to subcommittees or to one member of the committee. When considering and determining the compensation paid to our executive officers and directors, the Compensation Committee typically begins its annual process in the fall and finalizes new compensation arrangements in the beginning of the new year. The Compensation Committee generally meets at regular and special meetings with our Vice President of Human Resources and Compensia, a compensation consultant. The Compensation Committee also seeks input from other non-employee members of our Board of Directors and specific recommendations from our Chief Executive Officer as to compensation for executive officers other than the Chief Executive Officer. During a portion of each meeting, the Compensation Committee meets in executive session. Compensia was engaged by the Compensation Committee in June 2006 to help the Compensation Committee evaluate and determine executive compensation philosophy and programs for executive officer compensation, Board of Director compensation and employee equity compensation. Compensia generally attends meetings of the 5 Compensation Committee and also communicates with the Compensation Committee outside of meetings. Compensia reports to the Compensation Committee rather than to management, although Compensia may meet with management from time to time for purposes of gathering information that management may provide to the Compensation Committee. Currently, Compensia does not provide any other services to Packeteer and receives compensation only with respect to the services provided to the Compensation Committee. The Compensation Committee has authority under its charter to retain, approve fees for and terminate advisors, consultants and agents as it deems necessary to assist in the fulfillment of its responsibilities. Our Board of Directors has determined that each current member of the Compensation Committee satisfies the additional independence requirements for our Compensation Committee members set forth in the charter of the Compensation Committee. On January 24, 2007, the Board of Directors approved revisions to the charter setting forth new independence standards for Compensation Committee members. In anticipation of these changes, Mr. Elliott, a member of the Compensation Committee during 2006, resigned on January 4, 2007. For more information on our Compensation Committee and its philosophy, please refer to the section entitled “Compensation Discussion and Analysis.” The Report of the Compensation Committee is included immediately following the Compensation Discussion and Analysis. Corporate Governance and Nominating Committee. The Corporate Governance and Nominating Committee functions under a charter that is available on our website at: http://www.packeteer.com/company/investors/corpgov.cfm. The primary functions of the Corporate Governance and Nominating Committee include: (i) identifying and selecting or recommending director nominees for each election of directors; (ii) developing and recommending to the Board of Directors criteria for selecting qualified director candidates; (iii) considering committee member qualifications, appointment and removal, (iv) recommending codes of conduct and compliance mechanisms applicable to Packeteer; and (v) providing oversight in the evaluation of the Board of Directors and each committee. Director Nominations When considering the nomination of directors for election at an annual meeting, the Corporate Governance and Nominating Committee reviews annually the results of an evaluation performed by the Board of Directors, and the needs of the Board of Directors for various skills, experience or other characteristics. The Corporate Governance and Nominating Committee’s assessment of the Board of Directors’ needs includes issues of diversity, age, skills such as an understanding of technology, finance, marketing, manufacturing and international business, and expected contributions to the Board of Directors. When reviewing a potential candidate for nomination as director, including an incumbent who intends to stand for re-election, the Corporate Governance and Nominating Committee considers the perceived needs of the Board of Directors, the candidate’s relevant background, experience, skills and expected contributions, and the qualification standards established from time to time by the Corporate Governance and Nominating Committee. With respect to such standards, it is the Corporate Governance and Nominating Committee’s goal to assemble a Board of Directors that has a diversity of experience at policy-making levels in business, government, education and technology, and in areas that are relevant to our global activities. In addition, the Corporate Governance and Nominating Committee believes that members of the Board of Directors should possess the highest personal and professional ethics, integrity and values, and be committed to representing the long-term interests of our stockholders. They must have an inquisitive and objective perspective and mature judgment. They must also have experience in positions with a high degree of responsibility and be leaders in the companies or institutions with which they are affiliated. In addition to the benefits of diverse viewpoints, the Corporate Governance and Nominating Committee may also take into account the benefits of a constructive working relationship among directors. Members of the Board of Directors are expected to rigorously prepare for, attend, and participate in all Board of Directors and applicable committee meetings. Other than the foregoing, there are no stated criteria for director nominees, although the Corporate Governance and Nominating Committee may also consider such other factors as it may deem, from time to time, are in the best interests of Packeteer and our stockholders. The Corporate Governance and Nominating Committee considers candidates for directors proposed by directors, management or stockholders, and evaluates any such candidates against the criteria and pursuant to the policies and procedures set forth above. If the Corporate Governance and Nominating Committee believes that the 6 Board of Directors requires additional candidates for nomination, it engages, as appropriate, a third party search firm to assist in identifying qualified candidates. As part of the nominating process, all incumbent directors and nonincumbent nominees are required to submit a completed form of directors’ and officers’ questionnaire and all incumbent directors may be required to participate in a self-assessment process. The nomination process may also include interviews and additional background and reference checks for non-incumbent nominees, at the discretion of the Corporate Governance and Nominating Committee. In addition, stockholders may recommend or nominate directors for election at an annual meeting, provided the advance notice requirements set forth in our Bylaws have been met. Candidates recommended by stockholders will be evaluated against the same criteria and pursuant to the same policies and procedures applicable to the evaluation of candidates proposed by directors or management. Communications with Directors Any stockholder who wishes to contact our Chairman of the Board of Directors or any of the other members of the Board of Directors may do so in writing by mail to: Chairman of the Board of Directors, c/o Corporate Secretary, Packeteer, Inc., 10201 North De Anza Boulevard, Cupertino, California 95014; or by email to our Corporate Secretary: dyntema@packeteer.com. The Corporate Secretary shall maintain a log of such communications and transmit as soon as practicable such communications to the identified director addressee(s), unless there are safety or security concerns that mitigate against further transmission of the communication, as determined by the Corporate Secretary in consultation with our corporate counsel. The Board of Directors or individual directors so addressed shall be advised of any communication withheld for safety or security reasons as soon as practicable. Code of Business Conduct and Ethics The Board of Directors has adopted a Code of Business Conduct and Ethics, which outlines the principles of legal and ethical business conduct under which we do business. The Code of Business Conduct and Ethics is applicable to all of our directors, officers and employees. The Code is available at http://www.packeteer.com/company/investors/corpgov.cfm. Any substantive amendment or waiver of the Code relating to executive officers or directors will be made only after approval by a committee comprised of a majority of our independent directors and will be promptly disclosed on our website within four business days. Corporate Governance Principles In July 2006, we adopted Corporate Governance Principles that address the role of the Board of Directors, composition of the Board of Directors, criteria for Board of Directors membership and other Board of Directors governance matters. These principles are available on our website at http://www.packeteer.com/company/investors/corpgov.cfm. Compensation Committee Interlocks and Insider Participation The members of the Compensation Committee for 2006 were Messrs. Krause (Chairman), Van Camp and Elliott. Except for Mr. Elliot, who served as President and Chief Executive Officer of Packeteer from April 1996 until his retirement in May 2002, none of the members of the Compensation Committee have ever been employees or officers of Packeteer. During 2006, no member of the Compensation Committee had any relationship with us requiring disclosure under Item 404 of Regulation S-K and none of our executive officers served on the compensation committee (or its equivalent) or board of directors of another entity any of whose executive officers served on our Compensation Committee or Board of Directors. For information on the compensation paid to the members of the Board of Directors, please see the section entitled “Director Compensation” under the heading “Executive Compensation.” 7 PROPOSAL NO. 2 RATIFICATION OF APPOINTMENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Audit Committee of the Board of Directors of Packeteer has selected KPMG LLP as independent registered public accounting firm to audit our consolidated financial statements for the year ending December 31, 2007. KPMG LLP has acted in such capacity since its appointment in 1996. A representative of KPMG LLP is expected to be present at the annual meeting, with the opportunity to make a statement if the representative desires to do so, and is expected to be available to respond to appropriate questions. Packeteer incurred the following fees for services rendered by KPMG LLP in the years ended December 31, 2006 and 2005: 2006 2005 Audit Fees(1) . . . . . . . . . Audit-Related Fees . . . . . Tax Fees(2) . . . . . . . . . . . All Other Fees(3). . . . . . . ................................... ................................... ................................... ................................... $1,617,200 $ 0 $ 199,800 $ 0 $1,817,000 $ 992,700 $ 0 $ 186,240 $ 694 $1,179,634 Total Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1) Audit Fees consist of fees incurred for professional services rendered for the audit of our consolidated annual financial statements and review of the interim consolidated financial statements included in quarterly reports, and services that are normally provided by KPMG LLP in connection with statutory and regulatory filings or engagements. Audit fees also included audit services related to our compliance with Section 404 of the Sarbanes-Oxley Act of 2002 regarding our internal controls over financial reporting. (2) Tax Fees consist of fees billed for professional services rendered for tax compliance, tax advice and tax planning (domestic and international). These services include assistance regarding federal, state and international tax compliance and international tax planning. This category includes a transfer pricing study for our Canadian subsidiary and analysis of our cost sharing arrangements and cost allocation methodologies with our international subsidiaries. (3) All Other Fees consist of fees for products and services other than the services reported above. In 2005, this category included fees related to subsidiary statutory filing requirements. The Audit Committee has determined that all services performed by KPMG LLP are compatible with maintaining the independence of KPMG LLP. In accordance with SEC rules, the Audit Committee pre-approves all audit and non-audit services provided by our independent registered public accounting firm. These services may include audit services, audit-related services, tax services and other services permitted by SEC rules governing auditor independence. The Audit Committee has adopted a policy for the pre-approval of services provided by the independent registered public accounting firm. Under the policy, the Audit Committee may also delegate authority to preapprove certain specified audit or permissible non-audit services to one or more of its members. A member to whom pre-approval authority has been delegated must report his or her pre-approval decisions, if any, to the Audit Committee at its next meeting. Unless the Audit Committee determines otherwise, the term for any service preapproved by a member to whom pre-approval authority has been delegated is 12 months. Vote Required and Recommendation of the Board Approval of this proposal requires the affirmative vote of a majority of the votes cast affirmatively or negatively at the annual meeting of stockholders, as well as the presence of a quorum representing a majority of all outstanding shares of our Common Stock, either in person or by proxy. Unless marked to the contrary, proxies received will be voted “FOR” ratification of the Audit Committee’s appointment of KPMG LLP as our independent registered public accounting firm for the year ending December 31, 2007. Abstentions and broker non-votes will 8 each be counted as present for purposes of determining the presence of a quorum but will not have any effect on the outcome of the proposal. Stockholder ratification of the selection of KPMG LLP as independent auditors is not required by our Bylaws or otherwise. The Board of Directors, however, is submitting the selection of KPMG LLP to the stockholders for ratification as a matter of good corporate practice. In the event that ratification of this selection of our independent registered public accounting firm is not approved by a majority of the shares of Common Stock voting thereon, the Audit Committee will review its future selection of an independent registered public accounting firm. Even if the appointment is ratified, the Audit Committee, in its discretion, may direct the appointment of a different independent registered public accounting firm at any time during the year if the Audit Committee determines that such a change would be in Packeteer’s and our stockholders’ best interest. The Board of Directors unanimously recommends that the stockholders vote “FOR” the ratification of the Audit Committee’s appointment of KPMG LLP as Packeteer’s independent registered public accounting firm for the year ending December 31, 2007. REPORT OF THE AUDIT COMMITTEE The following is the report of the Audit Committee with respect to Packeteer’s audited financial statements for the year ended December 31, 2006, which include the consolidated balance sheets as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income and cash flows for each of the years in the three-year period ended December 31, 2006, and the notes thereto. The Audit Committee oversees Packeteer’s financial reporting process on behalf of the Board of Directors, reviews the financial information issued to stockholders and others, including a discussion of the quality, not just the acceptability of the accounting principles, the reasonableness of significant judgments and the clarity of discussions in the financial statements, and monitors the systems of internal control and the audit process. Management has the primary responsibility for the financial statements and the reporting process, including internal control systems. KPMG LLP is responsible for expressing an opinion as to the conformity of our audited financial statements with generally accepted accounting principles. Review with Management The Audit Committee has reviewed and discussed Packeteer’s audited financial statements with management. Review and Discussions with Independent Registered Public Accounting Firm The Audit Committee has discussed with KPMG LLP, the Company’s independent registered public accounting firm, the matters required to be discussed by Statement on Auditing Standards 61, (Communications with the Audit Committee) as adopted by the Public Company Accounting Oversight Board in Rule 3600T. The Audit Committee has received from the auditors a formal written statement describing all relationships between the auditors and Packeteer that might bear on the auditors’ independence consistent with Independence Standards Board Standard No. 1 (Independence Discussions with Audit Committees), discussed with the auditors any relationships that may impact their objectivity and independence, and satisfied itself as to the auditors’ independence. Conclusion Based upon the review and discussions referred to above, the Audit Committee recommended to the Board of Directors that the Company’s audited financial statements be included in its Annual Report on Form 10-K for the year ended December 31, 2006. The Audit Committee and the Board of Directors have also recommended, subject 9 to stockholder approval, the selection of KPMG LLP as the Company’s independent registered public accounting firm for the year ending December 31, 2007. SUBMITTED BY THE AUDIT COMMITTEE OF THE BOARD OF DIRECTORS Steven J. Campbell Joseph A. Graziano, Chairman Bernard F. (Bud) Mathaisel Gregory E. Myers 10 EXECUTIVE OFFICERS Our executive officers and information concerning their ages and background as of April 1, 2007 are listed below: Name Age Title Dave Côté . . . . . . . . . . . . . . Arturo Cázares(1) . . . . . . . . Manuel R. Freitas . . . . . . . . Alan Menezes . . . . . . . . . . . Nelu Mihai . . . . . . . . . . . . . Greg Pappas . . . . . . . . . . . . David C. Yntema . . . . . . . . ......... ......... ......... ......... ......... ......... ......... 52 45 58 47 51 44 62 President, Chief Executive Officer and Director Vice President, Worldwide Sales Vice President, Operations and Customer Support Vice President, Marketing Vice President, Engineering Vice President, Human Resources Chief Financial Officer and Secretary Dave Côté has served as our President, Chief Executive Officer and director since October 2002. From April 1997 to October 2002, Mr. Côté served as Vice President of Worldwide Marketing and Communication ASSPs (Application-Specific Standard Products) for Integrated Device Technology, Inc., a semiconductor company. From January 1995 to November 1996, Mr. Côté served as Vice President of Marketing and Customer Support for ZeitNet Inc., which was acquired by Cabletron in 1996. From 1979 to 1995, he served in various marketing and sales positions, most recently as Director of Marketing at SynOptics, Inc. (now Nortel Networks). Mr. Côté holds a B.S. from the University of California at Davis and an M.B.A. from California State University at Sacramento. Arturo Cázares has served as our Vice President, Worldwide Sales since January 2004. Previously, he served as Senior Vice President, Worldwide Sales and Marketing at Menlo Worldwide, a supply chain logistics and transportation company, from September 2002 to January 2004. From July 1992 through August 2002, Mr. Cázares served in various executive management positions at 3Com Corporation. Most recently, Mr. Cázares was Vice President, Sales, Service & Marketing for 3Com’s Business Connectivity Company from June 2001 through September 2002 and as Vice-President of Worldwide Services of 3Com from April 2001 to June 2001. Mr. Cázares served as Vice President for 3Com EMEA from April 1999 through April 2001, and prior to that Mr. Cázares was Vice President for 3Com Americas International. Prior to 3Com, Mr. Cázares worked at Sun Microsystems and Fujitsu America. Mr. Cázares holds a B.S. in electrical engineering and an M.B.A. from Stanford University. Manuel R. Freitas has served as our Vice President, Operations and Customer Support since May 2000. Mr. Freitas served as an independent operations management consultant from April 1999 until November 1999 and then again from February 2000 through May 2000. From November 1999 to February 2000, he served as Vice President of Customer Operations for Vividence Corporation, an Internet services company. From February 1990 to March 1999, Mr. Freitas served in various positions at Adobe Systems, Inc., including Vice President of Worldwide Customer Operations from October 1995 to March 1999, interim Vice President of Sales and Support for the Americas from April 1998 to November 1998 and Director of OEM and Developer Support from February 1990 to September 1995. Prior to joining Adobe, Mr. Freitas served in product management, field operations management, and sales management positions at Schlumberger Technologies from 1980 to 1989. Mr. Freitas holds a B.A. in business administration from William Patterson College. Alan Menezes has served as our Vice President of Marketing since February 2007. From August 2005 through February 2007, Mr. Menezes served as Corporate Vice President, Marketing and Business Development at Wavion , a Wi-Fi (wireless fidelity) company. Prior to joining Wavion, he was Vice President of Marketing at Aperto Networks, a WiMAX (worldwide interoperability for microwave access) equipment provider, from November 1999 through August 2005. From 1983 through 1998, Mr. Menezes held various marketing and engineering positions at AccessLan Communications, Allied Telesyn International, 3Com, DSC and Nortel. In 1989, Mr. Menzes also cofounded OnStream Networks, a provider of broadband access solutions which was subsequently acquired by 3Com. He holds a B.S. in electrical engineering from the University of Alberta, Canada. (1) Mr. Cázares resigned as an officer of Packeteer on April 4, 2007. The information in this Proxy Statement has not otherwise been updated to reflect such resignation. 11 Nelu Mihai has served as our Vice President, Engineering since January 2006. Mr. Mihai served as Senior Vice President of Engineering and Operations at Cloudshield Technologies, a provider of servers for network traffic inspection, from April 2003 to March 2004. From April 2004 to January 2006, Mr. Mihai was a consultant for early stage private software, telecom, security and network semiconductor companies. In 2002, he co-founded SLA partners, an international consulting firm. From December 1999 to December 2001 he served as Chief Executive Officer and Chief Operating Officer of CPlane Inc, a telecommunication software company. Prior to 1999, he worked for six years at Bell Labs and AT&T, his last position there being Division Manager. Before 1994, he served in different positions at various Silicon Valley startup companies specializing in real time operating systems and at nuclear research institutes in Western Europe. Mr. Mihai holds a M.S. in computer engineering from Polytechnic University of Bucharest and a Ph.D in computer science from the Institute of Atomic Physics, Bucharest, with the doctorate work done at CERN Geneva, Switzerland. Greg Pappas has served as our Vice President of Human Resources since November 2005. From July 2004 through October 2005, Mr. Pappas served as Vice President of Human Resources of Extended Systems, Inc., a mobility software company. From June 2000 through July 2004, Mr. Pappas served as Vice President of Human Resources for GlobalEnglish Corporation, an Internet e-learning company. Prior to joining GlobalEnglish, from November 1998 through June 2000 Mr. Pappas served as Vice President of Human Resources for Inference Corporation, a knowledge management software company acquired by E-Gain Corporation. Mr. Pappas holds a B.S. in human resource administration from Kennedy-Western University. David C. Yntema has served as our Chief Financial Officer and Secretary since January 1999. From May 1994 through August 1998, Mr. Yntema served as Chief Financial Officer and Vice President, Finance and Administration of VIVUS, Inc., a pharmaceutical company. Prior to joining VIVUS, Mr. Yntema served as Chief Financial Officer for EO, Inc., a handheld computer company; MasPar Computer Corporation, a massively parallel computer company; and System Industries, a storage subsystem company; and has held a variety of other financial and general management positions. Mr. Yntema holds a B.A. in economics and business administration from Hope College and an M.B.A. from the University of Michigan and is a certified public accountant. There are no family relationships among any of our directors or executive officers. EXECUTIVE COMPENSATION Compensation Discussion and Analysis Overview The Compensation Committee is empowered to discharge the Board’s responsibilities relating to compensation and benefits for our executive officers. The Compensation Committee seeks to set compensation and benefits such that the total compensation paid to our executive officers is reasonable, competitive and reflective of corporate and individual performance. Philosophy and Objectives The Compensation Committee believes that the most effective executive compensation program is one that delivers compensation opportunities at levels generally consistent with market competitive practice, but provides for differentiated levels of actual compensation based on individual and company performance. Further, the Compensation Committee believes in creating a strong alignment between the interests of our executives and our stockholders by linking a significant portion of executive compensation to growth in the market value of our stock. We operate in a very competitive industry and are located in Silicon Valley where competition for executives is intense. Therefore, we have the additional objective of offering compensation programs that preserve our ability to attract and retain superior executives and providing competitive compensation to key employees relative to the compensation paid to similarly situated executives of our peer companies. The Compensation Committee’s objective is to structure our short and long-term incentive-based executive compensation programs to motivate executives to achieve our business goals and reward the executives for achieving these goals. In the process in developing a 2006 program to meet these goals, both management and our 12 Compensation Committee engaged consultants. During 2005 through early 2006, management engaged an individual compensation consultant to assist management in collecting market data and developing recommendations for the Compensation Committee. Also in 2005, the Compensation Committee engaged Aon Consulting, Inc., an independent compensation consulting firm, to conduct a review of our 2005 executive compensation program and to assist the Compensation Committee in considering 2006 executive compensation. When considering factors relevant to 2006 executive compensation, the Compensation Committee reviewed relevant market data that had been prepared by management’s consultant and subsequently validated by Aon. The Compensation Committee was also presented with corresponding alternatives to consider when making 2006 compensation decisions for our executive officers. After finalizing the 2006 executive compensation program, the Compensation Committee determined it would be appropriate to engage a consultant to provide ongoing consultation services to the Compensation Committee. Accordingly, the Compensation Committee engaged Compensia in June 2006 for these services, which included assistance with the development of our 2007 executive compensation program. Generally, the Compensation Committee begins each annual process in the fall and finalizes new compensation arrangements in January of the following year. The Compensation Committee typically meets at regular and special meetings with our Vice President of Human Resources and the Compensation Committee’s compensation consultant. Starting in December 2006, outside legal counsel also generally attends meetings of the Compensation Committee. Prior to the hiring of our Vice President of Human Resources, our Chief Financial Officer generally attended meetings of the Compensation Committee. The Compensation Committee seeks specific recommendations from our Chief Executive Officer as to compensation for executive officers other than the Chief Executive Officer, and additional input from nonemployee members of our Board of Directors. Additionally, when determining compensation for our Chief Executive Officer, the Compensation Committee reviews the feedback of our executive officers with respect to our Chief Executive Officer’s performance. In making compensation decisions, the Compensation Committee compares total compensation and each element of total compensation against a select peer group of publicly-traded networking and technology industry companies of similar size and organizational scope. The companies currently comprising the select peer group are: Blue Coat Systems Extreme Networks F5 Networks Foundry Networks Internet Security Systems MRV Communications NETIQ NetScout Systems Novatel Wireless Redback Networks Secure Computing SonicWALL WatchGuard Technologies Websense In addition the Compensation Committee also considers supporting data from industry surveys regarding a group of similarly-sized (by revenue and headcount) peers. The companies in the select peer group and in the similarly-sized group are not necessarily our direct competitors for customers, but are potential competitors for executive talent. For each executive position, the Compensation Committee generally targets its consultant’s assessment of the approximate median of the competitive range of both the select peer group and the similarly sized group as the level of compensation that would allow us to attract and retain talented officers. However, while evaluation of our executive compensation market data is an important factor in evaluating executive compensation packages as a whole, the Compensation Committee has determined that our executive compensation will not be based solely on specific, predetermined market levels. Departures from market levels may occur based upon the experience level, responsibilities, past performance and expected contributions of the individual. A significant percentage of total compensation is incentive-based. The Compensation Committee determines the allocation between either cash and non-cash or short-term and long-term incentive compensation on an annual basis, after reviewing information provided by its compensation consultant. There is no pre-established plan or target for such allocation. Rather, the Compensation Committee establishes an annual policy based on its goal to align our executive compensation program with relevant strategic objectives. 13 Compensation Elements In order to align executive compensation with our compensation philosophy, our executive officer compensation package contains three primary elements: base salary, cash bonuses and annual equity-based awards. In addition, we provide our executive officers a variety of benefits that are available generally to all salaried employees in the geographic location in which they are based. Each component of our executive compensation program is designed to reward different aspects of performance. The Compensation Committee sets executive officer base salary compensation at a level that it believes enables us to attract and retain strong executive talent. Our short-term incentive compensation program is designed to provide short-term incentives to our executives through cash bonus awards. Pay-outs, if earned, are made on a semi-annual basis and are determined based upon our achievement of designated corporate financial goals, including revenue and operating income results, compared to our financial plan for the related period. Our long-term incentive compensation program is designed to provide long-term incentives through equity-based awards that reward our executives for increasing stockholder value over time. Through 2006, our long-term incentive compensation program included only stock options subject to time based vesting. Starting in 2007, the Compensation Committee modified the long-term incentive compensation program to include a combination of stock options subject to time based vesting and performance share awards subject to vesting based upon long-term financial performance. With the exceptions of a modified short-term incentive compensation program for our Vice President of Worldwide Sales, severance benefits payable to our Chief Executive Officer and Chief Financial Officer and certain change in control benefits payable to our Chief Executive Officer, our executive compensation packages do not differentiate between our executives listed in the Summary Compensation Table below, referred to in this Proxy Statement as our Named Executive Officers, and other executive officers. Base Salary Our executive base salaries are based upon individual and company performance and the individual’s expected contribution and experience, as well as the annual evaluation of market data of peer companies. In the process of determining base compensation for 2006, the Compensation Committee considered data prepared by management’s consultant and confirmed by Aon reflecting that, on average, our executive base salaries generally trailed the select peer group and similarly-sized peer group median by 8% at the end of 2005. Effective January 2006, executives received an increase from 2005 which ranged between 0% and 10.4%. Mr. Pappas, a new hire in late 2005, and Mr. Cázares, our Vice President of Worldwide Sales, did not receive an increase in their base salaries. In the process of determining base compensation for 2007, Compensia presented data reflecting that our overall executive base salaries, on average, were expected to trail select peer group and similarly-sized peer group median by 8% by the end of 2006. Effective January 2007, each of our executive officers received an increase in base salary from 2006 which ranged between 2.2% to 10.7%. Short Term Incentive Compensation Our short term incentive compensation is structured as a performance-based cash bonus plan. The cash bonuses for all of our executive officers are based on an assigned target incentive rate, expressed as a percentage of each officer’s annual base salary. The cash bonuses are awarded on the basis of our performance by comparing our actual revenue and operating income results against revenue and operating income goals established semi-annually by the Board of Directors for the first and second half of the year. The Compensation Committee believes revenue and operating income to be the best measures of financial success and believes that performance at or above revenue and operating income goals will ultimately translate into improved stockholder value. The revenue and operating income goals for 2006 performance represented a substantial stretch beyond our corresponding results for 2005. Although the Compensation Committee realized that achievement of the 2006 goals would be very difficult, it also believed that the goals were appropriate based on a review of the potential market demand for our products. If earned, bonuses are paid semi-annually and are based on the assigned target incentive amount for the applicable six month period. The target incentive amount for each such period is equal to one-half of the officer’s annual base salary multiplied by the target incentive rate. For example, if the officer’s annual base salary is $100,000 and the target incentive rate is 40%, then in each semi-annual period the target incentive amount would be 14 $20,000. The bonus actually earned for each semi-annual period is adjusted upward or downward based on our actual revenue and operating income performance in comparison to a revenue goal and operating income goal. Our Compensation Committee believes that semi-annual cash bonuses are reasonable and effective tools for incentivizing executive performance when tied to our achievement of these financial performance goals. For executive officers other than Mr. Cázares, 67% of the aggregate bonus earned for a period is based on achievement of the revenue goal and the remaining 33% is based on achievement of the operating income goal. For each semi-annual period, we must achieve at least 80% of our revenue goal and positive operating income in order for these executives to receive any bonus. Achievement of both goals at target levels results in a semi-annual bonus payment equal to the target incentive amount for the period. The threshold for a minimum payment under the revenue component is 80% of the revenue goal. At this level of performance, such minimum payment is 50% of the target amount payable under the revenue component. Achievement of the revenue goal in excess of 80% will increase the amount payable under the revenue component on a linear basis, subject to a performance cap of 120% resulting in a maximum payment equal to 150% of the target amount payable under the revenue component. The threshold for a minimum payment under the operating income component is 95% of the operating income goal. At this level of performance, such minimum payment is 50% of the target amount payable under the operating income component. Any achievement of the operating income goal above 100% will not increase the amount payable under the operating income component beyond the target level payment. Our formula for determining Mr. Cázares’ short-term incentive compensation differs as it is intended to emphasize performance of the sales organization and reward him for this performance against our revenue goals. Accordingly, 75% of Mr. Cázares’ short-term incentive compensation is based upon achievement of revenue quotas under the sales commission plan and is paid monthly. The remaining 25% of the short-term incentive compensation for Mr. Cázares is a cash bonus based on our achievement of the operating income goal and which is paid semiannually. Annual revenue quotas under the sales commission plan are derived from the semi-annual budgets approved by the Board of Directors at the beginning of each year and confirmed or adjusted semi-annually. In setting target incentive rates for 2006, the Compensation Committee determined that our Chief Executive Officer’s target incentive rate did not provide a compensation opportunity consistent with that of Chief Executive Officers at our peer companies and that pre-existing target incentives for each of our executives were within the appropriate range. Accordingly, our Chief Executive Officer’s target incentive rate was increased from 60% to 70% and the target incentive rates for executives other than the Chief Executive Officer were unchanged from the prior year. Based upon the above, the 2006 executive compensation elements approved by the Compensation Committee for the Named Executive Officers, and the target incentive amounts actually earned by such persons under the 2006 performance-based cash bonus plan, were as follows: Officer Name Position 2006 Annual Target 2006 Annual Target 2006 Base Salary Incentive Earned Incentive Amount Rate (Annualized) 2006 Target ($)(1) ($) ($) Incentive Rate CEO & President Chief Financial Officer VP Worldwide Sales VP Operations and Customer Support Nelu Mihai . . . . . . . VP Engineering Former Officer: David Puglia . . . . . . VP Marketing Dave Côté . . . . . . . . David C. Yntema . . Arturo Cázares . . . . Manuel R. Freitas . . 375,000 265,000 230,000 225,000 230,000 237,000 70% 40% 90%(2) 40% 40% 40% 262,500 106,000 51,750(2) 90,000 92,000 94,800 212,223 85,698 25,875(2) 72,762 69,554 49,110(3) (1) Reflects annual target incentive earned for 2006 performance. Actual bonus compensation for performance in the second half of 2006 was paid in early 2007. (2) As described above, Mr. Cázares’ Annual Target Incentive Amount of $51,750 represents 25% of the Target Incentive Rate multiplied by his base salary rate. Mr. Cázares’ Annual Target Incentive Earned of $25,875 was paid based upon our partial achievement of the operating income goals. In addition to the Annual Target 15 Incentive Amount, Mr. Cázares was eligible to earn short-term incentive compensation under the sales commission plan in an amount equal to 75% of the Target Incentive Rate multiplied by his base salary, or $155,250. For 2006, Mr. Cázares earned $157,993 under the sales commission plan. (3) Mr. Puglia was no longer an employee effective November 30, 2006 and was therefore ineligible to receive a bonus under our performance-based cash bonus plan for the semi-annual period ended December 31, 2006. For other payments made to Mr. Puglia in connection with his departure, please see the Summary Compensation Table below. Other Bonus Payments We may also grant one time performance bonuses based on individual contributions and responsibilities rather than financial metrics. In January 2007, we paid discretionary bonuses to Messrs. Cázares and Freitas in the amount of $6,000 each and to Messrs. Yntema and Mihai in the amount of $7,500 each. These bonuses were recommended by our Chief Executive Officer and approved by the Compensation Committee in recognition of contributions made during 2006 in connection with the acquisition and integration of Tacit Networks. Additionally, pursuant to authority granted to our Chief Executive Officer from the Compensation Committee, Mr. Freitas was awarded other bonus compensation valued at approximately $8,000 in recognition of additional management duties he performed in 2005 and 2006 while we were searching for a Vice President, Engineering. Long-Term Incentive Compensation For 2006 and prior years, the Compensation Committee awarded long-term incentive compensation through stock option awards, with the objective of providing executives with compensation tied to improvements in the market price of our Common Stock. These grants are designed to align the interests of the executive officer with those of the stockholders and provide each individual with a significant incentive to manage Packeteer from the perspective of an owner with an equity stake in the company. For 2006, annual grants were approved at our regularly scheduled Board of Directors meeting on January 25, 2006. Each option permits the officer to acquire shares of our Common Stock at a price per share equal to the closing price per share of our Common Stock as reported on Nasdaq Global Select Market on January 25, 2006. Contingent upon the officer’s continued employment, one-quarter of the options vest after 12 months following the grant date and the balance vest monthly over the following three years. Accordingly, the option will provide a return to the executive officer only if the officer remains employed by us during the vesting period, and then only if the market price of the shares appreciates over the option term. The size of the option award granted to each executive officer in 2006 was set by the Compensation Committee at a level that was intended to create a meaningful opportunity for stock ownership based upon the individual’s current position, the individual’s personal performance in recent periods, the individual’s potential for future responsibility and promotion over the option term, comparison of award levels in prior years and comparison of award levels earned by executives at our peer companies and similarly-sized companies in our broad industry group. The Compensation Committee also took into account the number of unvested options held by the executive officer in order to maintain an appropriate level of retention value for that individual. The relative weight given to each of these factors varied from individual to individual. The Compensation Committee also reviewed compensation survey data for Packeteer’s industry prepared and analyzed by management’s consultant and Aon. The Compensation Committee approved stock option awards for executive officers in 2006 ranging from 50,000 shares to 110,000 shares. Messrs. Pappas and Mihai each received an option grant at the time they started employment in late 2005 and early 2006, respectively, in each case based upon the offer we negotiated with them. Further information about these grants is reflected in the Summary Compensation table and the Grants of Plan-Based Awards table. During the latter part of 2006, the Compensation Committee began working with Compensia to consider adjustments in our long-term incentive compensation approach. In early 2007, the Compensation Committee determined that the annual long-term incentive award for executive officers should include both an option award as well as an additional type of incentive in the form of a performance share award. When determining the appropriate allocation between these awards, the Compensation Committee sought to achieve a balance between the focus on share value appreciation represented by option awards and the focus on long-term revenue and operating income performance represented by performance share awards. For 2007, this goal resulted in a mix of award types in which the annual stock option award generally constitutes approximately 65% of the aggregate target award, and the 16 performance share award (if vested at target levels as described below) generally constitutes approximately 35% of the aggregate target award. Each performance share awarded represents the right to receive one share of our Common Stock following the end of a three-year performance period, subject to applicable vesting terms. The right vests based on the achievement of a specific revenue growth rate and average annual operating margin goals and continued employment of the executive through a specified vesting date following the end of the performance period. If our performance against these financial measures falls below certain minimum levels, no performance shares will vest. If our performance against these measures is at target levels, our executives will vest in the target number of shares subject to the awards, which range from 20,000 to 50,000. If our performance against these financial measures exceeds target levels, the number of performance shares vesting will exceed 100% of the target number of shares, subject to a maximum of 250%. All equity awards to our employees, including executive officers, have been granted at fair market value on the date of grant and are reflected in our consolidated financial statements. We do not have any program, plan or obligation that requires us to grant equity compensation on specified dates. However, we typically schedule a Compensation Committee meeting and make annual grants on the date of our regular Board of Directors meeting in January of each year, as well as on the hire date for new employees. Compensation Committee Philosophy on Change in Control and Severance Benefits In July 2006, the Compensation Committee approved certain change in control benefits for our executives and certain additional severance benefits for Dave Côté, our Chief Executive Officer, and David C. Yntema, our Chief Financial Officer. For a summary and quantification of the change in control and the severance benefits, please see the discussion under the section entitled “Executive Compensation — Potential Payments upon a Termination or Change in Control” below. The Compensation Committee determined to provide change in control arrangements in order to mitigate some of the risk that exists for executives working in an environment where there is a meaningful likelihood that we may be acquired. Our change in control and severance arrangements are intended to attract and retain qualified executives who may have attractive alternatives absent these arrangements. The change in control arrangements are also intended to mitigate a potential disincentive to consideration and execution of an acquisition, particularly where the services of these executive officers may not be required by the acquirer. The Compensation Committee, with the help of Compensia, noted that over 75% of our select peer group companies provide change in control benefits to executive officers, and the Compensation Committee designed this policy to be in line with the practices in this peer group. Similarly, the Compensation Committee determined that severance benefits for our Chief Executive Officer and Chief Financial Officer were appropriate for these positions based on competitive market data provided by Compensia. While the Compensation Committee determined that it was appropriate to approve change in control and severance benefits for our executives, it awarded benefits that it believes are aligned at the lower end of the spectrum of competitive practices. For example, accelerated vesting of equity awards only occurs in limited circumstances, such as a termination or resignation in specified circumstances following a change in control or if awards are not assumed by the acquiring or successor company in a change of control. Only two of our executive officers, our Chief Executive Officer and Chief Financial Officer, are entitled to severance benefits other than those relating to a change in control. Separately, cash payments awarded in connection with any qualified termination or resignation are determined as a multiple of base salary alone, rather than multiples of base salary and bonus. No gross up for excise taxes are payable in connection with severance or change in control benefits. Additionally, the Compensation Committee believes that the terms “cause” and “resignation for good reason” in our change in control and severance benefit arrangements and our performance award agreements are carefully defined to support reasonable transition considerations and our goal of retaining our executives through an acquisition. Other Benefits Executive officers are eligible to participate in all of our employee benefit plans, such as our 1999 employee stock purchase plan; medical, dental, vision, group life, disability, and accidental death and dismemberment 17 insurance; and our 401(k) plan, in each case on the same basis as other employees. Except in limited circumstances, it is our policy not to provide any special perquisites or benefits to executive officers. Tax Considerations The Compensation Committee considers the impact of Section 162(m) of the Internal Revenue Code in determining the mix of elements of executive compensation. This section limits the deductibility of non-performance based compensation paid to each of our Named Executive Officers to $1 million annually. The stock options and performance share awards granted to our executive officers under our 1999 Stock Incentive Plan, or the 1999 Plan, are intended to be treated under current federal tax law as performance-based compensation exempt from the limitation on deductibility. Salaries and bonuses paid under our annual bonus program do not qualify as performance-based compensation for purposes of Section 162(m). The Compensation Committee intends to consider the impact of Section 162(m) on the deductibility of future executive compensation, but reserves the right to provide for compensation to executive officers that may not be fully deductible. COMPENSATION COMMITTEE REPORT We, the Compensation Committee of the Board of Directors of Packeteer, have reviewed and discussed the Compensation Discussion and Analysis contained in this Proxy Statement with management. Based on such review and discussion, we have recommended to the Board of Directors that the Compensation Discussion and Analysis be included in this Proxy Statement and in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. THE COMPENSATION COMMITTEE L. William Krause, Chairman Peter Van Camp 18 Summary Compensation Table The following table sets forth information concerning the compensation earned during the year ended December 31, 2006 by our Chief Executive Officer, our Chief Financial Officer, our three other most highlycompensated executive officers and David Puglia, a former executive officer who would have been included among the three other most highly compensated executive officers had he continued to serve as an executive officer through December 31, 2006. These individuals are referred to in this Proxy Statement as our “Named Executive Officers.” 2006 SUMMARY COMPENSATION TABLE Salary ($)(1) Bonus ($)(2) Option Awards ($)(3) Non-Equity All Incentive Plan Other Compensation Compensation ($)(2) ($)(4) Total ($) Name and Principal Position Year Dave Côté . . . . . . . . . . . . . . . . . . . . . President and Chief Executive Officer David C. Yntema . . . . . . . . . . . . . . . . Chief Financial Officer Arturo Cázares . . . . . . . . . . . . . . . . . . Vice President Worldwide Sales Manuel R. Freitas . . . . . . . . . . . . . . . . Vice President Operations and Customer Support Nelu Mihai(7). . . . . . . . . . . . . . . . . . . Vice President, Engineering Former Officer: David Puglia . . . . . . . . . . . . . . . . . . . Former Vice President Marketing 2006 375,000 2006 265,000 0 7,500 1,022,105 425,510 692,037 425,510 212,223 85,698 25,875 72,762 1,929 3,785 492 2,060 1,611,257 787,493 1,112,397 739,421 2006 387,993(5) 6,000 2006 225,000 14,089(6) 2006 215,256 7,500 477,363 69,554 1,084 770,757 2006 244,595 0 560,337 49,110 131,260(8) 985,302 (1) Unless otherwise noted, reflects the annual base salaries paid to the Named Executive Officers in 2006. (2) Performance-based bonuses are generally paid under our performance-based cash bonus plan and the amounts of such bonuses are reported under the Non-Equity Incentive Plan Compensation column. Additional discretionary bonuses awarded by the Compensation Committee are reported under the Bonus column. Unless otherwise noted, the amounts reported under the Bonus column represent discretionary cash bonuses awarded to several executive officers for contributions made during 2006 in connection with the acquisition and integration of Tacit Networks. These discretionary bonuses were approved by the Compensation Committee on January 31, 2007. (3) Dollar amount of compensation expense related to stock options recognized for financial statement reporting purposes in accordance with FAS 123(R). The assumptions used in the calculation of these amounts are included in Note 1 to our Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2006. (4) Unless otherwise noted, represents premiums paid for group term life insurance benefits. (5) Represents (a) $230,000 in annual salary and (b) $157,993 in commissions earned in 2006. (6) Represents (a) $6,000 in a discretionary cash bonus for performance related to the Tacit acquisition and (b) $8,089 in an additional discretionary bonus awarded to Mr. Freitas in recognition of additional management duties he performed in 2005 and 2006 while we were searching for a Vice President, Engineering. This additional discretionary bonus was awarded by the Chief Executive Officer pursuant to authority granted by our Compensation Committee. (7) Mr. Mihai commenced employment with Packeteer in January 2006. (8) Represents $1,023 in premiums paid for group term life insurance benefits while Mr. Puglia was our employee. Mr. Puglia’s resigned his employment with us effective November 30, 2006 and pursuant to a separation agreement, Mr. Puglia is entitled to receive $98,750 in severance, $20,000 in a negotiated bonus and up to $11,487 in COBRA benefits. The foregoing reported amount for COBRA benefits assumes Mr. Puglia is not covered under 19 another employer’s group health plan through April 30, 2007. As a result of the resignation of Mr. Puglia’s employment, unvested options held by Mr. Puglia to purchase 144,480 shares of our Common Stock were cancelled. For more information regarding Mr. Puglia’s separation agreement, see the section entitled “Potential Payments upon Termination or Change in Control — Benefits Paid to Mr. Puglia upon Separation.” Grants of Plan-Based Awards The following table sets forth certain information with respect to stock and option awards and other plan-based awards granted during the year ended December 31, 2006 to our Named Executive Officers: GRANTS OF PLAN-BASED AWARDS Estimated Future Payouts Under Non-Equity Incentive Plan Awards(1) All Other Option Awards: Number of Grant Date Fair Securities Exercise or Base Value of Underlying Price of Stock and Maximum ($) Options Awards Option Awards (3) (#)(4) ($/sh) ($)(5) Name Grant Date Threshold ($)(2) Target ($) Dave Côté . . . . . . David C. Yntema . Arturo Cázares(6) . Manuel R. Freitas . Nelu Mihai. . . . . . Former Officer: David Puglia(8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1/25/2006 1/25/2006 1/25/2006 1/25/2006 1/25/2006 87,938 35,510 0 30,150 30,820 31,758 262,500 106,000 51,750 90,000 92,000 94,800 350,438 141,510 51,750 120,150 122,820 126,558 110,000 50,000 50,000 50,000 175,000(7) 50,000 9.51 9.51 9.51 9.51 9.51 9.51 572,002 260,001 260,001 260,001 910,002 260,001 . . . . . . . . . 1/25/2006 (1) We award short term incentive compensation under our performance-based cash bonus plan as described under the section entitled “Compensation Discussion and Analysis — Short Term Incentive Compensation.” The amounts under the Threshold, Target and Maximum columns assume that identical performance levels are achieved in both semi-annual periods. The actual amount paid to each Named Executive Officer in 2006 under the performance-based cash bonus plan is set forth above in the Summary Compensation Table under the NonEquity Incentive Plan Compensation column. (2) Assumes achievement of 80% of the revenue goal and positive operating income at a level less than 95% of the operating income goal for both semi-annual periods. See the section entitled “Compensation Discussion and Analysis — Short Term Incentive Compensation” for more information. (3) Assumes achievement of 120% of revenue goal and 100% of the operating income goal for both semi-annual periods. See the section entitled “Compensation Discussion and Analysis — Short Term Incentive Compensation” for more information. (4) Options to purchase our Common Stock vest and become exercisable at the rate of: (a) 25% of the shares upon completion of 12 months of service following the date of grant and (b) the remainder of the shares in 36 equal monthly installments upon completion of each additional month of service thereafter. See the section entitled “Executive Compensation — Potential Payments upon a Termination or Change in Control” for a description of applicable acceleration features. (5) Reflects the grant date fair value of each equity award in accordance with FAS 123(R). The assumptions used in the calculation of this amount are included in Note 1 to our Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2006. (6) Mr. Cázares’ short term incentive compensation under our performance-based cash bonus plan is calculated on a different basis than for other Named Executive Officers. See the section entitled “Compensation Discussion and Analysis — Short Term Incentive Compensation” for more information. (7) Reflects the initial option grant awarded to Mr. Mihai upon his hire as our new Vice President, Engineering. 20 (8) As a result of Mr. Puglia’s resignation from employment with us effective November 30, 2006, he was not eligible to receive cash payouts under the short-term incentive program for the semi-annual period ended December 31, 2006. Additionally, unvested options to purchase 144,480 shares of our Common Stock held by Mr. Puglia were cancelled. Outstanding Equity Awards at Year-End The following table sets forth certain information with respect to the unexercised options held by our Named Executive Officers as of December 31, 2006: OUTSTANDING EQUITY AWARDS AT DECEMBER 31, 2006 OPTION AWARDS(1) Number of Securities Undrlying Unexercised Options Option Exercise (#) Price Unexercisable ($) 782 0 33,855 71,875 110,000 0 0 0 2,292 10,834 31,250 50,000 59,584 26,042 50,000 0 0 2,292 10,834 31,250 50,000 175,000(2) 0 0 8.36 3.50 19.40 14.00 9.51 48.06 16.88 4.71 8.36 19.40 14.00 9.51 18.10 14.00 9.51 12.00 16.88 8.36 19.40 14.00 9.51 9.51 12.15 14.00 Name Dave Côté . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Number of Securities Underlying Unexercised Options(#) Exercisable 36,718 407,000 91,145 66,125 0 Option Expiration Date 1/22/2013 10/7/2012 1/28/2014 1/26/2015 1/25/2016 1/26/2010 1/29/2011 10/22/2011 1/22/2013 1/28/2014 1/26/2015 1/25/2016 1/12/2014 1/26/2015 1/25/2016 5/24/2010 1/29/2011 1/22/2013 1/28/2014 1/26/2015 1/25/2016 1/25/2016 2/28/2007 2/28/2007 David C. Yntema . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 30,000 43,541 107,708 29,166 28,750 0 Arturo Cázares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,416 23,958 0 Manuel R. Freitas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000 30,000 25,667 29,166 28,750 0 Nelu Mihai . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Former Officer: David Puglia(3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 113,020 27,500 (1) Options vest and become exercisable at the rate of: (a) 25% of the shares upon completion of 12 months of service measured from the date of grant and (b) the remainder of the shares in 36 equal monthly installments upon completion of each additional month of service thereafter. See the section entitled “Executive Compensation — Potential Payments upon a Termination or Change in Control” for a description of applicable acceleration features. (2) Reflects the initial option grant awarded to Mr. Mihai upon his hire as our new Vice President, Engineering. (3) In connection with Mr. Puglia’s resignation from employment with us effective November 30, 2006, unvested options to purchase 144,480 shares of our Common Stock held by Mr. Puglia were cancelled. 21 Option Exercises and Stock Vested The following table sets forth certain information concerning option exercises by our Named Executive Officers during the year ended December 31, 2006: OPTION EXERCISES AND STOCK VESTED Option Awards Number of Shares Value Realized on Acquired on Exercise (#) Exercise ($)(1) Name Dave Côté . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . David C. Yntema . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Arturo Cázares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manuel R. Freitas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Nelu Mihai. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Former Officer: David Puglia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,000 0 0 15,167 0 0 360,530 0 0 69,494 0 0 (1) Based on the difference between the market price of our Common Stock on the date of exercise and the exercise price. Potential Payments upon Termination or Change in Control Corporate Transaction in which Options are Not Assumed Each outstanding option granted under the Discretionary Option/Stock Appreciation Rights Grant Program under our 1999 Plan, including options held by our Named Executive Officers, will automatically vest in full upon a “corporate transaction” if the option is not assumed or otherwise continued in effect by the successor corporation or replaced with an equivalent cash incentive program. In addition, any outstanding unvested shares of our Common Stock that were issued under the Discretionary Option/Stock Appreciation Rights Grant Programs or under the Restricted Stock/Restricted Stock Unit Program under the 1999 Plan will automatically vest in full upon a corporate transaction if our repurchase rights with respect to those shares are not assigned to the successor corporation or otherwise continued in effect. Under the 1999 Plan, a “corporate transaction” is generally defined as the occurrence of: • an acquisition of Packeteer by a stockholder-approved merger, • a merger in which voting stock is transferred to the persons who acquired control pursuant to either (i) the completion of a tender or exchange offer for more than 50% of our outstanding voting stock or (ii) a change in the majority of the Board of Directors effected through one or more contested elections for membership on the Board of Directors, or • a sale of substantially all of our assets. 22 Estimated Benefit to our Named Executive Officers upon a Corporate Transaction in which Options are Not Assumed The following table provides an estimate of the incremental benefit our Named Executive Officers would receive from the accelerated vesting of their options upon a corporate transaction in which the options are not assumed or otherwise continued in effect by the successor, and assumes that the triggering event for such accelerated vesting occurred on December 29, 2006, the last business day of our most recently completed fiscal year. This table does not reflect the value of equity awards granted after December 29, 2006. Name Value of Acceleration of Vesting of Options ($)(1) Dave Côté . . . . . . . . . David C. Yntema . . . . Arturo Cázares . . . . . . Manuel R. Freitas . . . . Nelu Mihai . . . . . . . . . ......................................... ......................................... ......................................... ......................................... ......................................... 453,998 216,510 204,500 216,510 715,750 (1) Reflects 100% acceleration of vesting of options that were unvested on December 29, 2006. Value of acceleration is calculated as the difference between the closing market price per share of our Common Stock on December 29, 2006 of $13.60 and the exercise price per share of unvested options having an exercise price per share less than $13.60. Benefits Payable to Executives Other than the Chief Executive Officer and Chief Financial Officer upon Involuntary Termination or Resignation for Good Reason Following a Change in Control In March 2007, we entered into Change in Control Agreements with each of our executive officers other than Dave Côté, our Chief Executive Officer, and David Yntema, our Chief Financial Officer, reflecting benefits that were initially approved by the Compensation Committee in July 2006. Pursuant to these Change in Control Agreements, if, within 12 months following a “change in control,” the executive officer is involuntarily terminated without “cause” or resigns for “good reason,” he will be entitled to the following benefits provided that he executes a release of claims: • a lump sum cash severance payment equal to 18 months of base salary; • continuation of health insurance, life insurance and long-term disability benefits for 12 months following termination; • accelerated vesting in full of any outstanding stock option or other equity award that was granted with an exercise price equal to or greater than the fair market value of the underlying shares on the grant date; and • accelerated vesting of 50% of the then unvested portion of any outstanding restricted stock, restricted stock unit, performance share (other than the performance share awards granted in January 2007, discussed further below) or other outstanding equity award that does not have an exercise price or that was granted with an exercise price less than fair market value of the underlying shares on the grant date. The following are summaries of terms defined in the Change in Control Agreements: “Change in control” is generally defined as the occurrence of: • any acquisition of beneficial ownership of more than 50% of our outstanding voting stock; • an acquisition of Packeteer by merger; • a change in the majority of our Board of Directors effected through one or more contested elections for membership on the Board of Directors; or • a sale of substantially all of our assets. 23 “Cause” for involuntary termination is generally defined as any of the following actions by the executive: • theft, dishonesty, misconduct, breach of fiduciary duty for personal profit, or falsification of any of our documents or records; • material failure to abide by our code of conduct or other policies; • misconduct that results in a required accounting restatement; • unauthorized use, misappropriation, destruction or diversion of any of our tangible or intangible assets or corporate opportunity; • any intentional act which has a material detrimental effect on our reputation or business; • repeated failure or inability to perform any reasonable assigned duties after written notice, and a reasonable opportunity to cure, such failure or inability; • any material breach of any employment, non-disclosure, non-competition, non-solicitation or other similar agreement which is not cured pursuant to the terms of such agreement; • failure to cooperate in a corporate investigation; or • conviction (including any plea of guilty or nolo contendere) of any criminal act involving fraud, dishonesty, misappropriation or moral turpitude, or which impairs the executive’s ability to perform his duties on our behalf. “Good reason” for resignation is generally defined as the occurrence, during the period commencing upon the date of the consummation of a change in control and ending on the date 12 months thereafter, of any of the following conditions without executive’s informed written consent, which condition remains in effect ten business days after executive’s written notice of such condition: • a material, adverse change in the executive’s title, duties or responsibilities; • a decrease in the executive’s base salary rate or target bonus amount; • a relocation of the executive’s work place that increases the executive’s regular commute by more than 50 miles one-way; or • a material breach by us or our successor of the agreement providing for change in control benefits following the consummation of a change in control. In addition to the foregoing benefits, each executive officer will continue to be indemnified to the fullest extent permitted by applicable law against liability arising out of his service as an officer and will be entitled to advancement of fees and expenses incurred to the fullest extent permitted by law. We or our successor will be required to continue coverage of the former executive officer under a policy of directors’ and officers’ liability insurance for six years. Pursuant to the Change in Control Agreements, each executive officer has agreed to continue to abide by the terms of our confidentiality and proprietary rights agreement and to non-solicitation of our employees and customers for 12 months following an involuntary termination of employment without cause or a resignation for good reason within 12 months after a change in control. The Change in Control Agreements have a three year term that will automatically be extended if it would otherwise expire during the period between a public announcement of a definitive agreement for a change in control and the earlier of the termination of such definitive agreement or twelve months following the change in control. The extended term will then automatically expire upon the earlier of such termination or twelve months following the change in control. Benefits Payable to our Chief Executive Officer and our Chief Financial Officer upon Involuntary Termination or Resignation for Good Reason Following a Change in Control In March 2007, we entered into a Severance and Change in Control Agreement with each of Messrs. Côté and Yntema, reflecting severance benefits that were initially approved by the Compensation Committee in July 2006. 24 These Severance and Change in Control Agreements supersede the severance and change in control provisions contained in Mr. Côté’s employment agreement and Mr. Yntema’s offer letter. Pursuant to these Severance and Change in Control Agreements, if, within 12 months following our change in control, Mr. Côté or Mr. Yntema is involuntarily terminated without cause or resigns for good reason, he will be entitled to the same benefits to which other executives are entitled under the Change in Control Agreements in the same circumstances, provided he executes a release of claims against us, except that Mr. Côté will be entitled to a lump sum cash severance payment equal to 24 months of base salary rather than 18 months. The Severance and Change in Control Agreements also contain the additional terms included in the Change in Control Agreements outlined above, and utilize the same definitions of “change in control,” “cause” and “good reason.” Estimated Benefits Payable to our Named Executive Officers upon Involuntary Termination or Resignation for Good Reason Following a Change in Control The following table provides an estimate of the incremental benefits that would be paid or provided to a Named Executive Officer if such executive is involuntarily terminated without cause or resigns for good reason within 12 months following our change in control, and assumes that the triggering event for such payments occurred on December 29, 2006. This table does not include the value of (i) any accrued benefits that were earned and payable as of that date, including bonuses deemed earned by the executive pursuant to the terms of the Change in Control Agreements, (ii) any accrued benefits that are generally available to salaried employees which do not discriminate in scope, terms or operation in favor of executive officers, or (iii) any equity awards granted after December 29, 2006. Lump Sum Cash Payment ($)(2) Health, Life Insurance and Long-Term Disability Benefits ($)(3) Value of Acceleration of Vesting of Options ($)(4) Total Payments ($) Name(1) Dave Côté . . . . . . . . . . . . . . . . . . . David C. Yntema . . . . . . . . . . . . . . Arturo Cázares . . . . . . . . . . . . . . . Manuel R. Freitas . . . . . . . . . . . . . Nelu Mihai . . . . . . . . . . . . . . . . . . 750,000(5) 397,500 345,000 337,500 345,000 16,134 11,941 6,275 11,909 16,134 453,998 216,510 204,500 216,510 715,750 1,220,132 625,951 555,775 565,919 1,076,884 (1) See the section entitled “Benefits Paid to Mr. Puglia upon Separation” below for disclosure related to Mr. Puglia. (2) Unless otherwise noted, consists of a lump sum cash payment equal to 18 months of 2006 base salary at the monthly base salary rate in effect immediately prior to the assumed termination date of December 29, 2006. (3) Consists of 12 months of continued health insurance, life insurance and long-term disability benefits. The value of these benefits is based on the premium cost as in effect on December 29, 2006. (4) Reflects 100% acceleration of vesting of options that were unvested on December 29, 2006. Value of acceleration is calculated as the difference between the closing market price per share of our Common Stock on December 29, 2006 of $13.60 and the exercise price per share of unvested options having an exercise price per share less than $13.60. (5) Consists of a lump sum cash payment equal to 24 months of 2006 base salary at the monthly base salary rate in effect immediately prior to the assumed termination date of December 29, 2006. Options and Performance Share Awards Granted to our Executive Officers after December 31, 2006 In January 2007, we granted stock options and performance share awards to our executive officers that are not included in the above tables. Unlike the stock options granted to our executive officers, the performance share awards are not covered by the Change in Control Agreements and Severance and Change in Control Agreements. Instead, pursuant to the terms of the agreements governing these performance share awards, the vesting of the target number of shares subject to each such award will accelerate in full upon a “corporate transaction” in which the award is not assumed or continued by our successor or replaced by our successor with a substantially equivalent award. If the award is assumed by, continued or replaced by our successor, but the executive is involuntarily 25 terminated without cause within 12 months following the corporate transaction, the shares subject to the award will vest in a number equal to the target number of shares subject to the award multiplied by the greater of (i) 50% or (ii) the percentage of the performance period that has elapsed as of the officer’s termination date. There will be no acceleration of vesting of the shares subject to the award in connection with an executive’s resignation for any reason. The performance share award agreements utilize the definition of “cause” used in the Change in Control Agreements, and the definition of “corporate transaction” used in the 1999 Plan. Involuntary Termination Other than Following a Change of Control Other than the Severance and Change in Control Agreements with our Chief Executive Officer and our Chief Financial Officer, we do not have arrangements with any of our executive officers providing for the payment of benefits upon the termination of employment by us other than within 12 months of our change in control. Pursuant to the Severance and Change in Control Agreements, each of Messrs. Côté and Yntema are entitled to the following cash severance payment from us if his employment is terminated by us without cause other than within 12 months following a change in control, provided that he executes a release of claims against us: • In the case of Mr. Côté, a lump sum cash severance payment equal to 12 months of his base salary; and • In the case of Mr. Yntema, a lump sum cash severance payment equal to nine months of his base salary. Estimated Benefits Payable to our Named Executive Officers upon Involuntary Termination Other than Following a Change in Control The following table provides an estimate of the incremental benefits that would be paid to a Named Executive Officers if the executive is terminated by us without cause other than within 12 months following our change in control, and assumes that the triggering event for such payments occurred on December 29, 2006. This table does not include the value of (i) any accrued benefits that were earned and payable as of that date, including bonuses deemed earned by the executive pursuant to the terms of the Severance and Change in Control Agreements, or (ii) any accrued benefits that are generally available to salaried employees which do not discriminate in scope, terms or operation in favor of executive officers. Name Lump Sum Cash Payment ($)(1) Dave Côté . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . David C. Yntema . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375,000 198,750 (1) Consists of a lump sum cash payment equal to 12 months of 2006 base salary in the case of Mr. Côté and nine months of 2006 base salary for Mr. Yntema, in each case at the monthly base salary rate in effect immediately prior to the assumed termination date of December 29, 2006. Benefits Paid to Mr. Puglia upon Separation On December 1, 2006, we entered into a separation agreement with David Puglia, our former Vice President, Marketing. Pursuant to this separation agreement, Mr. Puglia resigned his employment with us effective as of November 30, 2006. The principal terms of the agreement provide for our continuation of Mr. Puglia’s 2006 base salary through April 30, 2007 in the aggregate amount of $98,750, a negotiated bonus payment of $20,000 and our payment of his COBRA premiums through April 30, 2007, estimated to be $11,487, or such shorter period during which Mr. Puglia is not covered by another employer’s health plan. In connection with this agreement, Mr. Puglia provided a release of any claims he may have had against us and acknowledged his continuing obligations under a proprietary information and inventions agreement with us not to use or disclose any of our confidential or proprietary information without prior written authorization from us. 26 Compensation of Directors The following table sets forth information concerning the compensation earned during 2006 by each person who served as a director during 2006: Fees Earned or Paid in Cash(2) ($) Option Awards (3)(4)(5) ($) Total ($) Name(1) Steven J. Campbell . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Craig W. Elliott . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Joseph A. Graziano. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . L. William Krause . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bernard F. (Bud) Mathaisel . . . . . . . . . . . . . . . . . . . . . . . . . Gregory E. Myers(6). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Peter Van Camp . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000 28,000 46,000 44,000 32,000 16,000 28,000 96,221 96,221 96,221 96,221 147,340 55,497 96,221 128,221 124,221 142,221 140,221 179,340 71,497 124,221 (1) See the Summary Compensation Table for disclosure related to Dave Côté, who is also our Chief Executive Officer and President. Mr. Côté is our only employee director and does not receive any additional compensation for his services as a member of our Board of Directors. (2) Beginning January 1, 2006, each non-employee member of the Board of Directors who is an independent director for purposes of the applicable Nasdaq rules, is eligible to receive cash compensation in a year as follows: • each member of the Board of Directors will receive an annual retainer of $20,000, payable at the rate of $5,000 per quarter; • each member of the Audit Committee will receive an additional annual retainer of $12,000, payable at the rate of $3,000 per quarter; each member of the Compensation Committee will receive an additional annual retainer of $8,000, payable at the rate of $2,000 per quarter; and each member of the Corporate Governance and Nominating Committee will receive an annual retainer of $6,000, payable at the rate of $1,500 per quarter; and • the chair of the Audit Committee will receive an additional annual retainer of $8,000, payable at the rate of $2,000 per quarter; the chair of the Compensation Committee will receive an additional annual retainer of $6,000, payable at the rate of $1,500 per quarter; and the chair of the Corporate Governance and Nominating Committee will receive an annual retainer of $4,000, payable at the rate of $1,000 per quarter. (3) Under the Automatic Option Grant Program for non-employee directors as currently in effect under the 1999 Plan, our non-employee directors are eligible to receive option grants as follows: • each individual who first joins the Board of Directors as a non-employee director will be automatically granted, at the time of such initial election or appointment, an initial option to purchase 30,000 shares of our Common Stock, provided such person has not previously been in our employ; and • each incumbent who is to continue to serve as a non-employee director after the date of each annual stockholders meeting, whether or not such individual is standing for re-election at that particular annual meeting, will be automatically granted, on the date of that annual meeting, an option to purchase 15,000 shares of our Common Stock. Each option granted under the Automatic Option Grant Program has or will have an exercise price per share equal to the closing price per share on the Nasdaq Global Select Market (or its predecessor) on the grant date, and has or will have a maximum term of ten years, subject to earlier termination should the optionee cease to serve as a member of the Board of Directors. Each option granted to a non-employee director under the Automatic Option Grant Program is immediately exercisable for all the shares subject to the option, but any shares purchased under the option will be subject to repurchase by Packeteer, at the exercise price paid per share, upon the optionee’s cessation of service on the Board of Directors prior to vesting in those shares. The 27 shares subject to each initial option grant will vest in a series of six equal semi-annual installments upon the optionee’s completion of each six months of service on the Board of Directors over the 36 month period measured from the date of grant. The shares subject to each option granted in connection with and on the date of an annual stockholders meeting will vest in a series of two equal annual installments upon the optionee’s completion of each year of service as a member of the Board of Directors over the two-year period measured from the option grant date. The shares subject to each option granted to a non-employee director under the Automatic Option Grant Program will immediately vest in full upon a change in control or ownership as described in the 1999 Plan or upon the optionee’s death or disability while a member of the Board of Directors. (4) Dollar amount of compensation expense related to stock options recognized for financial statement reporting purposes in accordance with FAS 123(R). The assumptions used in the calculation of this amount are included in Note 1 to our Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2006. (5) For each non-employee member of our Board of Directors, below is the aggregate grant date fair value of each option award granted to each non-employee member of our Board of Directors in 2006 computed in accordance with FAS 123(R) and the aggregate number of option awards outstanding on December 31, 2006. Assumptions used in the calculation of the grant date fair value are included in Note 1 to our Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2006. Name Option Awards Granted in 2006 (#) Aggregate Grant Date Fair Value ($) Option Awards Outstanding (#) Steven J. Campbell . . . . . . . . . . . . . . . . . . . . . . . Craig W. Elliott . . . . . . . . . . . . . . . . . . . . . . . . . . Joseph A. Graziano . . . . . . . . . . . . . . . . . . . . . . . L. William Krause . . . . . . . . . . . . . . . . . . . . . . . . Bernard F. (Bud) Mathaisel . . . . . . . . . . . . . . . . . Gregory E. Myers . . . . . . . . . . . . . . . . . . . . . . . . Peter Van Camp . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 15,000 15,000 15,000 15,000 30,000 15,000 89,254 89,254 89,254 89,254 89,254 159,122 89,254 86,000 460,000 86,000 79,500 60,000 30,000 95,000 (6) Mr. Myers became a member of the Board of Directors and the Audit Committee on July 18, 2006. Additional Benefits Provided to Our Directors Under the terms of indemnification agreements that we enter into with each of our directors, we are obligated to indemnify each director against certain claims and expenses for which the director might be held liable in connection with past or future service on the Board of Directors. In addition, our Certificate of Incorporation provides that, to the greatest extent permitted by the Delaware General Corporation Law, its directors shall not be liable for monetary damages for breach of fiduciary duty as a director. 28 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth information known to us with respect to the beneficial ownership of our Common Stock as of April 1, 2007 of (i) each beneficial owner of 5% or more of the outstanding shares of our Common Stock; (ii) each director or director nominee; (iii) each of the Named Executive Officers; and (iv) all of our directors and executive officers as a group. Common Stock Number of Shares Percent of Beneficially Held Class(1) Name of Beneficial Owner T. Rowe Price Associates, Inc.(2) . . . . . . . . . . . . . . . . . . . . . 100 E. Pratt Street Baltimore, MD 21202 Royce & Associates, LLC(3) . . . . . . . . . . . . . . . . . . . . . . . . 1414 Avenue of the Americas New York, NY 10019 FMR Corp.(4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 Devonshire Street Boston MA 02109 Barclays Global Investors, NA(5) . . . . . . . . . . . . . . . . . . . . . 45 Fremont Street, 17th Floor San Francisco, CA 94105 Dave Côté(6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Steven J. Campbell(7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Craig W. Elliott(8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Joseph A. Graziano(9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . L. William Krause(10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bernard F. Mathaisel(11) . . . . . . . . . . . . . . . . . . . . . . . . . . . Gregory E. Myers(12) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Peter Van Camp(13) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Arturo Cázares(14) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Manuel R. Freitas(15) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Nelu Mihai(16) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . David C. Yntema(17) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . David Puglia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . All directors and officers as a group (14 persons)(18) . . . . . . * Less than 1%. ........ 2,347,350 6.5% ........ 2,607,800 7.2% ........ 3,472,009 9.7% ........ 2,108,051 5.9% ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ 608,832 426,896 492,650 261,000 84,500 60,000 35,000 100,000 235,165 148,443 53,333 331,168 0 2,900,862 1.7% 1.2% 1.4% * * * * * * * * * 0 7.6% (1) As of April 1, 2007, we had outstanding 35,976,326 shares of Common Stock. The persons named in this table have sole voting and/or investment power with respect to all shares of Common Stock shown as beneficially owned by them unless as otherwise noted below. In computing the number of shares beneficially owned by a person and the percentage ownership of that person, shares of Common Stock which that person could purchase by exercising outstanding options and options that will become exercisable within 60 days of April 1, 2007, including any outstanding options which are immediately exercisable, are deemed outstanding for the purpose of computing the percentage ownership of that person. Such shares, however, are not deemed outstanding for the purpose of computing the percentage ownership of any other person. Except as otherwise indicated, the address of each person listed on the table is c/o Packeteer, Inc., 10201 North De Anza Boulevard, Cupertino, California 95014. (2) Based on a Schedule 13G/A filed with the SEC on February 14, 2007. These securities are owned by various individual and institutional investors which T. Rowe Price Associates, Inc., or Price Associates, serves as investment advisor with power to direct investments and/or sole power to vote the securities. For purposes of 29 the reporting requirements of the Securities Exchange Act of 1934, Price Associates is deemed to be a beneficial owner of such securities; however, Price Associates expressly disclaims that it is, in fact, the beneficial owner of such securities. (3) Based on a Schedule 13G/A filed with the SEC on January 24, 2007. (4) Based on a Schedule 13G/A filed with the SEC on February 14, 2007. (5) Based on a Schedule 13G filed with the SEC on January 23, 2007. Includes 1,572,435 shares held by Barclays Global Investors, NA and 535,616 shares held by Barclays Global Fund Advisors. (6) Includes 608,832 shares of Common Stock issuable upon exercise of vested options within 60 days of April 1, 2007. (7) Includes 340,896 shares held by the Steven J. Campbell Rev Trust DTD 5/22/2000, of which Mr. Campbell is trustee, and 86,000 shares of Common Stock issuable upon exercise of immediately exercisable options held by Mr. Campbell, of which 78,500 will be vested within 60 days of April 1, 2007. (8) Includes 24,650 shares held by the Craig W. Elliot & Lisa A. Elliott TR Elliott Family Revocable Trust UA 11/09/99, of which Mr. Elliott is trustee, 460,000 shares of Common Stock issuable upon exercise of immediately exercisable options held by Mr. Elliott, of which 452,500 shares will be vested within 60 days of April 1, 2007, and 8,000 shares held by the Elliott Children’s Trust for the benefit of Mr. Elliott’s minor children, of which Wells Fargo is trustee. (9) Includes 175,000 shares held by Mr. Graziano and 86,000 shares of Common Stock issuable upon exercise of immediately exercisable options held by Mr. Graziano, of which 78,500 will be vested within 60 days of April 1, 2007. (10) Includes 5,000 shares held by Mr. Krause and 79,500 shares of Common Stock issuable upon exercise of immediately exercisable options held by Mr. Krause, of which 72,000 shares will be vested within 60 days of April 1, 2007. (11) Includes 60,000 shares of Common Stock issuable upon exercise of immediately exercisable options held by Mr. Mathaisel, of which 42,500 shares will be vested within 60 days of April 1, 2007. (12) Includes 5,000 shares held by Mr. Myers and 30,000 shares of Common Stock issuable upon exercise of immediately exercisable options held by Mr. Myers, of which 5,000 will be vested within 60 days of April 1, 2007. (13) Includes 5,000 shares held by Mr. Van Camp and 95,000 shares of Common Stock issuable upon exercise of immediately exercisable options held by Mr. Van Camp, of which 87,500 will be vested within 60 days of April 1, 2007. (14) Includes 6,000 shares held by Mr. Cázares and 229,165 shares of Common Stock issuable upon exercise of exercisable and vested options within 60 days of April 1, 2007. (15) Includes 944 shares held by Mr. Freitas and 147,499 shares of Common Stock issuable upon exercise of exercisable and vested options within 60 days of April 1, 2007. (16) Includes 53,333 shares of Common Stock issuable upon exercise of exercisable and vested options within 60 days of April 1, 2007. (17) Includes 32,628 shares held by the David C. Yntema Trust, of which Mr. Yntema is trustee, and 298,540 shares of Common Stock issuable upon exercise of exercisable and vested options held by Mr. Yntema within 60 days of April 1, 2007. (18) Includes 605,118 shares held directly or indirectly by such individuals and 2,295,744 shares of Common Stock issuable upon exercisable options within 60 days of April 1, 2007, of which 2,215,744 shares will be vested within 60 days of April 1, 2007. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS We have entered into indemnification agreements with each of our directors and officers and certain other employees that may, in some cases, be broader than the specific indemnification provisions contained in the Delaware General Corporation Law. The indemnification agreements may require us, among other things, to 30 indemnify the directors and officers against certain liabilities, other than liabilities arising from willful misconduct of a culpable nature, that may arise by reason of their status or service as directors or officers. These agreements also may require us to advance the expenses incurred by the directors and officers as a result of any proceeding against them as to which they could be indemnified. We have a directors’ and officers’ insurance policy to cover our obligations under these agreements. In accordance with our Audit Committee charter, our Audit Committee is responsible for reviewing and approving the terms and conditions of any related party transactions. Review of any related party transaction would include reviewing each such transaction for potential conflicts of interests and other improprieties. SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE Section 16(a) of the Securities Exchange Act of 1934 requires our executive officers and directors and persons who beneficially own more than 10% of our Common Stock to file initial reports of beneficial ownership and reports of changes in beneficial ownership with the SEC. Such persons are required by SEC regulations to furnish us with copies of all Section 16(a) forms filed by such person. Based upon (i) the copies of Section 16(a) reports which we have received from such persons for their 2006 transactions in the Common Stock and their Common Stock holdings and (ii) the written representations received from one or more of such persons that no Form 5 reports were required to be filed by them for 2006, the Company believes that all reporting requirements under Section 16(a) for such year were met in a timely manner by its directors and executive officers and each holder of more than 10% of the outstanding Common Stock. STOCKHOLDER PROPOSALS AND BUSINESS Stockholder proposals may be included in our proxy materials for an annual meeting so long as they are provided to us on a timely basis and satisfy the other conditions set forth in the applicable rules of the SEC. For a stockholder proposal to have been included in our proxy materials for the 2007 annual meeting, the proposal must have been received by David C. Yntema, Secretary, Packeteer, Inc., at 10201 North De Anza Boulevard, Cupertino, California 95014, our principal executive offices, not later than December 15, 2006. No stockholder proposals will be voted on at the 2007 annual meeting. Stockholder business that is not included in our proxy materials for the 2007 annual meeting may be brought before the 2007 annual meeting so long as we receive notice of the proposal as specified by our Bylaws, addressed to the Secretary at our principal executive offices, not earlier than March 24, 2007 and no later than May 3, 2007. Should a stockholder proposal be brought before the 2007 annual meeting, however, our management proxyholders will be authorized by our proxy form for the 2007 annual meeting to vote for or against the proposal, in their discretion. Stockholder Proposals for 2008 Annual Meeting of Stockholders. For a stockholder proposal to be included our proxy materials for the 2008 annual meeting of Stockholders, the proposal must be received at our principal executive offices, addressed to the Secretary, not later than December 15, 2007. 31 EQUITY COMPENSATION PLAN INFORMATION We currently maintain two compensation plans that provide for the issuance of our Common Stock to officers and other employees, directors and consultants. These consist of the 1999 Plan and the 1999 Employee Stock Purchase Plan, or the 1999 ESPP, each of which have been approved by stockholders. In addition, certain nonstatutory stock options granted under individual arrangements which have not been approved by stockholders remain outstanding. The following table sets forth information regarding outstanding options and shares reserved for future issuance under the foregoing plans and individual arrangements as of December 31, 2006: Number of Shares to be Issued Upon Exercise of Outstanding Options, Warrants and Rights (a) Weighted-Average Exercise Price of Outstanding Options, Warrants and Rights (b) Number of Shares Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Shares Reflected in Column (a)) (c) Plan Category(1) Equity compensation plans approved by security holders . . . . . . . . . . . . . . . . . Equity compensation plans not approved by security holders(3). . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . 7,059,669 $12.144 6,418,667(2) 9,333 7,050,336 $ 0.25 0 6,418,667 (1) The information presented in this table excludes options we assumed in connection with the acquisition of Tacit Networks. As of December 31, 2006, 89,505 shares of our Common Stock were issuable upon exercise of these assumed options, at a weighted average exercise price of $1.89 per share. (2) Includes 3,240,165 shares that are reserved for issuance under the 1999 ESPP. The shares that are reserved for issuance under the 1999 Plan and under the 1999 ESPP automatically increase on January 1 of each calendar year by a number of shares equal to 5% and 2%, respectively, of our outstanding shares as of the close of business on December 31 of the preceding calendar year. (3) Consists of nonstatutory options to purchase 9,333 shares of Common Stock that remain outstanding under two individual arrangements. All such options were granted before our initial public offering in July 1999 pursuant to a plan under which options are no longer granted. These options have terms of ten years and are presently exercisable. TRANSACTION OF OTHER BUSINESS At the date of this Proxy Statement, the Board of Directors knows of no other business that will be conducted at the 2007 annual meeting other than as described in this Proxy Statement. If any other matter or matters are properly brought before the meeting, or any adjournment or postponement of the meeting, it is the intention of the persons named in the accompanying form of proxy to vote the proxy on such matters in accordance with their best judgment. By order of the Board of Directors David C. Yntema Secretary Cupertino, California April 23, 2007 32 APPENDIX A ANNUAL REPORT TO STOCKHOLDERS PACKETEER, INC. 2006 ANNUAL REPORT For the Year Ended December 31, 2006 DELAWARE (State of incorporation) 77-0420107 (I.R.S. Employer Identification No.) 10201 NORTH DE ANZA BLVD. CUPERTINO, CALIFORNIA 95014 (Address of principal executive offices) Registrant’s telephone number, including area code: (408) 873-4400 Securities registered pursuant to Section 12(b) of the Act: Title of Class Name of Each Exchange on Which Registered Common Stock, $0.001 Par Value The Nasdaq Stock Market LLC Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes n No ¥ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes n No ¥ 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 n 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 the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. n Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer n Accelerated filer ¥ Non accelerated filer n Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes n No ¥ Based on the closing sale price of the common stock on the Nasdaq Global Select Market (formerly the Nasdaq National Market) on June 30, 2006, the aggregate market value of the voting common stock held by non-affiliates of the Registrant was $347,995,297. Shares of common stock held by each officer and director and by each person known by the Registrant to own 10% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. The number of shares outstanding of Registrant’s common stock, $0.001 par value, was 35,968,876 at March 11, 2007. DOCUMENTS INCORPORATED BY REFERENCE Information required by Part III, Items 10, 11, 12, 13 and 14 of this Form 10-K is incorporated by reference from the Registrant’s definitive Proxy Statement for the Registrant’s 2007 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after December 31, 2006. A-1 This 2006 Annual Report contains information from Packeteer, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2006. PART I ITEM 1. BUSINESS In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements regarding our strategy, financial performance and revenue sources that involve a number of risks and uncertainties, including those discussed under the title “RISK FACTORS” in Item 1A. Forward-looking statements in this report include, but are not limited to, those relating to future revenues, revenue growth and profitability, markets for our products, our ability to continue to innovate and obtain patent protection, operating expense targets, liquidity, new product development, the possibility of acquiring complementary businesses, products, services and technologies, the geographical dispersion of our sales, expected tax rates, our international expansion plans and our development of relationships with providers of leading Internet technologies. While this outlook represents our current judgment on the future direction of the business, such risks and uncertainties could cause actual results to differ materially from any future performance suggested below due to a number of factors, including the perceived need for our products, our ability to convince potential customers of our value proposition, the costs of competitive solutions, our reliance on third party contract manufacturers, continued capital spending by prospective customers and macro economic conditions. Readers are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Annual Report. Packeteer undertakes no obligation to publicly release any revisions to forward-looking statements to reflect events or circumstances arising after the date of this document, except as required by law. See “RISK FACTORS” appearing in Item 1A. Investors may access our filings with the Securities and Exchange Commission including our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and amendments to such reports on our website, free of charge, at www.packeteer.com, but the information on our website does not constitute part of this Annual Report. OVERVIEW Packeteer is a leading provider of wide area network, or WAN, Application Delivery systems designed to deliver a comprehensive set of visibility, Quality of Service, or QoS, control, compression, application acceleration and branch office service capabilities. Our product family includes PacketShaper, iShared, SkyX and Mobiliti Client products that can be deployed within large data centers, smaller branch office sites and software clients on PCs for mobile and Small Office/Home Office, or SOHO, users throughout a distributed enterprise. We deliver superior application performance and end user experience using an “intelligent overlay”, which bridges applications and IP networks, adapts to our customers’ existing infrastructure and addresses the demands created by a changing application environment in order to deliver high performance applications across all WAN and Internet links. INDUSTRY BACKGROUND Networked computing has created new challenges for Information Technology, or IT, managers. As more core business applications, such as SAP and Oracle, become distributed and Web-enabled, and the use of video over IP and voice over IP, or VOIP, increases, the amount of network data increases dramatically. This increase in data makes it difficult for businesses to ensure the performance of their applications. Further, enterprise users access graphic-intensive web sites, download large files, view streaming media presentations, monitor news and stock quotes and access peer-to-peer applications, instant messaging and other critical and non-critical information over the Internet. The resulting traffic deluge impacts network resources that serve point-of-sale, order processing, enterprise resource planning, supply-chain management and other vital business functions. Further, changes in application delivery and networking technologies present additional issues for enterprises. Server consolidation, which involves removing of branch office servers and consolidating files and storage into data centers, exposes limitations in application protocols like common internet file system, or CIFS, and network file system, or NFS. These file access protocols require a large number of round trips across the WAN to accomplish A-2 their tasks, slowing performance. In addition, consolidation centralizes certain services, creating new traffic types from services that were once delivered locally. The WAN/Application Bottleneck The adoption of Fast Ethernet and Gigabit Ethernet technologies has reduced network congestion on the local area network, or LAN. Simultaneously, the deployment of fiber infrastructure in the service provider backbone has also reduced bandwidth contention in that portion of the network. However, the bridge between the two, the WAN access link, is often constrained, expensive and difficult to upgrade, resulting in a bandwidth bottleneck. Today’s enterprise networks require solutions that ensure mission-critical application performance, increase network efficiency, and enable the convergence of data, voice and video traffic. Superior application performance, good user experience and high user productivity, especially at branch locations, are primary focus areas for IT departments. At the same time, they seek to leverage investments in application software and proactively control recurring network costs by optimizing bandwidth utilization. The Packeteer Solution For enterprise customers, our systems are designed to enable IT organizations to effectively deliver applications and performance while providing measurable cost savings in WAN investments. For service providers, our systems are designed to provide a platform for delivering application-intelligent network services that provide application level visibility and QoS control, expanding revenue opportunities. Our products are designed to enable businesses and service providers to realize the following key benefits: • gain application and network performance visibility and insight, • ensure proper performance for mission-critical applications, • permit easy deployment, • increase effective and available bandwidth, • enable time-sensitive interactive services, • enable server consolidation, • increase network efficiency and • reduce operational cost. OUR KEY STRATEGIES Our objective is to be the leading provider of WAN Application Delivery systems that give enterprises and service providers a new layer of control for applications delivered across intranets, extranets and the Internet. Key elements of our strategy include: Focus on Enterprise Performance Needs for Distributed Enterprises. We are focused on providing high performance, easy-to-use and cost-effective solutions to distributed enterprises whose businesses rely on networked applications. For these businesses, managing mission-critical application performance user experience and productivity will continue to be competitive requirements. We believe we have established a differentiated market position based on our development of a comprehensive solution and our early market leadership and brand awareness. We intend to continue to direct our development, sales and marketing efforts toward addressing the application performance needs of large, distributed enterprises. Continue to Build Indirect Distribution Channels. We currently have over 600 value-added resellers, distributors and systems integrators that sell our products in over 50 countries. We intend to continue to develop and support new reseller and distribution relationships, as well as to establish additional indirect channels with service providers and systems integrators. We believe this strategy will enable us to increase the worldwide deployment of our products. A-3 Expand Presence in Telecommunications Service Provider Market. We are actively pursuing opportunities in the telecommunications service provider market and currently have a variety of telecommunications service provider customers. We believe service providers are under increasing pressure to attract new subscribers, reduce subscriber turnover, improve operating margins and develop new revenue streams. Specifically, service providers seek to differentiate themselves through value-added service offerings, such as web hosting, application outsourcing and application service-level management. We believe our solutions enable service providers to deliver these higher value services by enhancing network and application performance and better managing and allocating network resources. Our goal is to increase demand for our solutions with service providers by leveraging our strong enterprise presence. Extend Product Scope beyond WAN Equipment into Adjacent Infrastructure. We are actively pursuing opportunities to expand the scope of value-added services that our product solutions provide beyond our traditional networking equipment focus into new markets that involve storage and servers. Through our 2006 acquisition of Tacit Networks, Inc., or Tacit, we have been able to consolidate new, value-added products into our existing solutions. The Tacit iShared product set provides alternative methods for branch office storage, branch office server infrastructure and branch office backup systems. We can also expand into these new areas through technology and distribution partnerships with third parties, such as our relationship with Microsoft and Brocade Communications. Extend WAN Application Performance Technology Leadership. Our technological leadership is based on our sophisticated traffic classification, flexible policy setting capabilities, precise rate control expertise, compression and acceleration technologies and ability to measure response time and network performance. We intend to invest our research and development resources to increase performance by handling higher speed WAN connections, increase functionality by identifying and managing additional applications or traffic types and increase system modularity. We also plan to invest our research and development resources to develop new leading-edge technologies for emerging markets. These development plans include extending our solutions to incorporate in-depth application-management techniques that will improve performance and heighten internal network security. PRODUCTS Our WAN Application Delivery products are designed to solve network and application performance problems through a family of appliances with multiple software options that provide visibility into application performance and network utilization, control over network performance and network utilization, compression and protocol acceleration to accelerate performance and increase WAN capacity. PacketShaper is designed to provide application traffic monitoring that builds on our industry-leading Layer 7 traffic classification, analysis and reporting technology to provide visibility into network utilization and application performance. PacketShaper ISP is designed to enable service providers to create differentiated services through fast and efficient bandwidth provisioning and management. The PacketShaper family currently includes the 1400, 1700, 3500, 7500, and 10000 models. The Shaping Module for PacketShaper is a software option designed to provide application-based traffic and bandwidth management to deliver predictable, efficient performance for applications running over the WAN and Internet. This module provides QoS using state-of-the-art bandwidth, traffic, service-level and policy management technology. The Compression Module for PacketShaper is a software option designed to provide increased throughput for application traffic through compression technology. Combining Layer 7 classification, traffic shaping and application-intelligent compression raises the level of control customers have over the performance of their network applications and associated bandwidth costs. The Acceleration Module for PacketShaper is a software option designed to overcome the latency issues associated with transmission control protocol, or TCP, and hypertext transfer protocol, or HTTP, over the WAN. Targeted at higher latency environments, this module provides significant improvements in throughput and performance for bulk applications like file transfer and large web applications. A-4 PolicyCenter is a directory-based policy management application that is designed to enable our enterprise and service provider customers to broadly deploy, scale and manage application QoS throughout the network. PolicyCenter is a lightweight directory access protocol, or LDAP, directory-enabled application running under Windows that enables customers to centrally administer and update policies, software versions, and device status for Packeteer-based networks. ReportCenter is an application that is designed to aggregate metrics from large deployments and create organization — wide reports to manage trends and provide support for capacity planning and usage analysis. ReportCenter lowers the cost of ownership for large deployments of PacketShaper appliances, improves the quality of information and eases administrative overhead. iShared is suited for environments with large amounts of collaborative traffic (files, email, and large documents) and/or undergoing server consolidation. The iShared product not only provides Wide Area File Services, or WAFS, with CIFS acceleration, but includes general WAN optimization technologies that include compression, byte caching, Web object caching and TCP acceleration. Moreover, iShared has the ability to deliver Microsoft-based branch office services like print services, domain name system/dynamic host configuration protocol, or DNS/DHCP, and Domain Controller, as well as acting as a distribution point or secondary server for SMS. iShared’s capabilities integrate natively with Microsoft security and management frameworks, ensuring compatibility that disables many other products in the space. iShared is available both in an appliance version, as well as an installable software package known as FlexInstall that delivers WAFS, optimization and service delivery on existing server infrastructure. SkyX products and technologies enhance the performance and efficiency of Internet and private network access, accelerating applications for high capacity data center to data center links, often found in disaster recovery architectures, as well as over satellite and long-haul networks. The product line includes the PX 250 and PX750 models. Mobiliti software products provide solutions for the mobile and SOHO users. Combining acceleration technologies with offline file access and backup services, Mobiliti delivers a software-based client solution installed on laptops and PCs. CUSTOMERS We sell all of our products primarily through an established network of more than 600 distributors, value-added resellers and system integrators in more than 50 countries, complemented by our direct sales organization. In 2006, sales to Alternative Technology, Inc. and Westcon, Inc. accounted for 23% and 18% of net revenues, respectively. These customers are distributors, who in turn sell to a large number of value-added resellers, system integrators and other resellers. MANUFACTURING We outsource all of our manufacturing, including warranty repair. Outsourcing our manufacturing enables us to reduce fixed costs and to provide flexibility in meeting market demand. We currently rely on our longstanding contract manufacturer, SMTC Manufacturing Corporation, or SMTC, located in San Jose, California, and to a lesser extent, three additional manufacturers for all of our manufacturing requirements. The manufacturing processes and procedures for these manufacturers are ISO certified. MARKETING AND SALES We target our marketing and sales efforts at channel sales partners, enterprises and service providers. Marketing and sales activities focus on reaching the corporate information technology organization managers responsible for the performance of mission-critical applications and maintenance of network performance in the enterprise. We also focus on reaching resellers and service providers that provide valued-added service offerings, such as application performance monitoring and management. We have a number of marketing programs to support the sale and distribution of our products and educate existing and potential enterprise and service provider customers about the benefits of our products. Our marketing A-5 efforts include publication of technical, educational and business articles in industry magazines, participation in tradeshows, conferences and technology seminars, electronic marketing, including web site-based communication programs, electronic newsletters and on-line end user seminars; and focused advertising, direct mail, public relations and analyst outreach. As of December 31, 2006, our worldwide sales and marketing organization consisted of 164 individuals, including managers, sales representatives and technical and administrative support personnel. We have domestic sales offices located throughout the United States. In addition, we have international sales offices located throughout Europe, the Asia Pacific region and Japan. We believe there is a strong international market for our products. Our international sales are conducted primarily through our overseas offices. Sales to customers outside of the Americas accounted for 53%, 54%, and 59% of net revenues in 2006, 2005, and 2004, respectively. RESEARCH AND DEVELOPMENT As of December 31, 2006, our research and development organization consisted of 146 employees providing expertise in different areas of our software: control and compression technologies, classification, central management, user interface, platform engineering and protocol acceleration. Since inception, we have focused our research and development efforts on developing and enhancing our WAN Application Delivery solutions. In 2006, 2005, and 2004, we spent $30.6 million, $21.8 million, and $15.0 million, respectively, on research and development efforts. During 2006, our major research and development programs included adding new Restriction of Hazardous Substances compliant hardware platforms for many of our PacketShaper and SkyX products and major upgrades to our PacketShaper products that integrate application acceleration technology gained through our acquisition of Mentat, Inc, or Mentat, in December 2004. In addition, we released new versions of the Tacit iShared and Mobiliti products, which included new features and capabilities. CUSTOMER SERVICE AND TECHNICAL SUPPORT Our customer service and support organization provides technical support services. Our technical support staff provides our customers with 24/7 support services and is strategically located in five regional service centers: in California, New Jersey, Japan, Malaysia, and The Netherlands. These services, which may include telephone/web support, next business day advance replacement and access to all software updates and upgrades, are typically sold as single or multi-year contracts to our resellers and end users. In addition, we have formal agreements with two third-party service providers to facilitate next business day replacement for end user customers located outside the United States covered by maintenance agreements providing this service level. We also provide our customers with a warranty, which is typically twelve months from the date of shipment to the end user. We believe that these programs improve service levels and lead to increased customer satisfaction. COMPETITION The WAN Application Delivery market in which we compete is a rapidly evolving and highly competitive sector of the WAN Application Optimization market. We expect competition to persist and intensify in the future as our sector becomes subject to increasing industry focus. Increased competition could result in reduced prices and gross margins for our products and could require increased spending by us on research and development, any of which could harm our business. We compete with Cisco Systems, Juniper Networks, other switch/router vendors, Riverbed Technology in the wide area file systems market segment, Citrix System through their Orbital Data acquisition, security vendors and several small private companies that sell products that utilize competing technologies to provide monitoring or bandwidth management, compression and acceleration. Although none of these companies currently offer an integrated visibility, control and compression solution such as our WAN Application Delivery system, Cisco and other network equipment providers have announced products or strategies which, if released, could be directly competitive with our products. Our products compete for information technology budget allocations with products that offer monitoring technologies, such as probes and related software. Lastly, we face indirect competition from companies that offer enterprise customers and service providers A-6 increased bandwidth and infrastructure upgrades that increase the capacity of their networks, which may lessen or delay the need for WAN Application Delivery solutions. We believe the principal competitive factors in the WAN Application Delivery market are: • ability to address the broad range of applications that enterprises must deliver, including ERP, to financial transactions, voice, video, file access and many more; • products to suit every required delivery point; • expertise and in-depth knowledge of applications; • ability to ensure end user performance in addition to aggregate performance of the WAN access link; • ability to integrate in the existing network architecture without requiring network reconfigurations or desktop changes; • timeliness of new product introductions; • ability to compress traffic without decreasing throughput, performance or network capacity; • ability to integrate traffic classification, management, reporting and acceleration into a single platform; and • compatibility with industry standards. INTELLECTUAL PROPERTY We rely on a combination of patent, copyright and trademark laws, and on trade secrets, confidentiality provisions and other contractual provisions to protect our proprietary rights. These measures afford only limited protection. As of December 31, 2006, we have 36 issued U.S. patents and 70 pending U.S. patent applications. We cannot assure you that our means of protecting our proprietary rights in the U.S. or abroad will be adequate or that competitors will not independently develop similar technologies. Our future success depends in part on our ability to protect our proprietary rights to the technologies used in our principal products. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use trade secrets or other information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights as fully as do the laws of the U.S. We cannot assure you that any issued patent will preserve our proprietary position, or that competitors or others will not develop technologies similar to or superior to our technology. Our failure to enforce and protect our intellectual property rights could harm our business, operating results and financial condition. From time to time, third parties, including our competitors, have asserted patent, copyright and other intellectual property rights to technologies that are important to us. We expect that we will increasingly be subject to infringement claims as the number of products and competitors in the market grows and the functionality of products overlaps. The results of any litigation matter are inherently uncertain. In the event of an adverse result in any litigation with third parties that could arise in the future, we could be required to pay substantial damages, including treble damages if we are held to have willfully infringed, to cease the manufacture, use and sale of infringing products, to expend significant resources to develop non-infringing technology, or to obtain licenses to the third-party technology. Licenses may not be available from any third-party that asserts intellectual property claims against us on commercially reasonable terms, or at all. In addition, litigation frequently involves substantial expenditures and can require significant management attention, even if we ultimately prevail. EMPLOYEES As of December 31, 2006, we employed a total of 421 full-time equivalent employees. Of the total number of employees, 146 were in research and development, 142 in sales and system engineering, 22 in marketing, 76 in customer support and operations and 35 in administration. Our employees are not represented by any collective bargaining agreement with respect to their employment by us. A-7 ITEM 1A. RISK FACTORS You should carefully consider the risks described below before making an investment decision. If any of the following risks actually occur, our business, financial condition or results of operations could be materially and adversely affected. In such case, the trading price of our common stock could decline, and you may lose all or part of your investment. IF THE WAN APPLICATION DELIVERY SYSTEMS MARKET FAILS TO GROW, OUR BUSINESS WILL FAIL The market for WAN Application Delivery systems is still developing and its success is not guaranteed. Therefore, we cannot accurately assess the size of the market, the products needed to address the market, the optimal distribution strategy, or the competitive environment that will develop. In order for us to be successful, our potential customers must recognize the value of more sophisticated bandwidth management solutions, decide to invest in the management of their networks and the performance of important business software applications and, in particular, adopt our bandwidth management solutions. OUR FUTURE OPERATING RESULTS ARE DIFFICULT TO PREDICT AND MAY FLUCTUATE SIGNIFICANTLY, WHICH COULD ADVERSELY AFFECT OUR STOCK PRICE We believe that period-to-period comparisons of our operating results cannot be relied upon as an indicator of our future performance, and that the results of any quarterly period are not necessarily indicative of results to be expected for a full fiscal year. We have experienced fluctuations in our operating results in the past and may continue to do so in the future. Our operating results are subject to numerous factors, many of which are outside of our control and are difficult to predict. As a result, our quarterly operating results could fall below our forecasts or the expectations of public market analysts or investors in the future. If this occurs, the price of our common stock would likely decrease. Factors that could cause our operating results to fluctuate include variations in: • the timing and size of orders and shipments of our products; • the mix of products we sell; • the mix and effectiveness of the channels through which those products are sold; • the timing and success of new product and upgrade introductions; • the geographical mix of the markets in which our products are sold; • the average selling prices of our products; • the amount and timing of our operating expenses; • the impact of changes in effective tax rates; and • the impact of acquisitions. In the past, revenue fluctuations resulted primarily from variations in the volume and mix of products sold and variations in channels through which products were sold. For example, for the three months ended September 30, 2005 we deferred recognition of revenue on approximately $3.6 million in product sales due to channel inventory levels, which contributed to our revenues being below analyst expectations. In addition, as an increasing portion of our revenues is derived from larger unit sales, the timing of such sales can have a material impact on quarterly performance. As a result, a delay in completion of large deals at the end of a quarter can result in our missing analysts’ forecasts for the quarter. Total operating expenses may fluctuate between quarters due to the timing of spending. For example, research and development expenses, specifically prototype expenses, consulting fees and other program costs, have fluctuated relative to the specific stage of product development of the various projects underway. Sales and marketing expenses have fluctuated due to the timing of specific events such as sales meetings or tradeshows, or the launch of new products. Additionally, operating costs outside the United States are incurred in local currencies, and are remeasured from the local currency to the U.S. dollar upon consolidation. As exchange rates vary, these operating costs, when remeasured, may differ from our prior performance and our expectations. A-8 Tax rates can vary significantly based upon the geographical mix of the markets in which our products are sold and may also cause our operating results to fluctuate. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for detailed information on our operating results. WE MAY BE UNABLE TO COMPETE EFFECTIVELY WITH OTHER COMPANIES IN OUR MARKET SECTOR WHO OFFER, OR MAY IN THE FUTURE OFFER, COMPETING TECHNOLOGIES We compete in a rapidly evolving and highly competitive sector of the networking technology market. We expect competition to persist and intensify in the future from a number of different sources. Increased competition could result in reduced prices and gross margins for our products and could require increased spending by us on research and development, sales and marketing and customer support, any of which could harm our business. We compete with general switch/route vendors such as Cisco Systems, Inc. and Juniper Networks, Inc. We also compete with more specialized vendors such as Riverbed Technology, which we compete with in the wide area file systems market segment. We also compete with security vendors and several small private companies that utilize competing technologies to provide bandwidth management, compression and acceleration. We expect this competition to increase particularly due to the anticipated requirement from enterprises to consolidate more functionality into a single appliance. In addition, our products and technology compete for information technology budget allocations with products that offer monitoring capabilities, such as probes and related software. Also, merger and acquisition activity by other companies can and has created new perceived competitors. Additionally, we face indirect competition from companies that offer enterprise customers and service providers increased bandwidth and infrastructure upgrades that increase the capacity of their networks, which may lessen or delay the need for WAN Application Delivery solutions. Many of our competitors and potential competitors are substantially larger than we are and have significantly greater financial, sales and marketing, technical, manufacturing and other resources and more established distribution channels. These competitors may be able to respond more rapidly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products than we can. We have encountered, and expect to encounter, prospective customers who are extremely confident in and committed to the product offerings of our competitors, and therefore are unlikely to buy our products. Furthermore, some of our competitors may make strategic acquisitions or establish cooperative relationships among themselves or with third parties to increase their ability to rapidly gain market share by addressing the needs of our prospective customers. Our competitors may enter our existing or future markets with solutions that may be less expensive, provide higher performance or additional features or be introduced earlier than our solutions. Given the market opportunity in the WAN Application Delivery solutions market, we also expect that other companies may enter or announce an intention to enter our market with alternative products and technologies, which could reduce the sales or market acceptance of our products and services, perpetuate intense price competition or make our products obsolete. If any technology that is competing with ours is or becomes more reliable, higher performing, less expensive or has other advantages over our technology, then the demand for our products and services would decrease, which would harm our business. Similarly, demand for our products could decrease if current or prospective competitors make prospective product release announcements claiming superior performance or other advantages regardless of the market availability of such products. IF WE DO NOT EXPAND OR ENHANCE OUR PRODUCT OFFERINGS OR RESPOND EFFECTIVELY AND ON A TIMELY BASIS TO TECHNOLOGICAL CHANGE, OUR BUSINESS MAY NOT GROW OR WE MAY LOSE CUSTOMERS AND MARKET SHARE Our future performance will depend on the successful development, introduction and market acceptance of new and enhanced products and features that address customer requirements in a cost-effective manner. We cannot assure you that our technological approach will achieve broad market acceptance or that other technologies or solutions will not supplant our approach. The WAN Application Delivery solutions market is characterized by ongoing technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. The introduction of new products, market acceptance of products based on new or alternative technologies, or the emergence of new industry standards, could render our existing products obsolete or make it A-9 easier for other products to compete with our products. Developments in router-based queuing schemes or alternative compression technologies could also significantly reduce demand for our product. Our future success will depend in part upon our ability to: • develop and maintain competitive products; • enhance our products by adding innovative features that differentiate our products from those of our competitors and meet the needs of our larger customers; • bring products to market and introduce new features on a timely basis at competitive prices; • integrate acquired technology into our products; • successfully negotiate and integrate acquisitions; • identify and respond to emerging technological trends in the market; and • respond effectively to new technological changes or new product announcements by others. We have experienced such delays in the past, including a delay in the integration of certain technology we acquired from Mentat. If we are unable to effectively perform with respect to the foregoing, or if we experience delays in product development, we could experience a loss of customers and market share. ANY ACQUISITIONS WE MAKE COULD RESULT IN DILUTION TO OUR EXISTING STOCKHOLDERS AND DIFFICULTIES IN SUCCESSFULLY MANAGING OUR BUSINESS We have made, and may in the future make, acquisitions of, mergers with, or significant investments in, businesses that offer complementary products, services and technologies. For example, in May 2006 we announced our acquisition of Tacit Networks, and in December 2004 we announced our acquisition of Mentat. There are risks involved in these activities, including but not limited to: • difficulty in integrating the acquired operations and retaining acquired personnel; • limitations on our ability to retain acquired distribution channels and customers; • diversion of management’s attention and disruption of our ongoing business; • difficulties in managing product development activities to define a combined product roadmap, ensuring timely development of new products, timely release of new products to market, and the development of efficient integration and migration tools; • the potential product liability associated with selling the acquired company’s products; and • the potential write-down of impaired goodwill and intangible and other assets. In particular, we recorded approximately $49.1 million in goodwill related to the acquisition of Tacit and $9.5 million in goodwill related to the acquisition of Mentat. Goodwill will be subject to impairment testing rather than being amortized over a fixed period. To the extent that the business acquired in that transaction does not remain competitive, some or all of the goodwill related to that acquisition could be charged against future earnings. These factors could have a material adverse effect on our business, results of operations or financial position, especially in the case of a large acquisition. In particular, we may complete acquisitions, which we believe will substantially contribute to our future revenues and profits, but may have an adverse impact on our profitability in the shorter term. Furthermore, we may incur indebtedness or issue equity securities to pay for future acquisitions. The issuance of equity or convertible debt securities could be dilutive to our existing stockholders. IF OUR INTERNATIONAL SALES EFFORTS ARE UNSUCCESSFUL, OUR BUSINESS WILL FAIL TO GROW The failure of our indirect partners to sell our products internationally will harm our business. Sales outside of the Americas accounted for 53%, 54%, and 59% of net revenues in 2006, 2005, and 2004, respectively. Our ability A-10 to grow will depend in part on the expansion of international sales, which will require success on the part of our resellers, distributors and systems integrators in marketing our products. We intend to expand operations in our existing international markets and to enter new international markets, which will demand management attention and financial commitment. We may not be able to successfully sustain and expand our international operations. In addition, a successful expansion of our international operations and sales in foreign markets will require us to develop relationships with suitable indirect channel partners operating abroad. We may not be able to identify, attract, manage or retain these indirect channel partners. Furthermore, to increase revenues in international markets, we will need to continue to establish foreign operations, to hire additional personnel to run these operations and to maintain good relations with our foreign indirect channel partners. To the extent that we are unable to successfully do so, or to the extent our foreign indirect channel partners are unable to perform effectively, our growth in international sales may be limited. Our international sales are currently all U.S. dollar-denominated. As a result, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in international markets. In the future, we may elect to invoice some of our international customers in local currency. Doing so will subject us to fluctuations in exchange rates between the U.S. dollar and the particular local currency and could negatively affect our financial performance. Additionally, operating costs outside the United States are incurred in local currencies, and are remeasured from the local currency to the U.S. dollar upon consolidation. As exchange rates vary, these operating costs, when remeasured, may differ from our prior performance and our expectations. Tax rates can vary significantly based upon the geographical mix of the markets in which our products are sold and may also cause our operating results to fluctuate. IF WE ARE UNABLE TO FAVORABLY ASSESS THE EFFECTIVENESS OF OUR INTERNAL CONTROL OVER FINANCIAL REPORTING, OR IF OUR INDEPENDENT AUDITORS ARE UNABLE TO PROVIDE AN UNQUALIFIED ATTESTATION REPORT ON OUR ASSESSMENT, OUR STOCK PRICE COULD BE ADVERSELY AFFECTED Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, or Section 404, our management is required to report on the effectiveness of our internal control over financial reporting in each of our annual reports. In addition, our independent auditor must attest to and report on management’s assessment of the effectiveness of our internal control over financial reporting. The rules governing the standards that must be met for management to assess our internal control over financial reporting are new and complex, and require significant documentation, testing and possible remediation. As a result, our efforts to comply with Section 404 have required the commitment of significant managerial and financial resources. As we are committed to maintaining high standards of public disclosure, our efforts to comply with Section 404 are ongoing, and we are continuously in the process of reviewing, documenting and testing our internal control over financial reporting, which will result in continued commitment of significant financial and managerial resources. Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 is included under the title “CONTROLS AND PROCEDURES” in Item 9A, and our independent registered public accounting firm’s attestation is included under the title “FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” in Item 8. Management’s assessment, and our registered public accounting firm’s attestation, concluded that our internal control over financial reporting as of December 31, 2006 was not effective due to material weaknesses related to our (i) accounting for income taxes and (ii) rebate reserves. Specifically, (i) we did not maintain effective controls to provide for the reconciliation of the income taxes payable account to supporting detail and the review of the income taxes payable account reconciliation by someone other than the preparer; and (ii) we did not maintain effective controls over the review of the rebate reserves as the review performed was not appropriately designed, nor was the review conducted in sufficient detail. Although we intend to diligently and regularly review and update our internal control over financial reporting in order to ensure compliance with the Section 404 requirements, in future years we may discover additional areas of our internal controls that need improvement, and our management may encounter problems or delays in completing the implementation and maintenance of any such improvements necessary to make a favorable assessment of our internal controls over financial reporting. We may not be able to favorably assess the effectiveness of our internal A-11 controls over financial reporting as of December 31, 2007 or beyond, or our independent auditors may be unable to provide an unqualified attestation report on our assessment. If this occurs, investor confidence and our stock price could be adversely affected. IF WE ARE UNABLE TO DEVELOP AND MAINTAIN STRONG PARTNERING RELATIONSHIPS WITH OUR INDIRECT CHANNEL PARTNERS, OR IF THEIR SALES EFFORTS ON OUR BEHALF ARE NOT SUCCESSFUL, OR IF THEY FAIL TO PROVIDE ADEQUATE SERVICES TO OUR END USER CUSTOMERS, OUR SALES MAY SUFFER AND OUR REVENUES MAY NOT INCREASE We rely primarily on an indirect distribution channel consisting of resellers, distributors and systems integrators for our revenues. Because many of our indirect channel partners also sell competitive products, our success and revenue growth will depend on our ability to develop and maintain strong cooperative relationships with significant indirect channel partners, as well as on the sales efforts and success of those indirect channel partners. We cannot assure you that our indirect channel partners will market our products effectively, receive and fulfill customer orders of our products on a timely basis or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. In order to support and develop leads for our indirect distribution channels, we plan to continue to expand our field sales and support staff as needed. We cannot assure you that this internal expansion will be successfully completed, that the cost of this expansion will not exceed the revenues generated or that our expanded sales and support staff will be able to compete successfully against the significantly more extensive and well-funded sales and marketing operations of many of our current or potential competitors. In addition, our indirect channel agreements are generally not exclusive and one or more of our channel partners may compete directly with another channel partner for the sale of our products in a particular region or market. This may cause such channel partners to stop or reduce their efforts in marketing our products. Our inability to effectively establish or manage our distribution channels would harm our sales. In addition, our indirect channel partners may provide services to our end user customers that are inadequate or do not meet expectations. Such failures to provide adequate services could result in customer dissatisfaction with us or our products and services due to delays in maintenance and replacement, decreases in our customers’ network availability and other losses. These occurrences could result in the loss of customers and repeat orders and could delay or limit market acceptance of our products, which would negatively affect our sales and results of operations. SALES TO LARGE CUSTOMERS WOULD BE DIFFICULT TO REPLACE IF LOST A limited number of indirect channel partners have accounted for a large part of our revenues to date and we expect that this trend will continue. Because our expense levels are based on our expectations as to future revenue and to a large extent are fixed in the short term, any significant reduction or delay in sales of our products to any significant indirect channel partner or unexpected returns from these indirect channel partners could harm our business. In 2006, sales to two customers, Alternative Technology, Inc. and Westcon, Inc. accounted for 23% and 18% of net revenues, respectively. In 2005, sales to Alternative Technology, Inc. and Westcon, Inc. accounted for 22% and 13% of net revenues, respectively. At December 31, 2006, Alternative Technologies and Westcon accounted for 18% and 23% of accounts receivable, respectively. These customers are indirect channel partners, who in turn sell to a large number of value-added resellers, system integrators and other resellers. In addition, as an increasing portion of our revenues is derived from larger unit sales, the timing of such sales can have a material impact on quarterly performance. As a result, a delay in completion of large deals at the end of a quarter can result in our missing analysts forecasts for the quarter. We expect that our largest customers in the future could be different from our largest customers today. End users could stop purchasing and indirect channel partners could stop marketing our products at any time. We cannot assure you that we will retain our current indirect channel partners or that we will be able to obtain additional or replacement partners. The loss of one or more of our key indirect channel partners or the failure to obtain and ship a number of large orders each quarter could harm our operating results. A-12 WE FACE RISKS RELATED TO INVENTORIES OF OUR PRODUCTS HELD BY OUR DISTRIBUTORS Many of our distributors maintain inventories of our products. We work closely with these distributors to monitor channel inventory levels so that appropriate levels of products are available to resellers and end users. However, if distributors reduce their levels of inventory or if they do not maintain sufficient levels to meet customer demand, our sales could be negatively impacted. Additionally, we monitor and track channel inventory with our distributors in order to estimate end user requirements. Overstocking could occur if reports from our distributors about expected customer orders are inaccurate, if customer orders are not fulfilled in a forecasted quarter or the demand for our products were to rapidly decline due to economic downturns, increased competition, underperformance of distributors or the introduction of new products by our competitors or ourselves. This could cause sales and cost of sales to fluctuate from quarter to quarter. OUR RELIANCE ON SALES OF OUR PRODUCTS BY OTHERS AND THE VARIABILITY OF OUR SALES CYCLE MAKES IT DIFFICULT TO PREDICT OUR REVENUES AND RESULTS OF OPERATIONS The timing of our revenues is difficult to predict because of our reliance on indirect sales channels and the variability of our sales cycle. The length of our sales cycle for sales through our indirect channel partners to our end users may vary substantially depending upon the size of the order and the distribution channel through which our products are sold. We generally ship product upon receipt of orders and as a result have limited unfulfilled product orders at any point in time. Substantially all of our revenues in any quarter depend upon customer orders that we receive and fulfill in that quarter. To the extent that an order that we anticipate will be received and fulfilled in a quarter is not actually received in time to fulfill prior to the end of that quarter, we will not be able to recognize any revenue associated with that order in the quarter. If revenues forecasted in a particular quarter do not occur in that quarter, our operating results for that quarter could be adversely affected. The greater the volume of an anticipated order, the lengthier the sales cycle for the order and the more material the potential adverse impact on our operating results if the order is not timely received in a quarter. In addition, as an increasing portion of our revenues is now derived from larger sales, the risk of delayed sales having a material impact on quarterly performance has increased. Furthermore, because our expense levels are based on our expectations as to future revenue and to a large extent are fixed in the short term, a substantial reduction or delay in sales of our products or the loss of any significant indirect channel partner could harm our business. WE HAVE RELIED AND EXPECT TO CONTINUE TO RELY ON A LIMITED NUMBER OF PRODUCTS FOR A SIGNIFICANT PORTION OF OUR REVENUES Most of our revenues have been derived from sales of our WAN Application Delivery systems and related maintenance and training services. We currently expect that our system-related revenues will continue to account for a substantial percentage of our revenues for the foreseeable future. Our future operating results are significantly dependent upon the continued market acceptance of our products and enhanced applications. Our business will be harmed if our products do not continue to achieve market acceptance or if we fail to develop and market improvements to our products or new and enhanced products. A decline in demand for our WAN Application Delivery systems as a result of competition, technological change or other factors would harm our business. INTRODUCTION OF OUR NEW PRODUCTS MAY CAUSE CUSTOMERS TO DEFER PURCHASES OF OUR EXISTING PRODUCTS WHICH COULD HARM OUR OPERATING RESULTS When we announce new products or product enhancements that have the potential to replace or shorten the life cycle of our existing products, customers may defer purchasing our existing products. These actions could harm our operating results by unexpectedly decreasing sales, increasing our inventory levels of older products and exposing us to greater risk of product obsolescence. A-13 THE AVERAGE SELLING PRICES OF OUR PRODUCTS COULD DECREASE RAPIDLY, WHICH MAY NEGATIVELY IMPACT GROSS MARGINS AND REVENUES We may experience substantial period-to-period fluctuations in future operating results due to the erosion of our average selling prices. The average selling prices of our products could decrease in the future in response to competitive pricing pressures, increased sales discounts, new product introductions by us or our competitors or other factors. Therefore, to maintain our gross margins, we must develop and introduce on a timely basis new products and product enhancements and continually reduce our product costs. Our failure to do so could cause our revenue and gross margins to decline. OUR PRODUCTS MAY HAVE ERRORS OR DEFECTS THAT WE FIND AFTER THE PRODUCTS HAVE BEEN SOLD, WHICH COULD INCREASE OUR COSTS AND NEGATIVELY AFFECT OUR REVENUES AND THE MARKET ACCEPTANCE OF OUR PRODUCTS Our products are complex and may contain undetected defects, errors or failures in either the hardware or software. In addition, because our products plug into our end users’ existing networks, they can directly affect the functionality of those networks. Furthermore, end users rely on our products to maintain acceptable service levels. We have in the past encountered errors in our products, which in a few instances resulted in network failures and in a number of instances resulted in degraded service. To date, these errors have not materially adversely affected us. Additional errors may occur in our products in the future. In particular, as our products and our customers’ networks become increasingly complex, the risk and potential consequences of such errors increases. The occurrence of defects, errors or failures could result in the failure of our customers’ networks or mission-critical applications, delays in installation, product returns and other losses to us or to our customers or end users. In addition, we would have limited experience responding to new problems that could arise with any new products that we introduce. These occurrences could also result in the loss of or delay in market acceptance of our products, which could harm our business. In particular, when a customer experiences what they believe to be a defect, error or failure, they will often delay additional purchases of our product until such matter is addressed or consider products offered by competitors. We may also be subject to liability claims for damages related to product errors. While we carry insurance policies covering this type of liability, these policies may not provide sufficient protection should a claim be asserted. A material product liability claim may harm our business. OUR RELIANCE ON THIRD-PARTY MANUFACTURERS FOR ALL OF OUR MANUFACTURING REQUIREMENTS COULD CAUSE US TO LOSE ORDERS IF THESE THIRD-PARTY MANUFACTURERS FAIL TO SATISFY OUR COST, QUALITY AND DELIVERY REQUIREMENTS We currently rely on SMTC, our longstanding contract manufacturer, and to a lesser extent, three additional manufacturers for all of our manufacturing requirements. Either we or SMTC and our other third-party manufacturers may terminate our contract with them without cause at any time. Third-party manufacturers may encounter difficulties in the manufacture of our products, resulting in product delivery delays. Any manufacturing disruption could impair our ability to fulfill orders. Our future success will depend, in significant part, on our ability to have these third party manufacturers, or others, manufacture our products cost-effectively and in sufficient volumes. We face a number of risks associated with our dependence on third-party manufacturers including: • reduced control over delivery schedules; • the potential lack of adequate capacity during periods of excess demand; • decreases in manufacturing yields and increases in costs; • the potential for a lapse in quality assurance procedures; • increases in prices; and • the potential misappropriation of our intellectual property. A-14 We have no long-term contracts or arrangements with our manufacturers which guarantee product availability, the continuation of particular payment terms or the extension of credit limits. We have experienced in the past, and may experience in the future, problems with our contract manufacturers, such as inferior quality, insufficient quantities and late delivery of product. To date, these problems have not materially adversely affected us. We may not be able to obtain additional volume purchase or manufacturing arrangements with these manufacturers on terms that we consider acceptable, if at all. If we enter into a high-volume or long-term supply arrangement and subsequently decide that we cannot use the products or services provided for in the agreement, our business will be harmed. In the future, we may seek to shift manufacturing of certain products from one manufacturer to another. We cannot assure you that we can effectively manage our third-party manufacturers or any such transition or that our third-party manufacturers will meet our future requirements for timely delivery of products of sufficient quality or quantity or facilitate any such transition efficiently. Any of these difficulties could harm our relationships with customers and cause us to lose orders. In the future, we may seek to use additional contract manufacturers. We may experience difficulty in locating and qualifying suitable manufacturing candidates capable of satisfying our product specifications or quantity requirements, or we may be unable to obtain terms that are acceptable to us. The lead-time required to identify and qualify new manufacturers could affect our ability to timely ship our products and cause our operating results to suffer. In addition, failure to meet customer demand in a timely manner could damage our reputation and harm our customer relationships, resulting in reduced market share. MOST OF THE COMPONENTS AND SOME OF THE SOFTWARE USED IN OUR PRODUCTS COME FROM SINGLE OR LIMITED SOURCES, AND OUR BUSINESS COULD BE HARMED IF THESE SOURCES FAIL TO SATISFY OUR SUPPLY REQUIREMENTS Almost all of the components used in our products are obtained from single or limited sources. Our products have been designed to incorporate a particular set of components. As a result, our desire to change the components of our products or our inability to obtain suitable components on a timely basis would require engineering changes to our products before we could incorporate substitute components. Any such changes could be costly and result in lost sales. We do not have any long-term supply contracts with any of our vendors to ensure sources of supply. If our contract manufacturer fails to obtain components in sufficient quantities when required, our business could be harmed. Our suppliers also sell products to our competitors. Our suppliers may enter into exclusive arrangements with our competitors, stop selling their products or components to us at commercially reasonable prices or refuse to sell their products or components to us at any price. Our inability to obtain sufficient quantities of single-sourced or limited-sourced components, or to develop alternative sources for components or products could harm our ability to maintain and expand our business. Similarly, the software for our ReportCenter product and certain of the software components for our iShared products are developed by single sources. We rely upon these providers for resolving software errors, developing software for product updates and providing certain levels of customer support for these products. It would be timeconsuming and costly to replace these providers if they failed to provide quality services in an efficient manner, or if our relationships with them were interrupted or terminated. We are currently involved in litigation with Valencia Systems, Inc., the sole provider of the software for our ReportCenter product, as described further in the Risk Factor entitled “THE PENDING LITIGATION TO WHICH WE ARE A PARTY, INCLUDING ANY ADVERSE RESOLUTION OF SUCH LITIGATION, MAY ADVERSELY IMPACT OUR BUSINESS.” An adverse outcome to that litigation, as well as any disruption in our access to the software development and maintenance services provided by our single source providers or our inability to develop alternative sources for these services, would adversely affect our business. THE PENDING LITIGATION TO WHICH WE ARE A PARTY, INCLUDING ANY ADVERSE RESOLUTION OF SUCH LITIGATION MAY ADVERSELY IMPACT OUR BUSINESS On June 22, 2006, we filed a lawsuit in Santa Clara Superior Court against Valencia Systems, Inc., or Valencia, alleging Valencia’s breach of a Software License and Development Agreement pursuant to which Valencia provides A-15 certain software development and maintenance services for us. This complaint followed an earlier arbitration demand from Valencia pursuant to which Valencia claimed damages of $3,000,000. We were granted injunctive relief in our action prohibiting Valencia from disparagement or discontinuing maintenance or support services. The court has ordered the matter to arbitration and the parties have not yet formally responded to the other’s allegations. Valencia’s motion for a preliminary injunction was denied by the arbitrator. We believe Valencia’s claims to be without merit and intend to defend this matter vigorously. However, this matter is in the early stages and we cannot reasonably estimate an amount of potential loss, if any, at this time. The results of litigation are inherently uncertain, and there can be no assurance that we will prevail. The costs and disruptions associated with the litigation with Valencia could have a material adverse effect on our business, financial condition and results of operations. Because Valencia is the sole provider of software development and maintenance services for our ReportCenter products, any disruption in our access to the development and maintenance services provided by Valencia could have a material adverse affect on us. For additional information regarding certain of the lawsuits in which we are involved, see Item 3, “Legal Proceedings.” CHANGES IN FINANCIAL ACCOUNTING STANDARDS ARE LIKELY TO IMPACT OUR FUTURE FINANCIAL POSITION AND RESULTS OF OPERATIONS New laws, regulations and accounting standards, as well as changes to and varying interpretations of currently accepted accounting practices in the technology industry might adversely affect our reported financial results, which could have an adverse effect on our stock price. Furthermore, guidance related to the expensing of the fair value of equity instruments provided to employees in SFAS No. 123(R), “Share Based Payments,” has materially adversely affected operating and net income for the year ended December 31, 2006, and may affect our stock price. CHANGES IN OR INTERPRETATIONS OF, TAX RULES AND REGULATIONS MAY ADVERSELY AFFECT OUR EFFECTIVE TAX RATES. As a global company, we are subject to taxation in the United States and various other countries. Unanticipated changes in our tax rates could affect our future results of operations. Our future effective tax rates could be unfavorably affected by changes in tax laws or the interpretation of tax laws, by unanticipated decreases in the amount of revenue or earnings in countries with low statutory tax rates, or by changes in the valuation of our deferred tax assets and liabilities or changes in our reserves. In addition, we are subject to examination of our income tax returns by the Internal Revenue Service and other domestic and foreign tax authorities, including a current examination by the Internal Revenue Service for our 2003 and 2004 tax returns, primarily related to our intercompany transfer pricing. We regularly assess the likelihood of outcomes resulting from these examinations to determine the adequacy of our provision for income taxes, and believe such estimates to be reasonable. However, there can be no assurance that the final determination of any of these examinations will not have an adverse effect on our operating results and financial position. OUR INABILITY TO ATTRACT, INTEGRATE AND RETAIN QUALIFIED PERSONNEL COULD SIGNIFICANTLY INTERRUPT OUR BUSINESS OPERATIONS Our future success will depend, to a significant extent, on the ability of our management to operate effectively, both individually and as a group. We are dependent on our ability to attract, successfully integrate, retain and motivate high caliber key personnel. Competition for qualified personnel and management in the networking industry, including engineers, sales and service and support personnel, is intense, and we may not be successful in attracting and retaining such personnel. There may be only a limited number of persons with the requisite skills to serve in these key positions and it may become increasingly difficult to hire such persons. Competitors and others have in the past and may in the future attempt to recruit our employees. With the exception of our CEO and CFO, we do not have employment contracts with any of our personnel. Our business will suffer if we encounter delays in hiring additional personnel as needed. In addition, if we are unable to successfully integrate new key personnel into our business operations in an efficient and effective manner, the attention of our management may be diverted from growing our business or we may be unable to retain such personnel. In January 2006, we hired a new Vice President, Engineering, and, in February 2007, we hired a new Vice President, Marketing. A-16 IF WE ARE UNABLE TO EFFECTIVELY MANAGE OUR GROWTH, WE MAY EXPERIENCE OPERATING INEFFICIENCIES AND HAVE DIFFICULTY MEETING DEMAND FOR OUR PRODUCTS In the past, we have experienced rapid and significant expansion of our operations. If further rapid and significant expansion is required to address potential growth in our customer base and market opportunities, this expansion could place a significant strain on our management, products and support operations, sales and marketing personnel and other resources, which could harm our business. In the future, we may experience difficulties meeting the demand for our products and services. The use of our products requires training, which is provided by our channel partners, as well as us. If we are unable to provide training and support for our products in a timely manner, the implementation process will be longer and customer satisfaction may be lower. In addition, our management team may not be able to achieve the rapid execution necessary to fully exploit the market for our products and services. We cannot assure you that our systems, procedures or controls will be adequate to support the anticipated growth in our operations. We may not be able to install management information and control systems in an efficient and timely manner, and our current or planned personnel, systems, procedures and controls may not be adequate to support our future operations. FAILURE TO ADEQUATELY PROTECT OUR INTELLECTUAL PROPERTY WOULD RESULT IN SIGNIFICANT HARM TO OUR BUSINESS Our success depends significantly upon our proprietary technology and our failure or inability to protect our proprietary technology would result in significant harm to our business. We rely on a combination of patent, copyright and trademark laws, and on trade secrets, confidentiality provisions and other contractual provisions to protect our proprietary rights. These measures afford only limited protection. As of December 31, 2006, we have 36 issued U.S. patents and 70 pending U.S. patent applications. Currently, none of our technology is patented outside of the United States. Our means of protecting our proprietary rights in the U.S. or abroad may not be adequate and competitors may independently develop similar technologies. Our future success will depend in part on our ability to protect our proprietary rights and the technologies used in our principal products. Despite our efforts to protect our proprietary rights and technologies unauthorized parties may attempt to copy aspects of our products or to obtain and use trade secrets or other information that we regard as proprietary. Legal proceedings to enforce our intellectual property rights could be burdensome and expensive and could involve a high degree of uncertainty. These legal proceedings may also divert management’s attention from growing our business. In addition, the laws of some foreign countries do not protect our proprietary rights as fully as do the laws of the U.S. Issued patents may not preserve our proprietary position. If we do not enforce and protect our intellectual property, our business will suffer substantial harm. CLAIMS BY OTHERS THAT WE INFRINGE ON THEIR INTELLECTUAL PROPERTY RIGHTS COULD BE COSTLY TO DEFEND AND COULD HARM OUR BUSINESS We may be subject to claims by others that our products infringe on their intellectual property rights. These claims, whether or not valid, could require us to spend significant sums and amount of time in litigation and customer relations, pay damages, delay product shipments, reengineer our products or acquire licenses to such third-party intellectual property. We may not be able to secure any required licenses on commercially reasonable terms, or at all. We expect that we will increasingly be subject to infringement claims as the number of products and competitors in the WAN Application Delivery systems market grows and the functionality of products overlaps. Any of these claims or resulting events could harm our business. IF OUR PRODUCTS DO NOT COMPLY WITH EVOLVING INDUSTRY STANDARDS AND GOVERNMENT REGULATIONS, OUR BUSINESS COULD BE HARMED The market for WAN Application Delivery systems is characterized by the need to support industry standards as these different standards emerge, evolve and achieve acceptance. In the United States, our products must comply with various regulations and standards defined by the Federal Communications Commission and Underwriters A-17 Laboratories. Internationally, products that we develop must comply with standards established by the International Electrotechnical Commission as well as with recommendations of the International Telecommunication Union. To remain competitive we must continue to introduce new products and product enhancements that meet these emerging U.S. and international standards. However, in the future we may not be able to effectively address the compatibility and interoperability issues that arise as a result of technological changes and evolving industry standards. Failure to comply with existing or evolving industry standards or to obtain timely domestic or foreign regulatory approvals or certificates could harm our business. OUR GROWTH AND OPERATING RESULTS WOULD BE IMPAIRED IF WE ARE UNABLE TO MEET OUR FUTURE CAPITAL REQUIREMENTS We currently anticipate that our existing cash and investment balances will be sufficient to meet our liquidity needs for the foreseeable future. However, we may need to raise additional funds if our estimates of revenues, working capital or capital expenditure requirements change or prove inaccurate or in order for us to respond to unforeseen technological or marketing hurdles or to take advantage of unanticipated opportunities. In addition, we expect to review potential acquisitions that would complement our existing product offerings or enhance our technical capabilities. Any future transaction of this nature could require potentially significant amounts of capital. These funds may not be available at the time or times needed or available on terms acceptable to us. If adequate funds are not available, or are not available on acceptable terms, we may not be able to take advantage of market opportunities to develop new products or to otherwise respond to competitive pressures. CERTAIN PROVISIONS OF OUR CHARTER AND OF DELAWARE LAW MAKE A TAKEOVER OF PACKETEER MORE DIFFICULT, WHICH COULD LOWER THE MARKET PRICE OF THE COMMON STOCK Our corporate documents and Section 203 of the Delaware General Corporation Law could discourage, delay or prevent a third- party or a significant stockholder from acquiring control of Packeteer. In addition, provisions of our certificate of incorporation may have the effect of discouraging, delaying or preventing a merger, tender offer or proxy contest involving Packeteer. Any of these anti-takeover provisions could lower the market price of the common stock and could deprive our stockholders of the opportunity to receive a premium for their common stock that they might otherwise receive from the sale of Packeteer. ITEM 1B. UNRESOLVED STAFF COMMENTS Not applicable ITEM 2. PROPERTIES We lease approximately 69,000 square feet of administrative and research and development facilities in Cupertino, California under a lease that expires in December 2014. In December 2007, the premises subject to the lease will be expanded to approximately 105,000 square feet. We also lease sales offices in various locations throughout the United States, as well as an additional research and development facilities in Los Angeles, California and South Plainfield, New Jersey. Our international leased offices include a research and development facility located in Canada and sales and support offices throughout Europe, the Asia Pacific region and Japan. We believe that our future growth can be accommodated by current facilities or by leasing the necessary additional space. ITEM 3. LEGAL PROCEEDINGS In November 2001, a putative class action lawsuit was filed in the United States District Court for the Southern District of New York against us, certain of our officers and directors, and the underwriters of our initial public offering. An amended complaint, captioned In re Packeteer, Inc. Initial Public Offering Securities Litigation, 01-CV-10185 (SAS), was filed on April 20, 2002. The amended complaint alleges violations of the federal securities laws on behalf of a purported class of those who acquired our common stock between the date of our initial public offering, or IPO, and December 6, 2000. The A-18 amended complaint alleges that the description in the prospectus for our IPO was materially false and misleading in describing the compensation to be earned by the underwriters of our IPO, and in not describing certain alleged arrangements among underwriters and initial purchasers of our common stock. The amended complaint seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of our common stock between July 27, 1999 and December 6, 2000. A special committee of the board of directors has authorized us to negotiate a settlement of the pending claims substantially consistent with a memorandum of understanding negotiated among class plaintiffs, all issuer defendants and their insurers. The parties have negotiated a settlement, which is subject to approval by the Court. On February 15, 2005, the Court issued an Opinion and Order preliminarily approving the settlement, provided that the defendants and plaintiffs agree to a modification narrowing the scope of the bar order set forth in the original settlement agreement. The parties agreed to a modification narrowing the scope of the bar order, and on August 31, 2005, the Court issued an order preliminarily approving the settlement. On December 5, 2006, the United States Court of Appeals for the Second Circuit overturned the District Court’s certification of the class of plaintiffs who are pursuing the claims that would be settled in the settlement against the underwriter defendants. Plaintiffs informed the District Court that they intend to seek further appellate review of this decision, and that they would like to be heard by the District Court as to whether the settlement may still be approved even if the the decision of the Court of Appeals is not reversed. The District Court indicated that it would defer consideration of final approval of the settlement pending plaintiffs’ request for further appellate review. We do not currently believe that the outcome of this proceeding will have a material adverse impact on our financial condition, results of operations or cash flows. No amount has been accrued as of December 31, 2006, as we believe a loss is neither probable nor estimable. On June 22, 2006, we filed a lawsuit in Santa Clara Superior Court against Valencia Systems, Inc., or Valencia, alleging Valencia’s breach of a Software License and Development Agreement pursuant to which Valencia provides certain software development and maintenance services for us. This complaint followed an earlier arbitration demand from Valencia pursuant to which Valencia claimed damages of $3,000,000. We were granted injunctive relief in its action prohibiting Valencia from disparagement or discontinuing maintenance or support services. The court has ordered the matter to arbitration and the parties have not yet formally responded to the other’s allegations. Valencia’s motion for a preliminary injunction was denied by the arbitrator. We believe Valencia’s claims to be without merit and intends to defend this matter vigorously. However, this matter is in the early stages and we cannot reasonably estimate an amount of potential loss, if any, at this time. The results of litigation are inherently uncertain, and there can be no assurance that we will prevail. In addition, we are subject to examination of its income tax returns by the Internal Revenue Service and other domestic and foreign tax authorities, including a current examination by the Internal Revenue Service for our 2003 and 2004 tax returns, primarily related to our intercompany transfer pricing. We regularly assess the likelihood of outcomes resulting from these examinations to determine the adequacy of our provision for income taxes, and believe such estimates to be reasonable. We are routinely involved in legal and administrative proceedings incidental to its normal business activities and believe that these matters will not have a material adverse effect on its financial position, results of operations or cash flows. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. A-19 PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON STOCK, RELATED STOCKHOLDER MATTERS AND ISSUER REPURCHASES OF EQUITY SECURITIES Our common stock has been quoted on the Nasdaq Global Select Market (formerly the Nasdaq National Market) under the symbol “PKTR” since our initial public offering on July 28, 1999. Prior to this time, there was no public market for our common stock. The following table shows the high and low closing prices per share of our common stock as reported on the Nasdaq Global Select Market for the periods indicated: High Low 2006: Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Third Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Second Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . First Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005: Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Third Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Second Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . First Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13.85 . . . . . . . . . . . . . . 11.81 . . . . . . . . . . . . . . 14.18 . . . . . . . . . . . . . . 13.80 . . . . . . . . . . . . . . $12.19 . . . . . . . . . . . . . . 14.78 . . . . . . . . . . . . . . 15.63 . . . . . . . . . . . . . . 17.18 $ 8.55 7.91 10.15 8.01 $ 7.36 11.05 10.99 13.03 As of March 11, 2007, there were approximately 307 holders of record of our common stock. We have never declared or paid any dividends on our capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. A-20 The graph depicted below shows a comparison of cumulative total stockholder returns for the Company, the Nasdaq Composite Index, the Nasdaq Computer Manufacturers Industry Index and the Standard and Poors 500 Index for the period commencing December 31, 2001 and ending on December 29, 2006. We have included the Nasdaq Computer Manufacturers Index in order to show a comparison of cumulative total stockholder returns for a relevant industry index. We will not provide information for the Standard and Poors 500 Index in the future. The past performance of our Common Stock is no indication of future performance. COMPARISON OF CUMULATIVE TOTAL RETURN FROM DECEMBER 31, 2001 THROUGH DECEMBER 29, 2006(1) Among Packeteer, The S & P 500 Index, The Nasdaq Composite Index And The Nasdaq Computer Manufacturers Index 400 350 300 Packeteer S & P 500 NASDAQ Composite NASDAQ Computer Manufacturers DOLLARS 250 200 150 100 50 0 12/31/01 12/31/02 12/31/03 12/31/04 12/30/05 12/29/06 12/31/01 12/31/02 12/31/03 12/31/04 12/30/05 12/29/06 Packeteer S & P 500 NASDAQ Composite NASDAQ Computer Manufacturers 100.00 100.00 100.00 100.00 93.08 77.90 69.66 67.48 230.39 100.24 99.71 109.37 196.07 111.15 113.79 115.04 105.43 116.61 114.47 107.28 184.53 135.03 124.20 134.84 (1) The graph assumes that $100 was invested in the Company at the closing price on December 31, 2001, in our Common Stock and in each index, and all dividends were reinvested. No cash dividends have been declared on our Common Stock. A-21 ITEM 6. SELECTED FINANCIAL DATA The selected consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements of Packeteer, Inc. and the Notes thereto included elsewhere in this report, in order to understand factors that may affect the comparability of the information below. Our actual results in future periods could differ materially from the historical results set forth below as a result of a number of factors, including the risks described under the title “RISK FACTORS” in Item 1A: 2006 Years Ended December 31, 2005 2004 2003 (In thousands, except per share data) 2002 CONSOLIDATED STATEMENTS OF OPERATIONS DATA: Net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $145,123 $112,941 $92,437 Product and service costs. . . . . . . . . . . . . . . . . . . . . . . . 36,935 27,738 22,837 Amortization of purchased intangible assets . . . . . . . . . . 2,150 1,557 38 Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . Operating expenses: Research and development . . . . . . . . . . . . . Sales and marketing. . . . . . . . . . . . . . . . . . General and administrative . . . . . . . . . . . . . In-process research and development . . . . . ........ ........ ........ ........ ........ 106,038 30,646 57,889 13,949 1,800 104,284 1,754 3,932 5,686 782 83,646 21,778 38,276 7,222 — 67,276 16,370 2,913 19,283 125 69,562 14,973 35,504 6,061 — 56,538 13,024 1,127 14,151 (383) $14,534 $72,723 $55,014 17,036 12,852 — — 55,687 12,202 26,433 5,494 — 44,129 11,558 701 12,259 1,226 42,162 10,877 23,420 4,636 — 38,933 3,229 915 4,144 415 Total operating expenses . . . . . . . . . . . . . . . . . . . . Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . Other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before provision (benefit) for income taxes . . . . Provision (benefit) for income taxes . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Basic net income per share . . . . . . . . . . . . . . . . . . . . . . $ Diluted net income per share . . . . . . . . . . . . . . . . . . . . . $ Shares used in computing basic net income per share . . . Shares used in computing diluted net income per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,904 $ 19,158 0.14 $ 0.14 $ 34,848 35,740 $11,033 $ 3,729 0.12 0.12 30,205 30,718 0.57 $ 0.55 $ 33,823 35,065 0.44 $ 0.35 $ 0.42 $ 0.32 $ 31,634 34,364 32,994 34,502 2006 2005 December 31, 2004 (In thousands) 2003 2002 CONSOLIDATED BALANCE SHEET DATA: Cash, cash equivalents and investments . . . . . . . . Working capital . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt obligations . . . . . . . . . . . . . . . . . Total stockholders’ equity . . . . . . . . . . . . . . . . . . $ 76,557 52,379 216,968 29,104 — 159,509 $122,677 103,961 168,657 22,115 — 128,607 $ 92,197 73,171 137,792 16,157 — 101,959 $ 86,707 75,273 104,699 9,592 — 83,418 $65,474 53,492 79,912 5,968 545 63,401 A-22 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion, which should be read in conjunction with our Consolidated Financial Statements and the Notes thereto included under the title “FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA”, contain forward-looking statements that involve risks and uncertainties. Forward-looking statements can be identified by words such as “anticipates,” “expects,” “believes,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed under the title “RISK FACTORS” in Item 1A. We assume no obligation to publicly release any revisions to forward-looking statements to reflect events or circumstances arising after the date of this document, except as required by law. OVERVIEW We are a leading provider of WAN Application Delivery systems designed to deliver a comprehensive set of visibility, QoS, control, compression, application acceleration and branch office service capabilities to enterprise customers and service providers. For enterprise customers, our systems are designed to enable IT organizations to effectively deliver applications and performance, while providing measurable cost savings in WAN investments. For service providers, our systems are designed to provide a platform for delivering application-intelligent network services that provide application level visibility and QoS control, expanding revenue opportunities. Our WAN Application Delivery system consists of a family of scalable appliances that can be deployed within large data centers as well as smaller remote sites throughout a distributed enterprise. Each appliance can be configured with software modules to deliver a range of WAN Application Traffic Management capabilities. Our product family includes PacketShaper, iShared, SkyX and Mobiliti Client products that can be deployed within large data centers, smaller branch office sites and software clients on PCs for mobile and SOHO users throughout a distributed enterprise. We deliver superior application performance and end user experience using an “intelligent overlay”, which bridges applications and IP networks, adapts to our customers’ existing infrastructure and addresses the demands created by a changing application environment in order to deliver high performance applications across all WAN and Internet links. In May 2006, we completed our acquisition of Tacit for an initial purchase price of $68.0 million in cash, including acquisition costs of $1.7 million. In addition, we assumed all the then outstanding options to purchase Tacit common stock, and converted those into options to purchase approximately 320,000 shares of our common stock. In addition to the cash paid that is included in the initial purchase price, the merger agreement required that $7.85 million of cash be placed in an escrow account to secure Tacit’s obligations under certain representation and warranty provisions. The escrow funds will be released fifteen days following the later of 90 days after completion of the audit of our 2006 financial statements or one year from the closing date of the acquisition, at which time the final purchase price will be adjusted. In connection with the acquisition, we have recorded $49.1 million of goodwill, $8.4 million of other intangible assets, and $11.2 million of net tangible assets. In addition, we wrote off acquired in-process research and development, or IPR&D, of $1.8 million because the acquired technologies had not reached technological feasibility and had no alternative uses. The financial information presented for 2006 includes the results of Tacit subsequent to the acquisition date. Our results for 2006 reflected an increase in net revenues of $32.2 million, or 28%, from $112.9 million in 2005. Net income for 2006 was $4.9 million compared to net income of $19.2 million for 2005. Included in cost of revenues and operating expenses for 2006 was stock-based compensation expense of $13.3 million related to stock options and Employee Stock Purchase Plan (ESPP) as a result of adopting Statement of Financial Accounting Standards (SFAS) No. 123(R), “Share-Based Payments” (SFAS 123(R)). There was no stock-based compensation expense related to stock options and ESPP recognized during 2005 and 2004. We believe that our current value proposition, which enables our enterprise customers to get more value out of existing network resources and improved performance of their critical applications, should allow us to grow our business again in 2007. Our growth rate and net revenues depend significantly on continued growth in the WAN Application Delivery market, our ability to develop and maintain strong partnering relationships with our indirect A-23 channel partners and our ability to expand or enhance our current product offerings or respond to technological change. Our growth in service revenues is dependent upon increasing the number of units under maintenance, which is dependent on both growing our installed base and renewing existing maintenance contracts. Our future profitability and rate of growth, if any, will be directly affected by the continued acceptance of our product in the marketplace, as well as the timing and size of orders and shipments, product mix, average selling price of our products and general economic conditions. Our failure to successfully convince the market of our value proposition and maintain strong relationships with our indirect channel partners to ensure the success of their selling efforts on our behalf, would adversely impact our net revenues and operating results. Our future revenue and profitability may also be impacted by future acquisitions. CRITICAL ACCOUNTING POLICIES Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to allowance for doubtful accounts and sales returns, inventory valuation, rebate and warranty reserves, valuation of long-lived assets, including intangible assets and goodwill, income taxes and stock-based compensation, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe that of our significant accounting policies, which are described in Note 1 of the Notes to Consolidated Financial Statements, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, we believe the accounting policies below are the most critical to aid in fully understanding and evaluating our consolidated results of operations and financial condition. Revenue recognition. We apply the provisions of Statement of Position, or SOP, 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions,” to all transactions involving the sale of hardware and software products. Revenue is generally recognized when all of the following criteria are met, as set forth in paragraph 8 of SOP 97-2: • persuasive evidence of an arrangement exists, • delivery has occurred, • the fee is fixed or determinable, and • collectibility is probable. Receipt of a customer purchase order is persuasive evidence of an arrangement. Sales through our distribution channel are evidenced by an agreement governing the relationship together with purchase orders on a transaction-by-transaction basis. Delivery generally occurs when product is delivered to a common carrier from Packeteer or its designated fulfillment house. For certain destinations outside the Americas, delivery occurs when product is delivered to the destination country. For maintenance contracts, delivery is deemed to occur ratably over the contract period. Our fees are typically considered to be fixed or determinable at the inception of an arrangement and are negotiated at the outset of an arrangement, generally based on specific products and quantities to be delivered. In the event payment terms are provided that differ significantly from our standard business practices, which are generally ninety days or less, the fees are deemed to not be fixed or determinable and revenue is recognized as the fees become due and payable. We assess collectibility based on a number of factors, including credit worthiness of the customer and past transaction history of the customer. A-24 Generally, product revenue is recognized upon delivery. However, product revenue on sales to major new distributors are recorded based on sell-through to the end user customers until such time as we have established significant experience with the distributor’s product exchange activity. Additionally, when we introduce new product into our distribution channel for which there is no historical customer demand or acceptance history, revenue is recognized on the basis of sell-through to end user customers until such time as demand or acceptance history has been established. We defer recognition of revenue on inventory in the distribution channel in excess of a certain number of days. On the same basis, we reduce the associated cost of revenues, which is primarily related to materials, and include this amount in inventory. We recognize these revenues and associated cost of revenues when the inventory levels no longer exceed expected supply. No amounts were deferred under this policy as of December 31, 2006 or 2005. We have analyzed all of the elements included in our multiple element arrangements and have determined that we have sufficient vendor specific objective evidence, or VSOE, of fair value to allocate revenue to the maintenance component of our product and to training. VSOE of fair value is based upon separate sales of maintenance renewals and training to customers. Accordingly, assuming other revenue recognition criteria are met, revenue from product sales is recognized upon delivery using the residual method in accordance with SOP 98-9. Revenue from maintenance is recognized ratably over the maintenance term and revenue from training is recognized when the training has taken place. To date, training revenues have not been material. Inventory valuation. Inventories consist primarily of finished goods and are stated at the lower of cost (on a first-in, first-out basis) or market. We record inventory write-downs for excess and obsolete inventories based on historical usage and forecasted demand. Factors which could cause our forecasted demand to prove inaccurate include our reliance on indirect sales channels and the variability of our sales cycle; the potential of announcements of our new products or enhancements to replace or shorten the life cycle of our current products, or cause customers to defer their purchases; loss of sales due to product shortages; and the potential of new or alternative technologies achieving widespread market acceptance and thereby rendering our existing products obsolete. If future demand or market conditions are less favorable than our projections, additional inventory write-downs may be required and would be reflected in cost of sales in the period the revision is made. Valuation of long-lived and intangible assets and goodwill. We test goodwill for impairment in accordance with Statement of Financial Accounting Standards (SFAS) 142, “Goodwill and Other Intangible Assets.” SFAS 142 requires that goodwill be tested for impairment at the “reporting-unit” level (“Reporting Unit”) at least annually and more frequently upon the occurrence of certain events, as defined by SFAS 142. Consistent with our determination that we have only one reporting segment as defined in SFAS 131, “Disclosures about Segments of an Enterprise and Related Information,” we have determined that we have only one Reporting Unit. Goodwill is tested for impairment annually on December 1 in a two-step process. First, we determine if the carrying amount of our Reporting Unit exceeds the “fair value” of the Reporting Unit, which would indicate that goodwill may be impaired. If we determine that goodwill may be impaired, we compare the “implied fair value” of the goodwill, as defined by SFAS 142, to our carrying amount to determine if there is an impairment loss. We do not have any goodwill that we consider to be impaired. In accordance with SFAS 144, “Accounting for Impairment or Disposal of Long-lived Assets”, we evaluate long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Recoverability of these assets is measured by comparison of the carrying amount of the asset to the future undiscounted cash flows the asset is expected to generate. If the asset is considered to be impaired, the amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. Sales return reserve. In accordance with SFAS 48, “Revenue Recognition When Right of Return Exists,” management must use judgment and make estimates of potential future product returns related to current period product revenue. When providing for sales return reserves, we analyze historical return rates, as we believe they are the primary indicator of possible future returns. Material differences may result in the amount and timing of our revenues if for any period actual returns differ from our judgments or estimates. The sales return reserve balances at December 31, 2006 and 2005 were $2.5 million and $1.6 million, respectively. A-25 Rebate reserves. Certain distributors and resellers can earn rebates under several of our programs. The rebates earned are recorded in accordance with Emerging Issues Task Force 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendors Products)”. For established programs, our estimates for rebates are based on historical usage rates. For new programs, rebate reserves are calculated to cover our maximum exposure until such time as historical usage rates are developed. When sufficient historical experience is established, there may be a reversal of previously accrued rebates if actual rebate claims are less than the maximum exposure. Additionally, there may be a reversal of previously accrued rebate reserves if rebates are not claimed before the expiration dates established for each program. Rebate reserves at December 31, 2006 and 2005 were $2.3 million and $1.6 million, respectively. Warranty reserves. Upon shipment of products to our customers, we provide for the estimated cost to repair or replace products that may be returned under warranty. Our warranty period is typically 12 months from the date of shipment to the end user customer. For existing products, the reserve is estimated based on actual historical experience. For new products, the warranty reserve is based on historical experience of similar products until such time as sufficient historical data has been collected on the new product. Factors that may impact our warranty costs in the future include our reliance on our contract manufacturer to provide quality products and the complexity of our products which may contain undetected defects, errors or failures in either the hardware or the software. To date, these problems have not materially adversely affected us. Warranty reserves amounted to $488,000 and $234,000 at December 31, 2006 and 2005, respectively. Stock Based Compensation. Effective January 1, 2006, we began accounting for stock options and ESPP shares under the provisions of SFAS 123(R), which requires the recognition of the fair value of equity-based compensation. The fair value of stock options and ESPP shares was estimated using a Black-Scholes option valuation model. This model requires the input of subjective assumptions, including expected stock price volatility and estimated life of each award. The fair value of equity-based awards is amortized over the vesting period of the award, net of estimated forfeitures, and we have elected to use the graded-option method. We make quarterly assessments of the adequacy of the tax credit pool to determine if there are any deficiencies that require recognition in the consolidated statements of operations. Prior to the implementation of SFAS 123(R), we accounted for stock options and Employee Stock Purchase Plan, or ESPP, shares under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and made pro forma footnote disclosures as required by SFAS No. 148, “Accounting For Stock-Based Compensation — Transition and Disclosure,” which amended SFAS No. 123, “Accounting For Stock-Based Compensation.” Pro forma net income and pro forma net income per share disclosed in the footnotes to the consolidated financial statements were estimated using a Black-Scholes option valuation model. The fair value of restricted shares issued in connection with an acquisition was calculated based upon the fair market value of our common stock at the date of grant. See Note 1 of the Notes to the Consolidated Financial Statements for additional information and related disclosures. Accounting for Income Taxes. We utilize the asset and liability method of accounting for income taxes pursuant to SFAS 109. Accordingly, we are required to estimate our income taxes in each of the jurisdictions in which we operate as part of the process of preparing our consolidated financial statements. This process involves estimating our actual current tax exposure, including assessing the risks associated with tax audits, together with assessing temporary differences resulting from the different treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. Due to the evolving nature of tax rules combined with the large number of jurisdictions in which we operate, it is possible that our estimates of our tax liability could change in the future, which may result in additional tax liabilities and adversely affect our results of operations, financial condition and cash flows. SFAS 109 provides for the recognition of deferred tax assets if it is more likely than not that those deferred tax assets will be realized. Management reviews deferred tax assets periodically for recoverability and makes estimates and judgments regarding the expected geographic sources of taxable income in assessing the need for a valuation allowance to reduce deferred tax assets to their estimated realizable value. Factors such as our cumulative profitability in the U.S. and our projected future taxable income were the key criteria in deciding to release a portion of the valuation allowance. If the estimates and assumptions used in our A-26 determination change in the future, we could be required to revise our estimates of the valuation allowances against our deferred tax assets and adjust our provisions for additional income taxes. Quantification of Errors. In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108 (SAB 108), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which addresses how uncorrected errors in previous years should be considered when quantifying errors in current-year financial statements. SAB 108 requires companies to consider both a “rollover” method which focuses primarily on the income statement impact of misstatements and the “iron curtain” method which focuses primarily on the balance sheet impact of misstatements when quantifying errors in current-year financial statements and the related financial statement disclosures. The transition provisions of SAB 108 permit a company to adjust retained earnings (accumulated deficit) for the cumulative effect of immaterial errors relating to prior years. In the three months ended December 31, 2006 we determined that errors had been made in our financial statements related to the recording of rebate reserves, resulting in an overstatement of rebate reserves of $500,000, net of taxes of $150,000. Historically, we have evaluated uncorrected differences utilizing the rollover approach. We believe the impact of these errors were immaterial to prior years under the rollover method. However, under SAB 108, which we were required to adopt for the year ended December 31, 2006, we must assess materiality using both the rollover method and the iron-curtain method. Under the iron-curtain method, the cumulative impact of the errors are material to our 2006 financial statements and, therefore, we have recorded an adjustment to our opening 2006 accumulated deficit balance in the amount of $350,000 in accordance with the implementation guidance in SAB 108. The impact on accumulated deficit is comprised of the following amounts (in thousands): Years Ended December 31, 2004 2005 Total Accumulated deficit Net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . RESULTS OF OPERATIONS $(603) 181 $(422) $103 (31) $ 72 $(500) 150 $(350) The following table includes selected consolidated statements of operations data for all quarters of the periods indicated (in thousands, except per share amounts): 2006 Quarter Ended September 30, June 30, December 31, March 31, Net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . Income (loss) from operations . . . . . . . . . . . . . Net income (loss) . . . . . . . . . . . . . . . . . . . . . . Basic net income (loss) per share . . . . . . . . . . . Diluted net income (loss) per share . . . . . . . . . $42,683 29,930 (637) 894 0.03 0.02 $35,986 26,062 (1,357) 301 0.01 0.01 $34,169 25,580 (386) (805) (0.02) (0.02) $32,285 24,466 4,134 4,514 0.13 0.13 A-27 December 31, 2005 Quarter Ended September 30, June 30, March 31, Net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . Income from operations . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic net income per share . . . . . . . . . . . . . . . Diluted net income per share . . . . . . . . . . . . . . $31,851 23,812 5,837 9,098 0.27 0.26 $24,835 18,206 2,008 2,255 0.07 0.06 $28,177 20,720 4,665 4,228 0.13 0.12 $28,078 20,908 3,860 3,577 0.11 0.10 The following table sets forth certain financial data as a percentage of net revenues for the periods indicated; however, these historical operating results are not necessarily indicative of the results for any future period: 2006 2005 2004 Net revenues: Product revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of revenues: Product costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of purchased intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . Total cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating expenses: Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . In-process research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest and other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before provision (benefit) for income taxes . . . . . . . . . . . . . . . . . . . . . . Provision (benefit) for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . OVERVIEW OF RESULTS OF OPERATIONS FOR 2006 76% 24 100 18 8 1 27 73 21 40 10 1 72 1 3 4 1 3% 76% 24 100 17 7 2 26 74 19 34 6 — 59 15 2 17 — 17% 81% 19 100 18 7 — 25 75 16 38 7 — 61 14 1 15 (1) 16% Net revenues for 2006 were $145.1 million, an increase of 28% over 2005. Gross profit was $106.0 million, or 74% of net revenues, and operating income was $1.8 million. During 2005, net revenues were $112.9 million, gross profit was $83.6 million, or 73% of net revenues, and operating income was $16.4 million. Included in operating income for 2006 was $13.3 million of stock-based compensation expense recognized under SFAS 123(R) related to stock options and ESPP. There was no stock-based compensation expense related to stock options and ESPP recognized during 2005 and 2004. During 2006, we continued to invest in our operations, with operating expenses of $90.3 million, excluding the $12.2 million impact of stock-based compensation related to stock option plans and the ESPP and $1.8 million from IPR&D expense related to the acquisition of Tacit. This represents an increase of $23.0 million, or 34%, from A-28 $67.3 million reported in 2005. Headcount at December 31, 2006 increased by 117, or 38% compared to December 31, 2005, primarily in sales and marketing and research and development. The Tacit acquisition accounts for 71 of this additional headcount. During 2006, we generated $20.4 million of cash from operating activities, compared to $28.9 million generated in 2005. At December 31, 2006 we had cash, cash equivalents and investments of $76.6 million, accounts receivable of $31.7 million and deferred revenues of $29.1 million. NET REVENUES Net revenues increased to $145.1 million in 2006 from $112.9 million in 2005 and from $92.4 million in 2004. The increase from 2005 to 2006 was $32.2 million, or 28%, and the increase from 2004 to 2005 was $20.5 million, or 22%. We expect revenue growth in 2007 will meet or exceed the revenue growth we reported for 2006. We derive our revenue from two sources, product revenues and service revenues. Product revenues consist primarily of sales of our WAN Application Delivery systems. Product revenues accounted for 76%, 76%, and 81% of our net revenues in 2006, 2005 and 2004, respectively. Product revenues increased to $110.1 million in 2006 from $85.6 million in 2005 and from $74.6 million in 2004. The increase in product revenues from 2005 to 2006 of $24.6 million, or 29%, is primarily the result of an increase in the number of units shipped and a slight increase in weighted average selling prices. In addition, we recognized revenue from Tacit products of $6.8 million in 2006. The increase from 2004 to 2005 of $11.0 million, or 15% was primarily due to an increase in the number of units shipped from year to year. There were no significant changes in average selling prices during 2005. Service revenues consist primarily of maintenance revenues and, to a lesser extent, training revenues. Maintenance revenues, which are included in service revenues, are recognized on a monthly basis over the life of the contract. The typical subscription and support term is twelve months, although multi-year contracts of up to three years are also sold. Service revenues accounted for 24%, 24%, and 19% of net revenues in 2006, 2005 and 2004, respectively. Service revenues increased to $35.0 million in 2006 from $27.4 million in 2005 and from $17.9 million in 2004. The increase from 2006 to 2005 of $7.6 million, or 28%, was due primarily to an increase in the number of units under maintenance contracts, as well as revenue from Tacit maintenance contracts of $955,000. The increase from 2004 to 2005 of $9.5 million, or 53%, was due primarily to increases in the number of units under maintenance contracts. For 2006, net revenues in the Americas increased to $67.6 million, from $52.6 million in 2005 and $37.9 million in 2004. Sales in the Americas accounted for 47%, 46% and 41% of net revenues for 2006, 2005 and 2004, respectively. Net revenues in Asia Pacific were $35.3 million, $27.7 million and $25.0 million, or 24%, 25% and 27% of net revenues in 2006, 2005 and 2004, respectively. Net revenues in Europe, the Middle East and Africa, or EMEA, of $42.2 million, $32.6 million and $29.5 million, represented 29%, 29% and 32% of net revenues in 2006, 2005 and 2004, respectively. We expect our geographic distribution of net revenues will be approximately the same in 2007 as we experienced in 2006. In 2006, sales to two customers, Alternative Technology, Inc., or Alternative Technology, and Westcon, Inc., or Westcon, accounted for 23% and 18% of net revenues, respectively. In 2005, sales to Alternative Technology and Westcon accounted for 22%, and 13% of net revenues, respectively. In 2004, sales to Alternative Technology and Westcon accounted for 22%, and 19% of net revenues, respectively. Sales to the top 10 indirect channel partners accounted for 73%, 65% and 71%, of net revenues in 2006, 2005 and 2004, respectively. Alternative Technology and Weston are distributors, who in turn sell to a large number of value-added resellers, system integrators and other resellers. At December 31, 2006, Alternative Technologies and Westcon accounted for 18% and 23% of gross accounts receivable, respectively. At December 31, 2005, Alternative Technologies and Westcon accounted for 20% and 13% of gross accounts receivable, respectively. COST OF REVENUES Our cost of revenues consists of the cost of finished products purchased from our contract manufacturers, overhead costs, service support costs and amortization of purchased intangible assets. A-29 We outsource all of our manufacturing. We design and develop a majority of the key components of our products, including printed circuit boards and software. In addition, we determine the components that are incorporated into our products and select the appropriate suppliers of these components. Our overhead costs consist primarily of personnel related costs for our product operations and order fulfillment groups and other product costs such as warranty and fulfillment charges. Service support costs consist primarily of personnel related costs for our customer support and training groups, as well as fees paid to third-party service providers to facilitate next business day replacement for end user customers located outside the United States. Additionally, we allocate overhead such as facilities, depreciation and IT costs to all departments based on headcount and usage. As such, general overhead costs are reflected in each cost of revenue and operating expense category. We must continue to work closely with our contract manufacturers as we develop and introduce new products and try to reduce production costs for existing products. Cost of revenues was $39.1 million in 2006, an increase of $9.8 million, or 33%, from $29.3 million in 2005 and from $22.9 million in 2004. Excluding the amortization of intangibles of $2.2 million and stock-based compensation of $1.1 million in 2006, the cost of revenues represented 25% of total net revenues for 2006, compared to 26% in 2005 and 25% in 2004. Product costs increased $6.5 million, or 33%, to $26.0 million in 2006 from $19.6 million in 2005. In 2005, the increase was $2.8 million, or 17%, from $16.8 million in 2004. The increase in 2006 from 2005 was primarily related to an increase in manufacturing costs of $4.1 million from 2005 due to increases in the number of units shipped, and to a lesser extent an increase in weighted average component cost. Other product costs increased $2.4 million in 2006 from 2005, primarily for overhead costs. Product costs for 2006 also included $414,000 of stock-based compensation related to stock option plans and the ESPP and increase of $460,000 in other personnel related costs due to increased headcount, as well as increases of $479,000 in inventory write-downs, $335,000 in warranty expense and $270,000 in freight costs. The increase in 2005 from 2004 was primarily due to an increase in manufacturing costs of $2.4 million, primarily due to a shift in product mix. Overhead and other product costs increased $427,000, including $287,000 in components costs and $134,000 in freight costs. Service costs increased $2.7 million, or 26%, to $10.9 million in 2006 from $8.2 million in 2005. The increase in 2006 from 2005 includes $732,000 of stock-based compensation related to stock option plans and the ESPP and increases of $1.2 million in other personnel costs due to increased headcount, $146,000 in travel, $138,000 in shipping costs and $196,000 in expensed support materials. In 2005, service costs increased $2.1 million, or 35%, from $6.1 million in 2004. The increase in 2005 from 2004 was due to a $784,000 increase in personnel costs resulting from increased headcount in our support group, a $379,000 increase in service fees paid to our third party maintenance provider, a $273,000 increase in product used to support our maintenance contracts and a $460,000 increase in royalties related to maintenance contracts. We expect service costs to continue at the higher levels reflected in 2006 as a result of the increase in the number of units under maintenance contracts. In connection with the acquisition of Tacit, we recorded $3.5 million of purchased intangible assets related to developed technology that are being amortized over their estimated useful lives of three years. In 2006, amortization expense of $735,000 related to these intangibles was included in cost of revenues. In connection with the acquisition of Mentat in 2004, we recorded $7.2 million of purchased intangible assets that are being amortized over their estimated useful lives of one to six years. In 2006, 2005 and 2004, amortization expense of $1.4 million, $1.6 million and $38,000, respectively, related to these intangibles was included in cost of revenues. To the extent our customer base continues to grow, we intend to continue to invest additional resources in our customer support group and expect that our fees to third-party service providers will continue to increase as our international installed base grows. We expect the cost of revenues in 2007, excluding the impact of stock-based compensation and amortization expenses, to approximate 27% of net revenues. RESEARCH AND DEVELOPMENT Research and development expenses consist primarily of salaries and related personnel expenses, allocated overhead, consultant fees and prototype expenses related to the design, development, testing and enhancement of our products and software. We have historically focused our research and development efforts on developing and enhancing our WAN Application Delivery solutions. A-30 Research and development expenses of $30.6 million in 2006 increased from $21.8 million in 2005 and from $15.0 million in 2004. The increased costs in 2006 from 2005 of $8.9 million, or 41%, were primarily due to increased personnel related expenses of $7.7 million, including amortization of stock-based compensation related to stock option plans and the ESPP of $3.9 million, and $3.8 million related to an increase in headcount from 105 at December 31, 2005 to 146 at December 31, 2006, primarily resulting from the Tacit acquisition. In addition, allocated corporate services and facilities costs increased $764,000 due to increased headcount and consulting fees increased $523,000 from 2005. The increase in 2005 from 2004 of $6.8 million, or 45%, was primarily related to increased salary and related personnel expenses, and to a lesser extent, project material, depreciation and other facilities related expenses. Personnel related expenses increased $5.2 million, including $867,000 in amortization of stock-based compensation related to the Mentat acquisition and $4.3 million related to an increase in headcount, partially resulting from the Mentat acquisition. Depreciation and other facilities related expenses increased $670,000 and were also primarily related to the Mentat acquisition. Research and development expenses represented 21%, 19% and 16% of net revenues in 2006, 2005 and 2004, respectively. As of December 31, 2006, all research and development costs have been expensed as incurred. We expect that in the future, our research and development spending will increase in absolute dollars as we continue to develop and maintain competitive products and enhance our current products by adding innovative features that differentiate our products from those of our competitors. We believe that continued investment in research and development is critical to attaining our strategic product and cost control objectives. We expect that our research and development expenses in 2007, excluding the impact of stock-based compensation expense, will approximate 19% of net revenues. SALES AND MARKETING Sales and marketing expenses consist primarily of salaries, commissions and related personnel expenses for those engaged in the sales, marketing and support of the product, as well as related trade show, promotional and public relations expenses and allocated overhead. Our sales force and marketing efforts are used to develop brand awareness, drive demand for system solutions and support our indirect channels. Sales and marketing expenses increased to $57.9 million in 2006 from $38.3 million in 2005 and from $35.5 million in 2004. The increase of $19.6 million, or 51%, in 2006 from 2005 included personnel related costs and various marketing program related costs. Personnel related costs in 2006 included an increase in stock-based compensation related to stock option plans and the ESPP of $5.2 million and an increase in salaries, commissions, bonuses and employee benefits of $7.6 million due primarily to the increase in headcount and increased sales commissions. This reflects an increase in sales and marketing headcount from 122 at December 31, 2005 to 164 at December 31, 2006, primarily resulting from the Tacit acquisition. Also included in personnel related costs in 2006 were severance costs of $584,000. The increase in 2006 from 2005 also reflected increases in travel and entertainment of $1.8 million, consulting and outside service costs of $1.6 million, demonstration unit costs of $827,000, and channel marketing program costs of $761,000, resulting from increased headcount and sales and marketing activities. Additionally, in 2006, amortization expense of $791,000 related to intangible assets purchased in the Tacit acquisition was included in sales and marketing expense. The increase of $2.8 million, or 8%, in 2005 from 2004 was primarily attributable to an increase in personnel related costs, and to a lesser extent, to increases in various channel marketing programs and demonstration units. Personnel related costs increased $1.9 million, as headcount increased to 122 at December 31, 2005 from 114 at December 31, 2004. The costs related to various channel marketing programs increased $469,000 and the cost of demonstration units increased $286,000 as a result of the introduction of two new PacketShaper products, as well as Mentat’s SkyX products, to our customer base during 2005. Sales and marketing expenses represented 40%, 34% and 38% of net revenues in 2006, 2005 and 2004, respectively We intend to continue to invest in appropriate sales and marketing campaigns and therefore expect sales and marketing expenses in absolute dollars to increase in the future. We expect that sales and marketing expenses in 2007, excluding the impact of stock-based compensation expense, will approximate 33% of net revenues. A-31 GENERAL AND ADMINSTRATIVE General and administrative expenses consist primarily of salaries and related personnel expenses for administrative personnel, professional fees, allocated overhead and other general corporate expenses. General and administrative expenses increased to $13.9 million in 2006 from $7.2 million in 2005 and from $6.1 million in 2004. The increase in 2006 of $6.7 million, or 93%, from 2005 was primarily due to personnel related costs, including an increase in stock-based compensation related to stock option plans and the ESPP of $3.0 million, and an increase in salaries and employee benefits of $1.2 million, due primarily to an increase in headcount from 28 at December 31, 2005 to 35 at December 31, 2006. In addition, professional fees increased $2.0 million, primarily for accounting, legal and tax related matters. In addition, depreciation and other facilities related expenses increased $730,000. The $1.2 million, or 19%, increase in expenses in 2005 from 2004 was primarily attributable to increased personnel related expenses and professional service fees. Personnel related costs, including salaries and recruiting fees increased $687,000 and professional service fees, primarily for accounting and tax related services increased $586,000. General and administrative expenses represented 10%, 6% and 7% of net revenues in 2006, 2005 and 2004, respectively. We expect general and administrative expenses in 2007, excluding the impact of stock-based compensation expense, will approximate 6% of net revenues. IN-PROCESS RESEARCH AND DEVELOPMENT Our methodology for allocating the purchase price relating to acquisitions to IPR&D was determined through established valuation techniques in the high-technology networking product industry. IPR&D expense for 2006 was $1.8 million for acquired IPR&D related to the acquisition of Tacit. IPR&D was expensed upon the closing of the acquisition during the three months ended June 30, 2006 because technological feasibility had not been established and no future alternative uses existed. The fair value of the existing purchased technology, as well as the technology under development, was determined using the income approach, which estimates the present value of future economic benefits such as cash earnings, cost savings, tax deductions, and proceeds from disposition. The present value calculations were developed by discounting expected cash flows to the present value at a rate of return that incorporates the risk-free rate for the use of funds, the expected rate of inflation, and risks associated with the particular investment. The discount rate of 19% selected was generally based on rates of return available from alternative investments of similar type and quality. The IPR&D expense for 2006 related primarily to projects associated with Tacit’s iShared WAN optimization technology (including the hardware appliance and the related software) enhancements and upgrades. The projects identified as in-process technology are those that were underway at the time of the Tacit acquisition and, at the date of acquisition, required additional effort to establish technological feasibility. The successful completion of these projects was a significant risk at the date of acquisition due to the remaining efforts to achieve technical viability, rapidly changing customer markets, uncertain standards for new products, and significant competitive threats. If an identified project is not successfully completed, there is no alternative future use for the project and the expected future income will not be realized. INTEREST AND OTHER INCOME, NET Interest and other income, net, consists primarily of investment income from our cash, cash equivalents and investments. Interest and other income, net increased to $3.9 million in 2006 from $2.9 million in 2005 and from $1.2 million in 2004. The increase in 2006 from 2005 was due to increased investment yields, partially offset by lower average balances of invested funds. The increase in 2005 from 2004 was due to increases in yields and higher balances of invested funds. INCOME TAX PROVISION (BENEFIT) We recorded a tax provision of $782,000 for 2006, reflecting an effective tax rate for the year of 14%. Included in the tax provision for 2006 was a $2.6 million increase in income tax reserves relating to transfer pricing exposure, the impact of $1.8 million of IPR&D related to the Tacit acquisition, and a $1 million tax benefit resulting from the A-32 revision of original estimates of the prior year tax provision upon preparation of the related tax return, partially offset by other adjustments. Absent these items, we would have recorded a tax benefit of approximately $1.4 million, which is primarily related to the utilization of tax credits. For 2005, we recorded a tax provision of $125,000 reflecting the release of $3.2 million of our valuation allowance on deferred tax assets. Without the release, our effective rate would have been approximately 17% instead of the 1% provision that we reported. Our tax provision in 2006 was also impacted by a relative decrease in earnings subject to taxation in countries that have lower statutory tax rates and an increase in non-deductible stock compensation, compared to 2005. For 2004, we realized a tax benefit of $383,000 reflecting the release of a portion of our valuation allowance on our deferred tax assets. Without the release, our effective rate would have been approximately 14% instead of the 3% benefit that we reported. Our future effective income tax rate depends on various factors, such as tax legislation, the geographic composition of our pre-tax income, and non-tax deductible stock compensation expenses. We carefully monitor these factors and timely adjust the effective income tax rate accordingly. RECENT ACCOUNTING PRONOUNCEMENTS In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109”, (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return that results in a tax benefit. Additionally, FIN 48 provides guidance on de-recognition, statement of operations classification of interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years beginning after December 15, 2006. We are evaluating the effect that the adoption of FIN 48 will have on our results of operations and financial condition and are not yet in a position to determine such effects. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurement”, (SFAS 157). This Standard defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We have not determined the effect that the adoption of SFAS 157 will have on our consolidated results of operations, financial condition or cash flows. See Note 1 in our Notes to Consolidated Financial Statements for information regarding other recent accounting pronouncements. LIQUIDITY AND CAPITAL RESOURCES Balance Sheet and Cash Flows Cash and Cash Equivalents and Investments. The following table summarizes our cash and cash equivalents and investments, which are classified as “available for sale” and consist of highly liquid financial instruments (in thousands): December 31, 2006 2005 Increase (Decrease) Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-33 $39,640 36,917 $76,557 $ 36,221 86,456 $122,677 $ 3,419 (49,539) $(46,120) The cash and cash equivalents balance increased $3.4 million and the combined balance decreased by $46.1 million during 2006 due to activities in the following areas (in thousands). Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash used in investing activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net change in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,428 (25,084) 8,075 $ 3,419 The decrease was primarily due to $74.8 million used in the acquisition of Tacit, net of cash and investments acquired, including $7.9 million held in escrow, partially offset by net cash provided by operating activities of $20.4 million and proceeds from the issuance of stock through option exercises and the ESPP totaling $7.1 million. In addition, $3.6 million was used for purchases of property and equipment. In 2006, although we recorded net income of $4.9 million, we generated $20.4 million in cash from operations primarily due to adjustments for noncash items (primarily depreciation, amortization and stock-based compensation). Our uses of cash for net working capital included increases of accounts receivable, partially offset by an increase in deferred revenue. We expect that cash provided by operating activities may fluctuate in future periods as a result of a number of factors, including fluctuations in our operating results, shipment linearity, accounts receivable collections, and excess tax benefits from stock-based compensation. Shipment linearity is a measure of the level of shipments throughout a particular quarter. Accounts receivable, net. The following table summarizes our accounts receivable, net (in thousands). December 31, 2006 2005 Increase (Decrease) Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $31,743 $15,759 $15,984 The increase in net accounts receivable was due to increased sales and a decreased shipment linearity in the three months ended December 31, 2006. Days sales outstanding (DSO) as of December 31, 2006 and 2005 was 68 days and 46 days, respectively. Our DSO is primarily impacted by shipment linearity and collections performance. A steady level of shipments and good collections performance will result in reduced DSO compared with a higher level of shipments toward the end of a quarter, which will result in a shorter amount of time to collect the related accounts receivable and increased DSO. Deferred Revenue. The following table summarizes our deferred revenue, net (in thousands). December 31, 2006 2005 Increase (Decrease) Current deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $23,931 Long-term deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,173 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,104 $18,986 3,129 22,115 $4,945 2,044 6,989 The increase in deferred service revenue reflects the impact of the increase in the number of units under maintenance contract and renewals, partially offset by the ongoing amortization of deferred maintenance revenue. Contractual Obligations We have contractual obligations in the form of operating leases. These are described in further detail in Note 4 of the Notes to the Consolidated Financial Statements. Additionally, we have purchase obligations reflecting open purchase order commitments, including $800,000 of third party licensing contract commitments. A-34 The following chart details our contractual obligations as of December 31, 2006 (in thousands): Payments Due by Period Less Than 1-3 1 Year Years 3-5 Years Contractual Obligations Total Cash obligations not reflected in Consolidated Balance Sheet Operating lease obligations(1) . . . . . . . . . . . . . . . . . . . Purchase obligations . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,095 12,469 $18,564 $ 2,871 11,669 $14,540 $2,228 400 $2,628 $ 996 400 $1,396 (1) In January 2007, we entered into an amendment to extend the term of the lease of our Cupertino, California facilities through December 2014 and to expand the premises subject to the lease. The lease payments under the amended lease, which will begin in December 2007, will be approximately $2.6 million per year, with a total commitment of $19 million over the extended lease term. This amount is not reflected in the above chart. Liquidity and Capital Resource Requirements During the past three years, we have had sufficient financial resources to meet our operating requirements, to fund our capital spending and to repay our bank line of credit. We expect to experience growth in our working capital needs for at least the next twelve months in order to execute our business plan. We anticipate that operating activities, as well as planned capital expenditures, will constitute a partial use of our cash resources. In addition, we may utilize cash resources to fund additional acquisitions or investments in complementary businesses, technologies or products. We believe that our current cash, cash equivalents and investments of $76.6 million at December 31, 2006 will be sufficient to meet our anticipated cash requirements for working capital and capital expenditures for at least the next twelve months. However, we may need to raise additional funds if our estimates of revenues, working capital or capital expenditure requirements change or prove inaccurate or in order for us to respond to unforeseen technological or marketing hurdles or to take advantage of unanticipated opportunities. These funds may not be available at the time or times needed, or available on terms acceptable to us. If adequate funds are not available, or are not available on acceptable terms, we may not be able to take advantage of market opportunities to develop new products or to otherwise respond to competitive pressures. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Fixed Income Investments Our exposure to market risks for changes in interest rates and principal relates primarily to investments in debt securities issued by U.S. government agencies and corporate debt securities. We place our investments with high credit quality issuers and, by policy, limit the amount of the credit exposure to any one issuer. Our investment securities are classified as available-for-sale and consequently are recorded on the balance sheet at fair value with unrealized gains and losses reported as a separate component of accumulated other comprehensive income. We do not use derivative financial instruments. In general our policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All highly liquid investments with less than three months to maturity from date of purchase are considered to be cash equivalents; investments with maturities between three and twelve months are considered to be short-term investments; and investments with maturities in excess of twelve months from the balance sheet date are considered to be long-term investments. At December 31, 2006, our investment portfolio included fixed-income securities with a fair value of approximately $67.1 million, having an average duration of 0.30 years. These securities are subject to interest rate risk and will decline in value if interest rates increase. Based on our investment portfolio at December 31, 2006, an immediate 10% increase in interest rates would result in a decrease in the fair value of the portfolio of approximately $124,000. While an increase in interest rates reduces the fair value of the investment portfolio, A-35 we will not realize the losses in the consolidated statements of operations unless the individual fixed-income securities are sold prior to recovery or the loss is determined to be other-than-temporarily impaired. Foreign Exchange We develop products in the United States and sell in North America, Asia, Europe and the rest of the world. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in worldwide markets. All sales are currently made in U.S. dollars; and as a result, a strengthening of the dollar could make our products less competitive in foreign markets. All operating costs outside the United States are incurred in local currencies, and are remeasured from the local currency to U.S. dollars upon consolidation. As exchange rates vary, these operating costs, when remeasured, may differ from our prior performance and our expectations. We have no foreign exchange contracts, option contracts or other foreign currency hedging arrangements. A-36 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements, and the related notes thereto, of Packeteer and the Reports of Independent Registered Public Accounting Firm are filed as a part of this Form 10-K. Page Number Reports of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consolidated Balance Sheets as of December 31, 2006 and 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consolidated Statement of Operations for the years ended December 31, 2006, 2005 and 2004. . . . . . Consolidated Statements of Stockholders’ Equity and Comprehensive Income for the years ended December 31, 2006, 2005 and 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004 . . . . Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-38 A-41 A-42 A-43 A-44 A-45 A-37 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders Packeteer, Inc.: We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting appearing under Item 9A(b), that Packeteer, Inc. did not maintain effective internal control over financial reporting as of December 31, 2006, because of the effect of material weaknesses identified in management’s assessment, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Management of Packeteer, Inc. is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. A material weakness is a control deficiency, or a combination of control deficiencies, that results in a more than remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment as of December 31, 2006: (i) the Company did not maintain effective controls to provide for the reconciliation of the income taxes payable account to supporting detail and the review of the income taxes payable account reconciliation by someone other than the preparer; and (ii) the Company did not maintain effective controls over the review of the rebate reserves as the review was not appropriately designed, nor was the review conducted in sufficient detail. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Packeteer, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2006. The aforementioned material weaknesses were considered in determining the nature, timing and extent of audit tests applied in our audit of the 2006 consolidated financial statements, and this report does not affect our report dated March 15, 2007, which expressed an unqualified opinion on those consolidated financial statements. A-38 In our opinion, management’s assessment that Packeteer, Inc. did not maintain effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, Packeteer, Inc. has not maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). /s/ Mountain View, California March 15, 2007 KPMG LLP A-39 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders Packeteer, Inc.: We have audited the accompanying consolidated balance sheets of Packeteer, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Packeteer, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. As discussed in Note 1 to the consolidated financial statements, effective January 1, 2006, Packeteer, Inc. adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 123R, Share-Based Payment. Also, as discussed in Note 1 to the consolidated financial statements, Packeteer, Inc. changed its method of quantifying financial statement errors in 2006. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Packeteer, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 15, 2007 expressed an unqualified opinion on management’s assessment of, and an adverse opinion on the effective operation of, internal control over financial reporting. /s/ Mountain View, California March 15, 2007 KPMG LLP A-40 PACKETEER, INC. CONSOLIDATED BALANCE SHEETS December 31, 2006 2005 (In thousands, except per share amounts) ASSETS Current assets: Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 39,640 Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,681 Accounts receivable, net of allowance for doubtful accounts and sales returns of $3,010 and $1,800, as of December 31, 2006 and 2005, respectively . . . . . . . . . . 31,743 Other receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216 Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,957 Prepaids and other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,249 Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104,486 Non-current assets: Property and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,968 Long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,236 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58,656 Purchased intangible assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,045 Other non-current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,577 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $216,968 LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,014 Accrued compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,567 Other accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,431 Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,164 Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,931 Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-current liabilities: Deferred revenue, less current portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred rent and other. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commitments and contingencies (Notes 4 and 5) Stockholders’ equity: Preferred stock, $0.001 par value; 5,000 shares authorized; no shares issued and outstanding as of December 31, 2006 and December 31, 2005 . . . . . . . . . . . . . . . Common stock, $0.001 par value; 85,000 shares authorized; 35,400 and 34,197 shares issued and outstanding as of December 31, 2006 and December 31, 2005, respectively . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred stock-based compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,107 5,173 179 57,459 $ 36,221 81,228 15,759 207 4,979 2,148 140,542 2,681 5,228 9,527 5,606 5,073 $168,657 $ 2,808 6,551 4,716 3,520 18,986 36,581 3,129 340 40,050 — 36 212,961 — (18) (53,470) — 34 188,046 (567) (182) (58,724) 128,607 $168,657 Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,509 Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $216,968 See accompanying notes to consolidated financial statements. A-41 PACKETEER, INC. CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, 2006 2005 2004 (In thousands, except per share amounts) Net revenues: Product revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $110,164 Service revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,959 Total net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of revenues(1): Product costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of purchased intangible assets. . . . . . . . . . . . . . . ......... ......... ......... ......... 145,123 26,028 10,907 2,150 39,085 106,038 30,646 57,889 13,949 1,800 104,284 1,754 3,932 5,686 782 4,904 0.14 0.14 34,848 35,740 414 732 4,371 5,241 3,037 $ 85,590 27,351 112,941 19,575 8,163 1,557 29,295 83,646 21,778 38,276 7,222 — 67,276 16,370 2,913 19,283 125 $ 19,158 $ $ 0.57 0.55 33,823 35,065 $ — — 867 25 9 $74,557 17,880 92,437 16,780 6,057 38 22,875 69,562 14,973 35,504 6,061 — 56,538 13,024 1,127 14,151 (383) $14,534 $ $ 0.44 0.42 32,994 34,502 $ — — 13 1 — Total cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating expenses(1): Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales and marketing, includes amortization of purchased intangible assets of $791 in 2006, and none in 2005 and 2004 . . . . . . . . . . . . . . General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . In-process research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest and other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before provision (benefit) for income taxes . . . . . . . . . . . . . . . . . . Provision (benefit) for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Basic net income per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Diluted net income per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Shares used in computing basic net income per share . . . . . . . . . . . . . . . . Shares used in computing diluted net income per share . . . . . . . . . . . . . . . (1) Stock-based compensation included in the costs and expenses line items: Product costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Service costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales and marketing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . See accompanying notes to consolidated financial statements. A-42 PACKETEER, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME Common Stock Shares Amount Accumulated Notes Additional Deferred Other Receivable Paid-in Stock-Based Comprehensive from Accumulated Capital Compensation Income (Loss) Stockholders Deficit (In thousands) Total Comprehensive Income Balances as of December 31, 2003 . . Issuance of restricted common stock, net of repurchases. . . . . . . . . . . Issuance of common stock upon exercise of stock options . . . . . . . Issuance of common stock pursuant to Employee Stock Purchase Plan . . . Repayments of notes receivable from stockholders . . . . . . . . . . . . . . Amortization of stock-based compensation . . . . . . . . . . . . . Comprehensive income: Unrealized loss on investments . . . Net income . . . . . . . . . . . . . . . . . . . . . . 32,501 110 510 297 — — — — 33,418 490 299 (10) — — — — 34,197 $32 — 1 — — — — — 33 1 — — — — — — 34 $175,820 1,624 2,925 1,256 — — — — 181,625 3,033 2,346 (149) 1,191 — — — 188,046 $ — $ (12) — — — — — (195) — (207) — — — — — 25 — (182) $ (6) — — — 6 — — — — — — — — — — — — $(92,416) — — — — — — 14,534 (77,882) — — — — — — 19,158 (58,724) $ 83,418 — 2,926 1,256 6 14 (195) 14,534 101,959 3,034 2,346 (7) 1,191 901 25 19,158 128,607 $ 25 19,158 $ (195) 14,534 $14,339 (1,624) — — — 14 — — (1,610) — — 142 — 901 — — (567) Comprehensive income . . . . . . . . . . Balances as of December 31, 2004 . . . Issuance of common stock upon exercise of stock options . . . . . . . . Issuance of common stock pursuant to Employee Stock Purchase Plan . . . . Repurchase of restricted common stock . . . . . . . . . . . . . . . . . . . Tax benefit from employee stock option plans . . . . . . . . . . . . . . . . . . . Amortization of stock-based compensation . . . . . . . . . . . . . . Comprehensive income: Unrealized gain on investments . . . . Net income . . . . . . . . . . . . . . . Comprehensive income . . . . . . . . . . Balances as of December 31, 2005 . . . Cumulative effect of adjustments from the adoption of SAB No. 108, net of taxes . . . . . . . . . . . . . . . . . . . Adjusted balances as of January 1, 2006 . . . . . . . . . . . . . . . . . . . Reclassification of deferred stock based compensation upon adoption of SFAS 123(R) . . . . . . . . . . . . . . Issuance of common stock upon exercise of stock options . . . . . . . . Issuance of common stock pursuant to Employee Stock Purchase Plan . . . . Stock options assumed in acquisition . . Tax benefit from employee stock option plans . . . . . . . . . . . . . . . . . . . Stock-based compensation related to acquisition . . . . . . . . . . . . . . . . Stock-based compensation related to stock options and Employee Stock Purchase Plan . . . . . . . . . . . . . . Comprehensive income: Unrealized gain on investments . . . . Net income . . . . . . . . . . . . . . . Comprehensive income . . . . . . . . . . Balances as of December 31, 2006 . . . 35,400 $36 $212,961 $ — $ (18) $— $(53,470) $159,509 $19,183 — 34,197 — 34 — 188,046 — (567) — (182) — — 350 (58,374) 350 128.957 — 888 315 — — — — 2 — — — — (567) 4,581 2,511 2,482 2,113 484 567 — — — — — — — — — — — — — — — — — — — — — — 4,583 2,511 2,482 2,113 484 — — — — — 13,311 — — — — — 164 — — — — — — 4,904 13,311 164 4,904 $ 164 4,904 $ 5,068 See accompanying notes to consolidated financial statements A-43 PACKETEER, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31, 2006 2005 2004 (In thousands) Cash flows from operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash provided by operating activities: Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization of purchased intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . Provision for (reversal of) allowance for doubtful accounts . . . . . . . . . . . . . . Write-down of inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock-based compensation related to Mentat acquisition . . . . . . . . . . . . . . . . Stock-based compensation related to stock options and ESPP. . . . . . . . . . . . . Excess tax benefit from stock-based compensation plans . . . . . . . . . . . . . . . . Tax benefits from employee stock option plans . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss on disposal of property and equipment . . . . . . . . . . . . . . . . . . . . . . . . In-process research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changes in operating assets and liabilities, net of acquired assets and assumed liabilities: Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaids and other current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . Cash flows from investing activities: Purchases of property and equipment, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sales and maturities of investments . . . . . . . . . . . . . . . . . . . . . . . . Acquisitions, net of cash acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Funds deposited into escrow in connection with acquisition . . . . . . . . . . . . . . . . . Net cash used in investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from financing activities: Proceeds from issuance of common stock, net of repurchases . . . . . . . . . . . . . . Sale of stock to employees under the ESPP . . . . . . . . . . . . . . . . . . . . . . . . . . . Excess tax benefit from stock-based compensation plans . . . . . . . . . . . . . . . . . Proceeds from repayment of notes receivable from stockholders . . . . . . . . . . . . Payments of notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Principal payments of capital lease obligations . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by financing activities . . . . . . . . . . . . . . . . . . . . . . . Net increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non-cash investing and financing activities: Issuance of restricted common stock, net of repurchases, to former Mentat employees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Options assumed in acquisition of Tacit . . . . . . . . . . . . . . . . . . . . . . . . . Supplemental disclosures of cash flow information: Cash paid during period for income taxes, net of refunds . . . . . . . . . . . . . Cash paid during period for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,904 2,630 2,941 292 568 484 13,311 (981) 2,829 (5,794) 9 1,800 (14,324) (9) 680 (522) 206 2,397 (247) 2,846 6,476 (68) 20,428 (3,626) (66,834) 120,156 (66,930) (7,850) (25,084) 4,583 2,511 981 — — — 8,075 3,419 36,221 $ 39,640 $ 19,158 2,414 1,557 (45) 89 901 — — 1,191 (2,967) 20 — 1,114 1,680 (1,962) (186) 6 84 (1,163) 1,082 5,958 (50) 28,881 (2,049) (109,851) 104,945 (1,750) — (8,705) 3,027 2,346 — — — — 5,373 25,549 10,672 $ 36,221 $ 14,534 1,728 38 89 86 14 — — — (2,375) 9 — (5,440) 475 (278) (12) 573 2,217 1,896 1,379 6,428 (33) 21,328 (1,931) (93,487) 72,810 (17,304) — (39,912) 2,926 1,256 — 6 (139) (457) 3,592 (14,992) 25,664 $ 10,672 ...... ...... ...... ...... $ — $ 2,482 $ $ 348 — $ $ $ $ — — 811 — $ 1,624 $ — $ $ 475 27 See accompanying notes to consolidated financial statements. A-44 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES DESCRIPTION OF BUSINESS Packeteer, Inc., along with its subsidiaries (collectively referred to herein as the “Company,” “Packeteer,” “we” and “us”) is a provider of wide area network, or WAN, Application Delivery systems designed to deliver a comprehensive set of visibility, Quality of Service, or QoS, control, compression, application acceleration and application service capabilities. Our product family includes PacketShaper, iShared, SkyX and Mobiliti Client products that can be deployed within large data centers, smaller branch office sites and software clients on PCs for mobile and Small Office/Home Office, or SOHO, users throughout a distributed enterprise. We deliver superior application performance and end user experience using an “intelligent overlay”, which bridges applications and IP networks, adapts to our customers’ existing infrastructure and addresses the demands created by a changing application environment in order to deliver high performance applications across all WAN and Internet links. The Company was incorporated on January 25, 1996, and commenced principal operations in 1997, at which time the Company began selling its products and related services. The Company currently markets and distributes its products via a worldwide network of resellers, distributors and systems integrators. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PREPARATION The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. USE OF ESTIMATES The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to allowance for doubtful accounts and sales returns, inventory valuation, rebate and warranty reserves, valuation of long-lived assets, including intangible assets and goodwill, income taxes and stock-based compensation, among others. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. REVENUE RECOGNITION Product revenues consist primarily of sales of the Company’s WAN Application Delivery systems, which include hardware, as well as software licenses, to distributors and resellers. Service revenues consist primarily of maintenance revenue and, to a lesser extent, training revenue. The Company applies the provisions of Statement of Position, or SOP, 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions,” to all transactions involving the sale of hardware and software products. Revenue is generally recognized when all of the following criteria are met, as set forth in paragraph 8 of SOP 97-2: • persuasive evidence of an arrangement exists, • delivery has occurred, • the fee is fixed or determinable, and • collectibility is probable. A-45 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Receipt of a customer purchase order is persuasive evidence of an arrangement. Sales through the Company’s distribution channel are evidenced by an agreement governing the relationship together with purchase orders on a transaction-by-transaction basis. Delivery generally occurs when product is delivered to a common carrier from Packeteer or its designated fulfillment house. For certain destinations outside the Americas, delivery occurs when product is delivered to the destination country. For maintenance contracts, delivery is deemed to occur ratably over the contract period. Fees are typically considered to be fixed or determinable at the inception of an arrangement and are negotiated at the outset of an arrangement, generally based on specific products and quantities to be delivered. In the event payment terms are provided that differ significantly from the Company’s standard business practices, which are generally ninety days or less, the fees are deemed to not be fixed or determinable and revenue is recognized as the fees become due and payable. The Company assesses collectibility based on a number of factors, including credit worthiness of the customer and past transaction history of the customer. Generally, product revenue is recognized upon delivery. However, product revenue on sales to major new distributors are recorded based on sell-through to the end user customers until such time as the Company has established significant experience with the distributor’s product exchange activity. Additionally, when the Company introduces new product into its distribution channel for which there is no historical customer demand or acceptance history, revenue is recognized on the basis of sell-through to end user customers until such time as demand or acceptance history has been established. The Company defers recognition of revenue on inventory in the distribution channel in excess of a certain number of days. On the same basis, the Company reduces the associated cost of revenues, which is primarily related to materials, and includes this amount in inventory. The Company recognizes these revenues and associated cost of revenues when the inventory levels no longer exceed expected supply. No amounts were deferred under this policy at December 31, 2006 or 2005. The Company has analyzed all of the elements included in its multiple element arrangements and has determined that it has sufficient vendor specific objective evidence, or VSOE, of fair value to allocate revenue to the maintenance component of its product and to training. VSOE is based upon separate sales of maintenance renewals and training to customers. Accordingly, assuming other revenue recognition criteria are met, revenue from product sales is recognized upon delivery using the residual method in accordance with SOP 98-9. Revenue from maintenance is recognized ratably over the maintenance term and revenue from training is recognized when the training has taken place. To date, training revenues have not been material. SALES RETURN RESERVES Management makes estimates of potential future product returns related to current period product revenue in accordance with Statement of Financial Accounting Standards (SFAS) 48, “Revenue Recognition When Right of Return Exists”. These sales return reserves are recorded as a reduction to revenue. The Company’s estimate for sales returns is based on its historical return rates and is recorded against accounts receivable. The following provides additional details on the sales return reserves (in thousands): Years Ended December 31, 2006 2005 2004 Balance at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additions, charged against revenues . . . . . . . . . . . . . . . . . . . . . . . Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-46 $ 1,625 5,604 (4,766) $ 2,463 $ 1,251 3,400 (3,026) $ 1,625 $ 713 2,247 (1,709) $ 1,251 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) ALLOWANCE FOR DOUBTFUL ACCOUNTS The allowance for doubtful accounts reduces trade receivables to the amount that is ultimately believed to be collectible. When evaluating the adequacy of the allowance for doubtful accounts, management reviews the aged receivables on an account-by-account basis, taking into consideration such factors as the age of the receivables, customer history and estimated continued credit-worthiness, as well as general economic and industry trends. The following provides additional details on the allowance for doubtful accounts (in thousands): Years Ended December 31, 2006 2005 2004 Balance at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 175 Provision for (reversal of) allowance for doubtful accounts receivable . . . 292 Addition to reserve related to acquisition of Tacit . . . . . . . . . . . . . . . . . . 277 Amounts written off, net of recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . (197) Balance at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 547 COST OF REVENUES $229 (45) — (9) $175 $149 89 — (9) $229 Our cost of revenues consists of the cost of finished products purchased from our contract manufacturers, overhead costs, service support costs and amortization of purchased intangible assets. The Company provides currently for the estimated costs that may be incurred under product warranties when products are shipped. CASH AND CASH EQUIVALENTS The Company considers all highly liquid investments with an original maturity of three months or less from date of purchase to be cash equivalents. Cash and cash equivalents consist primarily of cash on deposit with banks, money market instruments and investments in commercial paper that are stated at cost, which approximates fair market value. INVESTMENTS Management determines the appropriate classification of investment securities at the time of purchase and reevaluates such designation as of each balance sheet date. As of December 31, 2006 and 2005, all investment securities are designated as “available-for-sale.” These available-for-sale securities are carried at fair value based on quoted market prices, with the unrealized gains (losses) reported as a separate component of stockholders’ equity. The Company periodically reviews the realizable value of its investments in marketable securities. When assessing marketable securities for other-than temporary declines in value, we consider such factors as the length of time and extent to which fair value has been less than the cost basis, the market outlook in general and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. If an other-than-temporary impairment of the investments is deemed to exist, the carrying value of the investment would be written down to its estimated fair value. INVENTORIES Inventories consist primarily of finished goods and are stated at the lower of cost (on a first-in, first-out basis) or market. We record inventory write-downs for excess and obsolete inventories based on historical usage and forecasted demand. If future demand or market conditions are less favorable than our projections, additional inventory write-downs may be required and would be reflected in cost of revenues in the period the revision is made. The Company recorded write-downs of inventory of $568,000, $89,000 and $86,000 in 2006, 2005 and 2004, respectively. A-47 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Inventories consisted of the following at December 31 (in thousands): 2006 2005 Completed products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,785 Components . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172 Total inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,957 LONG-LIVED ASSETS $4,584 395 $4,979 Property and equipment, including equipment acquired under capital lease, is recorded at cost. Depreciation and amortization are provided using the straight-line method over the estimated useful lives of the assets, generally 18 months to four years. Leasehold improvements are amortized over the shorter of estimated useful lives of the assets or the lease term, generally five years. During 2004, the remaining leases were fully paid and the equipment under capital lease was transferred to computers and equipment. Property and equipment consisted of the following at December 31 (in thousands): 2006 2005 Computers and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Furniture and fixtures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: accumulated depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . Property and equipment, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,785 2,142 2,317 14,244 (10,276) $ 3,968 $ 7,323 1,439 1,582 10,344 (7,663) $ 2,681 Goodwill represents the excess purchase price over the estimated fair value of net assets acquired as of the acquisition date. Goodwill of $49.1 million and $9.5 million was recorded in connection with the acquisition of Tacit and Mentat, respectively. Other intangibles include purchased intangibles recorded in connection with the acquisition of Tacit and Mentat and are amortized using the straight-line method over the estimated useful lives of the assets. The following table provides additional details on goodwill and acquired intangible assets, net (in thousands): December 31, 2005 Balance Acquisition Amortization December 31, 2006 Balance Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . Other intangibles: Developed technology . . . . . . . . . . . . . . . Customer contracts and relationships . . . . Trade name . . . . . . . . . . . . . . . . . . . . . . $ 9,527 4,053 1,421 132 $15,133 $49,129 3,530 4,200 650 $57,509 $ — $58,656 5,828 4,637 580 $69,701 (1,755) (984) (202) $(2,941) A-48 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) The following tables set forth the carrying amount of other intangible assets that will continue to be amortized (in thousands): December 31, 2006 Gross Carrying Accumulated Amount Amortization Amortization Life Net Carrying Amount Intangibles: Developed technology . . . . . . . . . . . . . . . . Customer contracts and relationships . . . . . Trade name . . . . . . . . . . . . . . . . . . . . . . . . 3-5 yrs 3-6 yrs 3 yrs $ 8,630 6,100 850 $15,580 $(2,802) (1,463) (270) $(4,535) $ 5,828 4,637 580 $11,045 Amortization Life December 31, 2005 Gross Carrying Accumulated Amount Amortization Net Carrying Amount Intangibles: Developed technology. . . . . . . . . . . . . . . . . Customer contracts and relationships . . . . . . Trade name . . . . . . . . . . . . . . . . . . . . . . . . 5 yrs 6 yrs 3 yrs $5,100 1,900 200 $7,200 $(1,047) (479) (68) (1,594) $4,053 1,421 132 $5,606 Included in cost of revenues was amortization expense of $2.2 million, $1.6 million and $38,000 for 2006, 2005 and 2004, respectively. Included in sales and marketing expense was amortization expense of $791,000 in 2006 and none in 2005 and 2004. Based on the purchased intangible assets balance as of December 31, 2006, the estimated related future amortization is as follows (in thousands): Year Amount 2007 2008 2009 2010 ................................. ................................. ................................. ................................. ............................... ............................... ............................... ............................... $ 3,803 3,738 2,841 663 $11,045 Goodwill is tested for impairment annually on December 1 in a two-step process. First, the Company determines if the carrying amount of its Reporting Unit exceeds the “fair value” of the Reporting Unit, which would indicate that goodwill may be impaired. If the Company determines that goodwill may be impaired, the Company compares the “implied fair value” of the goodwill, as defined by SFAS 142, to its carrying amount to determine if there is an impairment loss. The Company does not have any goodwill that it considers to be impaired. In accordance with SFAS 144, “Accounting for Impairment or Disposal of Long-lived Assets”, the Company evaluates long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Recoverability of these assets is measured by comparison of the carrying amount of the asset to the future undiscounted cash flows the asset is expected to generate. If the asset is considered to be impaired, the amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. A-49 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Other Assets consisted of the following at December 31 (in thousands): 2006 2005 Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amounts held in escrow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,210 7,850 517 $27,577 $4,622 — 451 $5,073 ADVERTISING COSTS Advertising costs are expensed as incurred and the amounts were insignificant for all periods presented and are classified under sales and marketing expense. Advertising expenses for 2006, 2005 and 2004 were $470,000, $206,000, and $277,000, respectively. OTHER ACCRUED LIABILITIES Other accrued liabilities consisted of the following at December 31, (in thousands): 2006 2005 Rebate reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,311 Warranty reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,632 $8,431 REBATE RESERVES $1,634 234 2,848 $4,716 Certain distributors and resellers can earn rebates under several Packeteer programs. The rebates earned are recorded in accordance with Emerging Issues Task Force (EITF) 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendors Products)”. For established programs, the Company’s estimates for rebates are based on historical usage rates. For new programs, rebate reserves are calculated to cover the Company’s maximum exposure until such time as historical usage rates are developed. When sufficient historical experience is established, there may be a reversal of previously accrued rebates if actual rebate claims are less than the maximum exposure. Additionally, there may be a reversal of previously accrued rebate reserves if rebates are not claimed before the expiration dates established for each program. WARRANTY RESERVES Upon shipment of products to its customers, the Company provides for the estimated cost to repair or replace products that may be returned under warranty. The Company’s warranty period is typically 12 months from the date of shipment to the end user customer. For existing products, the reserve is estimated based on actual historical experience. For new products, the required reserve is based on historical experience of similar products until such time as sufficient historical data has been collected on the new product and is included in other accrued liabilities. A-50 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) The following provides a reconciliation of changes in Packeteer’s warranty reserve (in thousands): For the Years Ended December 31, 2006 2005 2004 Balance at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for current year sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Warranty costs incurred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . RESEARCH AND DEVELOPMENT COSTS $ 234 586 (332) $ 488 $ 315 242 (323) $ 234 $ 303 422 (410) $ 315 Development costs incurred in the research and development of new products, other than software, and enhancements to existing products are expensed as incurred. Costs for the development of new software products and enhancements to existing products are expensed as incurred until technological feasibility has been established, at which time any additional development costs would be capitalized in accordance with SFAS 86, “Accounting for Costs of Computer Software To Be Sold, Leased, or Otherwise Marketed.” To date, the Company’s software has been available for general release shortly after the establishment of technological feasibility, which the Company defines as a working prototype and, accordingly, capitalizable costs have not been material. STOCK-BASED COMPENSATION The Company has adopted a stock incentive plan that provides for the grant to eligible individuals of stock options, stock appreciation rights, restricted stock purchase rights and bonuses, restricted stock units, performance shares and performance units. The Company also has an Employee Stock Purchase Plan, or ESPP, which enables employees to purchase the Company’s common stock. On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options and employee stock purchases related to the ESPP based on estimated fair values. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R). Using the modified prospective transition method of adopting SFAS 123(R), the Company began recognizing compensation expense for stock-based awards granted or modified after December 31, 2005 and awards that were granted prior to the adoption of SFAS 123(R) but were still unvested at December 31, 2005. Under this method of implementation, no restatement of prior periods has been made. Stock-based compensation expense recognized under SFAS 123(R) in the consolidated statements of operations for 2006 related to stock options and ESPP was $12.1 million and $1.2 million, respectively. The estimated fair value of the Company’s stock-based awards, less expected forfeitures, is amortized over the awards’ vesting period using the graded vesting method. In addition, the stock-based compensation expense for 2006 included $484,000 related to restricted stock issued in connection with the Mentat acquisition that would have been included in the Company’s consolidated statements of operations under the provisions of APB 25. For 2005 and 2004, stockbased compensation expense of $901,000 and $14,000, respectively, was related to the Mentat acquisition. There was no stock-based compensation expense related to stock options and ESPP recognized during 2005 and 2004. As a result of adopting SFAS 123(R), the Company’s income before provision (benefit) for income taxes and net income for 2006 were reduced by $13.3 million and $9.2 million, respectively. The implementation of SFAS 123(R) reduced basic and fully diluted earnings per share by $0.26 for 2006. See Note 7 for additional information. A-51 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s statements of operations. Prior to January 1, 2006, the Company measured compensation expense for its employee stock-based compensation plans using the intrinsic value method under APB 25 and related interpretations. In accordance with APB 25, no stock-based compensation expense was recognized in the Company’s statements of operations for stock options granted to employees and directors that had an exercise price equal to the deemed fair value of the underlying common stock on the date of grant. Stock-based compensation expense recognized in the Company’s statements of operations in 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the pro forma provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), as amended, and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). As stock-based compensation expense recognized in the consolidated statements of operations in 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In the Company’s pro forma information required under SFAS 123 for the periods prior to 2006, the Company accounted for forfeitures as they occurred. Prior to the adoption of SFAS 123R, the Company presented all tax benefits for deductions resulting from the exercise of stock options and disqualifying dispositions as operating cash flows on its consolidated statement of cash flows. SFAS 123R requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow. This requirement reduced net operating cash flows and increased net financing cash flows in 2006. Total cash flow remained unchanged from what would have been reported under prior accounting rules. On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 123(R)-3 “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” This FSP provides a practical transition election related to the accounting for the tax effects of share-based payments awards to employees, as an alternative to the transition guidance for the additional paid-in capital pool, or APIC pool, in paragraph 81 of SFAS 123(R). The Company has elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of equity-based compensation pursuant to SFAS 123(R).The alternative transition method includes simplified methods to establish the beginning balance of the APIC pool related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R). Stock Options The exercise price of each stock option equals the market price of the Company’s stock on the date of grant. Most options are scheduled to vest over four years and expire no later than ten years from the grant date. The fair A-52 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model, assuming no expected dividends and the following weighted-average assumptions: Year Ended December 31, 2006 Stock Option Grants: Expected life (years) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk-free interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.62 62% 4.88% The computation of the expected volatility assumption used in the Black-Scholes calculations for new grants is based on a combination of historical and implied volatilities. When establishing the expected life assumption, the Company reviews historical employee exercise behavior of option grants with similar vesting periods. The weighted average grant date fair value of options granted during 2006 was $5.83. The weighted average fair value of options assumed in 2006 in connection with the acquisition of Tacit was $12.46. The total intrinsic value of options exercised during 2006 was $5.6 million. The total fair value of options that vested during 2006 was $10.4 million. At December 31, 2006, the Company had $10.1 million of total unrecognized compensation expense, net of estimated forfeitures, related to stock option plans that will be recognized over the weighted average period of 2.73 years. Cash received from stock option exercises was $4.6 million during 2006. Employee Stock Purchase Plan. The ESPP permits participants to purchase common stock through payroll deductions of up to 15% of an employee’s compensation, including commissions, overtime, bonuses and other incentive compensation. The purchase price per share is equal to 85% of the fair market value per share on the participant’s entry date into the offering period or, if lower, 85% of the fair market value per share on the semi-annual purchase date. The number of shares issued under the ESPP during 2006 was 315,000. Compensation expense is calculated using the fair value of the employees’ purchase rights granted under the Black-Scholes model, assuming no expected dividends and the following weighted average assumptions: Year Ended December 31, 2006 ESPP Rights: Expected life (years) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk-free interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.19 61% 5.07% Based on the Black-Scholes option pricing model, the weighted average estimated fair value of purchase rights under the ESPP was $3.75 for 2006. Restricted Stock Issued in Acquisition In connection with the acquisition of Mentat, Inc., or Mentat, in December 2004, the Company recorded deferred stock-based compensation of approximately $1.6 million associated with the issuance of restricted shares. Beginning in 2006, stock-based compensation expense related to purchase acquisitions is calculated under SFAS 123(R) and recognized over the remaining vesting periods. During 2006, the Company recorded stockbased compensation expense of $484,000 related to the acquisition and credited additional paid-in capital. Prior to 2006, a portion of the purchase consideration for purchase acquisitions was recorded as deferred stock-based compensation. The balance for deferred stock-based compensation was reflected as a reduction to additional paid-in capital in the consolidated statements of shareholders’ equity. Amortization of stock-based compensation A-53 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) associated with these shares totaled $901,000 and $14,000, respectively, for 2005 and 2004. As of December 31, 2006, the Company has $89,000 of unrecognized compensation expense related to these restricted shares, which will be recognized over the remaining vesting period of 12 months. Pro Forma Information under SFAS 123 for Periods Prior to 2006 Prior to January 1, 2006, the Company followed the disclosure-only provisions under SFAS 123, as amended. The following table illustrates the effect on net income and earnings per share for 2005 and 2004 if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data): Years Ended December 31, 2005 2004 Net income as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Add: Stock-based compensation under APB 25 related to acquisitions, net of tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deduct: Stock-based employee compensation expense determined under fair value-based method for all awards, net of tax . . . . . . . . . . . . . . . . . . . . . . . Pro forma net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per share: Basic — as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted — as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic — pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted — proforma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19,158 599 (10,021) $ 9,736 $ $ $ $ 0.57 0.55 0.29 0.28 $14,534 9 (8,595) $ 5,948 $ $ $ $ 0.44 0.42 0.18 0.17 Compensation expense for pro forma purposes is reflected over the vesting period, in accordance with the method described in FASB Interpretation (FIN) 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.” For pro forma purposes, the fair value of the Company’s stock option grants and ESPP awards was estimated using the Black-Scholes option-pricing model, assuming no expected dividends and the following weightedaverage assumptions for the years ended December 31: 2005 2004 Employee Stock Option Plan: Expected life (years) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk-free interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.34 3.28 90% 102% 4.03% 2.64% 2005 2004 Employee Stock Purchase Plan: Expected life (years) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk-free interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.25 1.26 63% 91% 3.90% 3.62% Prior to January 1, 2006, the expected life and expected volatility of the stock options were based upon historical data and implied volatility factors. Forfeitures of employee stock options were accounted for on an asincurred basis. A-54 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Based on the Black-Scholes option pricing model, the weighted average estimated fair value of employee stock option grants was $7.86 and $10.34, respectively, for the years ended December 31, 2005 and 2004, respectively. The total intrinsic value of options exercised during the years ended December 31, 2005 and 2004 was $3.8 million and $4.1 million, respectively. The weighted-average fair value of the purchase rights granted under the ESPP during 2005 and 2004 was $5.30 and $4.84, respectively. CONCENTRATIONS OF RISK Financial instruments, which potentially subject the Company to concentrations of credit risk, consist primarily of cash, cash equivalents, investments and accounts receivable. The Company’s cash, cash equivalents and investments are maintained with highly accredited financial institutions and investments are placed with high quality issuers. The Company believes no significant concentration of credit risk exists with respect to these financial instruments. Credit risk with respect to trade receivables is limited as the Company performs ongoing credit evaluations of its customers. Based on management’s evaluation of potential credit losses, the Company believes its allowances for doubtful accounts are adequate. A limited number of indirect channel partners have accounted for a large part of our revenues to date and we expect that this trend will continue. The following table provides details of sales to individual customers who accounted for 10% or more of total revenues: Years Ended December 31, 2006 2005 2004 Alternative Technology, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Westcon, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23% 18% 22% 13% 22% 19% At December 31, 2006, Alternative Technologies, Inc. and Westcon, Inc. accounted for 18% and 23% of accounts receivable, respectively. At December 31, 2005, Alternative Technologies and Westcon accounted for 20% and 13% of gross accounts receivable, respectively. The Company principally relies on one, and to a lesser extent three additional, contract manufacturers for all of its manufacturing requirements. Any manufacturing disruption could impair its ability to fulfill orders. The Company’s reliance on these third-party manufacturers for all its manufacturing requirements could cause it to lose orders if these third-party manufacturers fail to satisfy the Company’s cost, quality and delivery requirements. INCOME TAXES The Company uses the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance for any tax benefits of which future realization is uncertain. FOREIGN CURRENCY TRANSACTIONS The Company’s sales to international customers are U.S. dollar-denominated. As a result, there are no foreign currency gains or losses related to these transactions. The functional currency for the Company’s foreign subsidiaries is the U.S. dollar. Accordingly, the entities remeasure monetary assets and liabilities at period-end exchange rates, while non-monetary items are remeasured at historical rates. Income and expense accounts are remeasured at the average rates in effect during the year. A-55 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Remeasurement adjustments are recognized in income as transaction gains or losses in the year of occurrence. To date, the effect of such amounts on net income has not been significant. OTHER COMPREHENSIVE INCOME (LOSS) The Company reports comprehensive income or loss in accordance with the provisions of SFAS 130, “Reporting Comprehensive Income.” SFAS 130 establishes standards for reporting comprehensive income and loss and its components in financial statements. Other comprehensive income (loss) consists entirely of unrealized gains (losses) on marketable securities available for sale of $164,000, $25,000 and $(195,000) for 2006, 2005 and 2004, respectively. Accordingly, the accumulated other comprehensive income (loss) as of December 31, 2006 and 2005 related entirely to net unrealized losses on marketable securities available for sale. Tax effects of unrealized losses are not considered material for any periods presented. NET INCOME PER SHARE Basic net income per share has been computed using the weighted-average number of common shares outstanding during the period, less the weighted-average number of common shares that are subject to repurchase. Diluted net income per share has been computed using the weighted average number of common and potential common shares outstanding during the period, as calculated using the treasury stock method. For purposes of computing diluted earnings per share, weighted average common share equivalents do not include stock options with an exercise price that exceeded the average fair market value of the Company’s common stock for the period, as the effect would be anti-dilutive. Additionally, all common share equivalents are excluded from diluted earnings per share for loss periods. Options to purchase shares of common stock that were excluded from the computation were as follows (in thousands): Years Ended December 31, 2006 2005 2004 Shares issuable under stock options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,199 4,174 2,170 Basic net income per share has been computed using the weighted-average number of common shares outstanding during the period, less the weighted-average number of common shares that are subject to repurchase. Diluted net income per share has been computed using the weighted average number of common and potential common shares outstanding during the period. A-56 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) The following table presents the calculation of basic and diluted net income per share (in thousands, except per share amounts): Years Ended December 31, 2006 2005 2004 Numerator: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Denominator: Basic: Weighted-average common shares outstanding. . . . . . . . . . . . . Less: common shares subject to repurchase . . . . . . . . . . . . . . . Basic weighted-average common shares outstanding . . . . . . Diluted: Basic weighted-average common shares outstanding . . . . . . . . Add: potentially dilutive common shares from stock Options and ESPP and shares subject to repurchase . . . . . . . . . . . . . Add: potentially dilutive common shares from warrants . . . . . . Diluted weighted-average common shares outstanding . . . . . Basic net income per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted net income per share . . . . . . . . . . . . . . . . . . . . . . . . . . . QUANTIFICATION OF ERRORS $ 4,904 $19,158 $14,534 34,910 (62) 34,848 34,848 872 20 35,740 $ 0.14 $ 0.14 33,932 (109) 33,823 33,823 1,221 21 35,065 $ 0.57 $ 0.55 33,104 (110) 32,994 32,994 1,485 23 34,502 $ 0.44 $ 0.42 In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108 (SAB 108), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which addresses how uncorrected errors in previous years should be considered when quantifying errors in current-year financial statements. SAB 108 requires companies to consider both a “rollover” method which focuses primarily on the income statement impact of misstatements and the “iron curtain” method which focuses primarily on the balance sheet impact of misstatements when quantifying errors in current-year financial statements and the related financial statement disclosures. The transition provisions of SAB 108 permit a company to adjust retained earnings (accumulated deficit) for the cumulative effect of immaterial errors relating to prior years. In the three months ended December 31, 2006, we determined that errors had been made in our financial statements related to the recording of rebate reserves, resulting in an overstatement of rebate reserves of $500,000, net of taxes of $150,000. Historically, the Company has evaluated uncorrected differences utilizing the rollover approach. The Company believes the impact of these errors were immaterial to prior years under the rollover method. However, under SAB 108, which the Company was required to adopt for the year ended December 31, 2006, the Company must assess materiality using both the rollover method and the iron-curtain method. Under the iron-curtain method, the cumulative impact of the errors related to the rebate reserve are material to the Company’s 2006 financial statements and, therefore, the Company has recorded an adjustment to its opening 2006 accumulated deficit balance in the amount of $350,000 in accordance with the implementation guidance in SAB 108. A-57 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) The impact on accumulated deficit is comprised of the following amounts (in thousands): Years Ended December 31, 2004 2005 Total Accumulated deficit Net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(603) 181 $(422) $103 (31) $ 72 $(500) 150 $(350) RECENT ACCOUNTING PRONOUNCEMENTS In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109”, (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return that results in a tax benefit. Additionally, FIN 48 provides guidance on de-recognition, statement of operations classification of interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company is evaluating the effect that the adoption of FIN 48 will have on its results of operations and financial condition and is not yet in a position to determine such effects. In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurement”, (FAS 157). This Standard defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company has not determined the effect that the adoption of FAS 157 will have on its consolidated results of operations, financial condition or cash flows. 2. BUSINESS COMBINATIONS Acquisition of Tacit Networks, Inc. On May 16, 2006, the Company completed its acquisition of Tacit Networks, Inc., or Tacit, a privately held company headquartered in South Plainfield, New Jersey. Tacit was a developer of products that allow enterprises with multiple locations to more efficiently store and transfer data between remote sites and central data storage sites. The acquisition expanded the Company’s product offerings of branch office infrastructure solutions that enable organizations pursuing server, storage and resource consolidation to meet cost, security and regulatory compliance objectives. Tacit became a wholly owned subsidiary of the Company in a transaction accounted for using the purchase method. The Company acquired 100% of the outstanding shares of Tacit for an initial purchase price of $68.0 million in cash, including acquisition costs of $1.7 million. In addition, the Company assumed all of the then outstanding options to purchase Tacit common stock, and converted those into options to purchase approximately 320,000 shares of the Company’s common stock. In addition to the cash paid that is included in the initial purchase price, the merger agreement required that $7.85 million of cash be placed in an escrow account to secure Tacit’s obligations under certain representation and warranty provisions. The escrow funds will be released fifteen days following the later of 90 days after completion of the audit of the Company’s 2006 financial statements or one year from the closing date of the acquisition, at which time the final purchase price will be adjusted. A-58 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) The results of operations of Tacit are included in the Company’s Consolidated Statements of Operations beginning May 16, 2006, the closing date of the acquisition. The following table summarizes the initial purchase price (in thousands): Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair value of options assumed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquisition related transaction costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total initial purchase price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $66,358 2,482 1,655 $70,495 The fair value of the assumed options, both vested and unvested, was determined using a Black-Scholes valuation model consistent with the Company’s valuation of stock options in accordance with SFAS 123(R). See Note 1. Unrecognized compensation expense associated with the fair value of the unvested options assumed was approximately $1.2 million which is not included in the initial purchase price above. Under the purchase method of accounting, the initial purchase price as shown in the table above is allocated to Tacit’s net tangible and intangible assets based on their estimated fair values as of the date of the completion of the acquisition. The escrow funds are included in other non-current assets in the accompanying consolidated balance sheets and have not been included in goodwill. When the funds are released to the former stockholders of Tacit, additional goodwill will be recorded. In addition, adjustments may be made to the allocation of the initial purchase price to reflect adjustments to deferred taxes related to the acquisition, as well as future tax benefits related to stock options assumed in the acquisition. The preliminary allocation of the initial purchase price as of December 31, 2006 is as follows (in thousands): Amount Cash and cash equivalents . . . . . . . . . . . . . . . . . Short-term investments . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . . . . . . . . . Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaids and other current assets . . . . . . . . . . . . Property and equipment . . . . . . . . . . . . . . . . . . . Net deferred tax assets . . . . . . . . . . . . . . . . . . . . Accounts payable and accrued liabilities . . . . . . . Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Identifiable intangible assets . . . . . . . . . . . . . . . . In-process research and development . . . . . . . . . ............................... ............................... ............................... ............................... ............................... ............................... ............................... ............................... ............................... ............................... ............................... ............................... $ 1,083 3,620 1,952 226 862 300 9,036 (5,380) (513) 49,129 8,380 1,800 $70,495 Total initial purchase price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Identifiable intangible assets Identifiable intangible assets, which consist primarily of customer relationships, trade names and technology, are amortized on a straight-line basis over their estimated useful lives. The customer relationships intangible relates to Tacit’s ability to sell existing, in-process and future versions of its products to its existing customers. Developed technology intangibles include a combination of patented and unpatented technology, trade secrets, and computer A-59 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) software that represent the foundation for current and planned new products. The following table presents details of the purchased intangible assets (in thousands, except years): Estimated Useful Life (In years) Amount Intangible Assets Developed technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Customer relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trade name . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 4 3 $3,530 4,200 650 $8,380 Goodwill Approximately $49.1 million of the initial purchase price has been allocated to goodwill. Goodwill represents the excess of the purchase price over the fair value of the underlying net tangible and intangible assets. The goodwill was attributed to the premium paid to expand and quicken the combined company’s ability to serve the growing markets for Wide Area File Services and branch office server solutions. Management believes the acquisition positions the combined company as a leading supplier of branch office server solutions delivering network services, network data reductions and file and bulk data caching. None of the goodwill recorded as part of the Tacit acquisition will be deductible for United States federal income tax purposes. Goodwill will be deductible for state income tax purposes in those states in which the Company elects to step up its basis in the acquired assets. In accordance with SFAS No. 142, goodwill will not be amortized but instead will be tested for impairment at least annually (more frequently if certain indicators are present). In the event that management determines that the value of goodwill has become impaired, the Company would incur an accounting charge for the amount of impairment during the period in which the determination is made. In-process research and development The Company estimates that $1.8 million of the purchase price represents in-process research and development, (IPR&D), primarily related to projects associated with Tacit’s iShared network wide area network, or WAN, optimization technology (including the hardware appliance and the related software) enhancements and upgrades that had not yet reached technological feasibility and have no alternative future use. The Company’s methodology for allocating the purchase price of acquisitions to IPR&D was determined through established valuation techniques in the high-technology networking product industry. The fair value of the technology under development, as well as the existing purchased technology, was determined using the income approach, which estimates the present value of future economic benefits such as cash earnings, cost savings, tax deductions, and proceeds from disposition. The present value calculations were developed by discounting expected cash flows to the present value at a rate of return that incorporates the risk-free rate for the use of funds, the expected rate of inflation, and risks associated with the particular investment. The discount rate of 19% selected was generally based on rates of return available from alternative investments of similar type and quality. Net deferred tax assets Net deferred tax assets of $9.0 million include tax effects of fair value adjustments primarily related to intangible assets and net operating loss tax carryforwards, net of a valuation allowance of $1.7 million, the benefit from which will be allocated to goodwill when , and if, it is subsequently realized. A-60 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Pro forma financial information The unaudited financial information in the table below summarizes the combined results of operations of Packeteer and Tacit, on a pro forma basis, as though the companies had been combined as of the beginning of each of the periods presented. The pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisition had taken place at the beginning of each of the periods presented. The pro forma financial information for 2006 also includes incremental stock-based compensation expense due to the assumption of Tacit stock options, investment banking fees, and other acquisition related costs, recorded in Tacit’s historical results of operations during May 2006. The pro forma financial information for all periods presented also includes amortization charges from acquired intangibles, adjustments to interest income, and related tax effects. The unaudited pro forma financial information for 2006 combines the historical results for Packeteer for 2006, which include the results of Tacit subsequent to May 16, 2006, and the historical results for Tacit for the period from January 1, 2006 to May 16, 2006. The unaudited pro forma financial information for 2005 combines the historical results for Packeteer and Tacit. The following table summarizes the pro forma financial information, unaudited, (in thousands, except per share amounts): Year Ended December 31, 2006 2005 Total net revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income (loss) per share: Basic. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquisition of Mentat . . . . . . . . . . . . . . . $148,360 ............... (2,639) ............... $ ............... $ (0.08) (0.08) $116,450 879 $ $ 0.03 0.03 On December 21, 2004, Packeteer acquired all of the outstanding common stock of Mentat, a privately held company located in Los Angeles, California. Mentat products are designed to provide high performance networking solutions for satellite and high-latency networks. The acquisition deepens and extends Packeteer’s intellectual property and provides advanced acceleration capabilities for new WAN performance solutions for global customers. The aggregate purchase price of Mentat was approximately $19.1 million, including acquisition costs. Of the $19.1 million, $17.3 million was paid in cash upon closing and the remaining $1.8 million was paid to the former shareholders of Mentat upon the collection of a non-trade receivable. The non-trade receivable was collected in January 2005 and was immediately paid to the former shareholders of Mentat per the terms of the purchase agreement. Our methodology for allocating the purchase price relating to purchase acquisitions is determined through established valuation techniques in the high-technology networking industry. Goodwill is measured as the excess of the cost of acquisition over the sum of the amounts assigned to tangible and identifiable intangible assets acquired, less liabilities assumed. The following table presents the allocation of the acquisition cost, including professional fees and other related acquisition costs, to the assets acquired and liabilities assumed, based on their fair values (in thousands): Net tangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-61 $ 2,327 7,200 9,527 $19,054 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Of the $7.2 million acquired intangibles, $5.1 million was assigned to developed technology, $1.9 million to customer contracts and relationships and $200,000 to trade name. These intangible assets have useful lives ranging from one to six years. Both the purchased intangible assets and the goodwill are expected to be deductible for tax purposes. In March 2005, an OEM customer of Mentat exercised its option to buyout its license agreement. In accordance with the terms of the license, for a total of $3.0 million, the customer was granted a perpetual, non-transferable and non-exclusive binary and source code license to certain Mentat software plus support and maintenance for a period of twelve months. The $3.0 million fee was initially recorded as deferred revenue and revenue was recognized over the following twelve-month period. In 2006 and 2005, Packeteer included $669,000 and $2.3 million, respectively, in revenues under this arrangement, with no balance remaining in deferred revenue at December 31, 2006. A portion of the purchased intangible asset “Customer Contracts and Relationships” was related to this particular customer contract. The estimated useful life on this portion of the intangible asset was reduced from six years to one year and was fully amortized at December 31, 2006. In addition, under the terms of the agreement, Packeteer was to pay up to $3.7 million in retention bonuses to former Mentat employees including both cash and restricted stock to incent Mentat employees to remain with Packeteer. The cash bonuses, totaling approximately $2.0 million were to be paid to the Mentat employees in equal installments, one half one year from the date of acquisition and the remainder on the two year anniversary of the acquisition, so long as the employee remains employed with Packeteer on each of the installment dates. During 2006 and 2005, $690,000 and $870,000, respectively, was paid to former Mentat employees under the cash retention bonus plan. No amounts remain payable at December 31, 2006. The restricted stock retention bonuses totaling approximately 114,000 restricted shares were valued at $1.7 million; however, approximately 4,000 shares valued at $59,000 were repurchased on the date of acquisition due to employee terminations. Amortization of stock-based compensation expense associated with these shares totaled $484,000, $901,000 and $14,000 for the years ended December 31, 2006, 2005 and 2004, respectively. See Note 1. Mentat’s results of operations have been included in the consolidated financial statements since the date of acquisition, December 21, 2004. The results of operations of Mentat were not material for the periods prior to the acquisition. A-62 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) 3. FINANCIAL INSTRUMENTS The Company’s cash equivalents and investments consist of the following at December 31, 2006 and 2005 (in thousands): Available-for-Sale Securities Gross Gross Unrealized Unrealized Losses Gains Amortized Cost Estimated Fair Value DECEMBER 31, 2006 Commercial paper and money markets . . . . . . . . . . Asset and mortgage backed securities . . . . . . . . . . Corporate bonds . . . . . . . . . . . . . . . . . . . . . . . . . . Total debt securities . . . . . . . . . . . . . . . . . . . . . . US Treasury and agencies . . . . . . . . . . . . . . . . . . . $ 31,442 7,514 11,473 50,429 16,656 $ 67,085 $ 1 8 3 12 2 14 $ (1) (21) (2) (24) (8) $ (32) $ 31,442 7,501 11,474 50,417 16,650 $ 67,067 $ 30,150 25,681 11,236 $ 67,067 Amounts included in cash and cash equivalents . . . Amounts included in short-term investments . . . . . Amounts included in long-term investments . . . . . . DECEMBER 31, 2005 Commercial paper and money markets . . . . . . . . . . Asset and mortgage backed securities . . . . . . . . . . Corporate bonds . . . . . . . . . . . . . . . . . . . . . . . . . . Total debt securities . . . . . . . . . . . . . . . . . . . . . . US Treasury and agencies . . . . . . . . . . . . . . . . . . . $ 17,160 23,987 19,215 60,362 59,402 $119,764 $— 4 2 6 2 $ 8 $ (1) (62) (14) (77) (113) $(190) $ 17,159 23,929 19,203 60,291 59,291 $119,582 $ 33,126 81,228 5,228 $119,582 Amounts included in cash and cash equivalents . . . Amounts included in short-term investments . . . . . Amounts included in long-term investments . . . . . . The amortized cost and estimated fair values of the Company’s investments as of December 31, 2006, shown by effective maturity date, are as follows (in thousands): Amortized Cost Estimated Fair Value Mature in one year or less. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mature between one year and two years . . . . . . . . . . . . . . . . . . . . . . . . . . . . $55,843 11,242 $67,085 $55,831 11,236 $67,067 All variable rate securities, including asset and mortgage backed securities, are classified as short-term investments regardless of the underlying reset date. A-63 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) The following tables show the fair values and gross unrealized losses for those investments that were in an unrealized loss position as of December 31, 2006 and 2005, aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in thousands): Less Than 12 Months Fair Unrealized Value Loss 12 Months or Greater Fair Unrealized Value Loss Total Unrealized Loss Fair Value DECEMBER 31, 2006 Security Description Commercial paper and money markets . . . . . . . . . . . . . . . Asset and mortgage backed securities . . . . . . . . . . . . . . Corporate bonds . . . . . . . . . . US Treasury and agencies . . . $ 7,925 4,434 3,353 11,526 $27,238 $— (21) (2) (8) $(31) $149 — — — $149 $ (1) — — — $ (1) $ 8,074 4,434 3,353 11,526 $27,387 $ (1) (21) (2) (8) $(32) Total Unrealized Loss Less Than 12 Months Fair Unrealized Value Loss 12 Months or Greater Fair Unrealized Value Loss Fair Value DECEMBER 31, 2005 Security Description Commercial paper and money markets . . . . . . . . $12,434 Asset and mortgage backed securities . . . . . . . . . . . . 9,762 Corporate bonds . . . . . . . . . 7,370 US Treasury and agencies . . 35,532 $65,098 $ (1) (45) (2) (107) $(155) $ — $— (17) (12) (6) $(35) $12,434 11,360 8,695 42,073 $74,562 $ (1) (62) (14) (113) $(190) 1,598 1,325 6,541 $9,464 The Company invests in investment grade securities. The unrealized losses on these investments were caused by interest rate increases and not credit quality. At this time, we believe that, due to the nature of the investments, the financial condition of the issuers, and Packeteer’s ability and intent to hold the investments through these short-term loss positions, factors would not indicate that these unrealized losses should be viewed as “other-than-temporary.” A-64 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) 4. COMMITMENTS AND GUARANTEES The Company leases its facilities under non-cancelable lease agreements that expire at various dates through 2011. Some of these arrangements contain renewal options, and require the Company to pay taxes, insurance and maintenance costs. Rent expense was $2.6 million, $2.2 million and $2.0 million for the years ended December 31, 2006, 2005 and 2004, respectively. As of December 31, 2006, the future minimum rental payments under operating leases are as follows (in thousands): Years Ending December 31, Lease Obligations 2007 2008 2009 2010 2011 ........................... ........................... ........................... ........................... ........................... .................................. .................................. .................................. .................................. .................................. $2,871 1,229 999 648 348 $6,095 Total future minimum lease payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additionally, our distributor and reseller agreements generally include a provision for indemnifying such parties against certain liabilities if our products are claimed to infringe a third-party’s intellectual property rights. To date, we have not incurred any costs as a result of such indemnifications and have not accrued any liabilities related to such obligations in the accompanying consolidated balance sheets. In January 2007, the Company entered into an agreement to amend the lease agreement for its headquarters. See additional information in Note 10. 5. CONTINGENCIES In November 2001, a putative class action lawsuit was filed in the United States District Court for the Southern District of New York against the Company, certain officers and directors of the Company, and the underwriters of the Company’s initial public offering. An amended complaint, captioned In re Packeteer, Inc. Initial Public Offering Securities Litigation, 01-CV-10185 (SAS), was filed on April 20, 2002. The amended complaint alleges violations of the federal securities laws on behalf of a purported class of those who acquired the Company’s common stock between the date of the Company’s initial public offering, or IPO, and December 6, 2000. The amended complaint alleges that the description in the prospectus for the Company’s IPO was materially false and misleading in describing the compensation to be earned by the underwriters of the Company’s IPO, and in not describing certain alleged arrangements among underwriters and initial purchasers of the Company’s common stock. The amended complaint seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of the Company’s common stock between July 27, 1999 and December 6, 2000. A special committee of the board of directors has authorized the Company to negotiate a settlement of the pending claims substantially consistent with a memorandum of understanding negotiated among class plaintiffs, all issuer defendants and their insurers. The parties have negotiated a settlement, which is subject to approval by the Court. On February 15, 2005, the Court issued an Opinion and Order preliminarily approving the settlement, provided that the defendants and plaintiffs agree to a modification narrowing the scope of the bar order set forth in the original settlement agreement. The parties agreed to a modification narrowing the scope of the bar order, and on August 31, 2005, the Court issued an order preliminarily approving the settlement. On December 5, 2006, the United States Court of Appeals for the Second Circuit overturned the District Court’s certification of the class of plaintiffs who are pursuing the claims that would be settled in the settlement against the underwriter defendants. Plaintiffs informed the District Court that they intend to seek further appellate review of this decision, and that they would like to be heard by the District Court as to whether the settlement may still be approved even if the the A-65 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) decision of the Court of Appeals is not reversed. The District Court indicated that it would defer consideration of final approval of the settlement pending plaintiffs’ request for further appellate review. We do not currently believe that the outcome of this proceeding will have a material adverse impact on our financial condition, results of operations or cash flows. No amount has been accrued as of December 31, 2006, as we believe a loss is neither probable nor estimable. On June 22, 2006, the Company filed a lawsuit in Santa Clara Superior Court against Valencia Systems, Inc., or Valencia, alleging Valencia’s breach of a Software License and Development Agreement pursuant to which Valencia provides certain software development and maintenance services for the Company. This complaint followed an earlier arbitration demand from Valencia pursuant to which Valencia claimed damages of $3,000,000. The Company was granted injunctive relief in its action prohibiting Valencia from disparagement or discontinuing maintenance or support services. The court has ordered the matter to arbitration and the parties have not yet formally responded to the other’s allegations. Valencia’s motion for a preliminary injunction was denied by the arbitrator. The Company believes Valencia’s claims to be without merit and intends to defend this matter vigorously. However, this matter is in the early stages and the Company cannot reasonably estimate an amount of potential loss, if any, at this time. The results of litigation are inherently uncertain, and there can be no assurance that the Company will prevail. No amount has been accrued as of December 31, 2006, as we believe a loss is neither probable nor estimable. In addition, the Company is subject to examination of its income tax returns by the Internal Revenue Service and other domestic and foreign tax authorities, including a current examination by the Internal Revenue Service for its 2003 and 2004 tax returns, primarily related to its intercompany transfer pricing. The Company regularly assesses the likelihood of outcomes resulting from these examinations to determine the adequacy of its provision for income taxes, and believe such estimates to be reasonable. The Company is routinely involved in legal and administrative proceedings incidental to its normal business activities and believes that these matters will not have a material adverse effect on financial position, results of operations or cash flows. 6. INCOME TAXES Income (loss) before provision (benefit) for income taxes is attributable to the following geographic locations for the periods ended December 31 (in thousands): 2006 2005 2004 United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before provision (benefit) for income taxes . . . . . . . . . . . $ (9,736) 15,422 $ 5,686 $ 6,060 13,223 $19,283 $ 2,627 11,524 $14,151 A-66 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Our income tax provision (benefit) for 2006, 2005 and 2004 consists of the following (in thousands): 2006 2005 2004 Current: Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred: Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision (benefit) for income taxes . . . . . . . . . . . . . . . . . . . . . $ 3,670 149 2,757 6,576 (3,984) (1,656) (154) (5,794) $ 782 $ 1,681 37 1,374 3,092 (387) (1,910) (670) (2,967) $ 125 $ 1,174 6 812 1,992 (2,375) — — (2,375) $ (383) The provision (benefit) for income taxes differs from the amount computed by applying the statutory federal tax rate to income before tax as follows (in thousands): For the Years Ended December 31, 2006 2005 2004 Federal tax at statutory rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State taxes, net of federal benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in valuation allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Non deductible in-process research and development . . . . . . . . . . . . Non deductible stock-based compensation . . . . . . . . . . . . . . . . . . . . Other non deductible expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative minimum income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign tax differential . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total provision (benefit) for income taxes . . . . . . . . . . . . . . . . . . . $ 1,990 (980) — 630 1,126 110 — (1,487) (607) — $ 782 $ 6,749 (90) (3,168) — — 77 — (1,967) (1,476) — $ 125 $ 4,953 6 (6,117) — 65 1,172 (895) 400 33 $ (383) A-67 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) The components of the deferred tax assets at December 31 are set forth below (in thousands): 2006 2005 Deferred tax assets: Various accruals, reserves and other temporary differences not deductible for tax purposes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,357 Property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,298 Net operating loss carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,845 Tax credit carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,509 Gross deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax liabilities: Intangible assets related to acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total gross net deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Valuation allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41,009 (2,690) (2,690) 38,319 (17,961) $ 3,326 540 10,978 6,864 21,708 — — 21,708 (16,368) $ 5,340 Net deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,358 Net current deferred tax assets of $1.1 million and $0.7 million are included in prepaids and other current assets at December 31, 2006 and 2005, respectively. Net long-term deferred tax assets of $19.2 million and $4.6 million are included in other non-current assets at December 31, 2006 and 2005, respectively. A valuation allowance has been provided to reduce the deferred tax asset to an amount management believes is more likely than not to be realized. Expected realization of deferred tax assets for which a valuation allowance has not been recognized is based upon the reversal of existing taxable temporary differences and taxable income expected to be generated in the future. The net change in the total valuation allowance in 2006 was an increase of $1.6 million, which is comprised of an increase in valuation allowance of $1.7 million for deferred tax assets related to the acquisition of Tacit, offset by a $0.1 million release of valuation allowance for deferred taxes attributable to employee stock deductions. The net change in the total valuation allowance in 2005 was a decrease of $2.5 million, which is comprised of a release of valuation allowance of $3.2 million, partially offset by an increase in valuation allowance for deferred tax assets attributable to employee stock option deductions. The net change in the total valuation allowance in 2004 was a decrease of $5.8 million, of which $2.4 million related to release of valuation allowance and $3.7 million related to the utilization of net operating loss carryforwards that previously had valuation allowances established against them. Approximately $16.3 million of the valuation allowance for deferred tax assets is attributable to employee stock option deductions, the benefit from which will be allocated to additional paid-in capital when, and if, it is subsequently realized. Approximately $1.7 million of the valuation allowance is attributable to Tacit pre-acquisition net operating losses and research credits, the benefit from which will be allocated to goodwill when, and if, it is subsequently realized. Deferred tax liabilities have not been recognized for undistributed earnings of foreign subsidiaries because it is management’s intention to indefinitely reinvest such undistributed earnings outside the U.S. At December 31, 2006, the Company has net operating loss carryforwards for federal, California and New Jersey income tax purposes of approximately $58.5 million, $10.0 million and $28.6 million, respectively. If not utilized, the federal net operating loss carryforwards will begin to expire in 2020, and the California net operating loss carryforwards will begin to expire in 2012 and the New Jersey net operating loss carryforwards will begin to expire in 2010. At December 31, 2006, the Company had federal, California, New Jersey and Canadian research credit carryforwards of approximately $4.2 million, $4.2 million, $0.1 million and $0.8 million, respectively. If not A-68 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) utilized, the federal research credit carryforwards will begin to expire in 2011. The California research credit carryforwards can be carried forward indefinitely. The New Jersey research credit carryforward will begin to expire in 2020. The Canadian research credits will begin to expire in 2015. The Company’s income taxes payable for federal, state and foreign purposes have been reduced by the tax benefits from employee stock options. The Company receives an income tax benefit calculated as the difference between the fair market value of the stock issued at the time of exercise and the option price, tax effected. The net tax benefits from employee stock option transactions were $2.8 million in 2006, of which $0.7 million consisted of tax benefits from employee stock option transactions related to fully vested options assumed in the acquisition of Tacit and were reflected as a decrease to goodwill and $2.1 million were reflected as an increase to addition paid-in capital in the Consolidated Statements of Shareholders’ Equity. The net tax benefits from employee stock option transactions were $1.2 million in 2005, all of which were reflected as an increase to additional paid-in capital. No tax benefits from employee stock option transactions were recorded in 2004. The Company is undergoing an examination by the Internal Revenue Service for its 2003 and 2004 tax returns, primarily related to our intercompany transfer pricing. Management believes that adequate amounts have been accrued for potential adjustments resulting from the examination. 7. STOCKHOLDERS’ EQUITY PREFERRED AND COMMON STOCK The Company’s Board of Directors has authorized 5,000,000 shares of preferred stock. The authorized preferred stock shares are undesignated and the Board has the authority to issue and to determine the rights, preference and privileges thereof. The Company’s Board of Directors has authorized 85,000,000 shares of common stock. WARRANTS As of December 31, 2006, 45,000 warrants to purchase common stock were outstanding and exercisable with a $6.25 exercise price per share and an expiration date in May 2009. 1999 STOCK INCENTIVE PLAN In May 1999, the Company’s Board of Directors adopted and its stockholders approved the 1999 Stock Incentive Plan (1999 Plan), which became effective on July 27, 1999, and serves as the successor program to its 1996 Equity Incentive Plan (the predecessor plan). All options outstanding under the Predecessor Plan on the effective date were incorporated into the 1999 Plan and were treated as outstanding options under the 1999 Plan. The number of shares reserved under the 1999 Plan automatically increases annually beginning on January 1, 2000 by the lesser of three million shares or 5% of the total number of shares of common stock outstanding. Under the 1999 Plan, the Company may grant incentive or nonstatutory stock options, stock appreciation rights, restricted stock purchase rights and bonuses, restricted stock units, performance shares and performance units to eligible participants, including its officers, other key employees, our non-employee directors and certain consultants. The 1999 Plan is generally administered by the Compensation Committee of the Board of Directors, which sets the terms and conditions of the options and other awards. Non-statutory stock options and incentive stock options are exercisable at prices not less than 85% and 100%, respectively, of the fair value on the date of grant. The options become 25% vested one year after the date of grant with 1/48 per month vesting thereafter and expire at the end of 10 years from date of grant or sooner if terminated by the Board of Directors. As of December 31, 2006, an aggregate of approximately 14.7 million shares have been reserved under the 1999 Plan, of which approximately 3.2 million were available for future grant. A-69 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) STOCK OPTIONS ASSUMED IN ACQUISITION In connection with the acquisition of Tacit, the Company assumed all the then outstanding options to purchase Tacit common stock granted under their 2000 Equity Incentive Plan, and converted those into options to purchase approximately 320,000 shares of the Company’s common stock, of which approximately 90,000 were outstanding and approximately 59,000 were unvested as of December 31, 2006. In most circumstances, these options become fully vested upon involuntary termination. A summary of stock option activity under stock option plans follows (in thousands, except per share data): Options Outstanding Weighted Weighted Average Average Remaining Exercise Contractual Shares Price Term (Years) (In thousands, except per share amounts) Available for Grant Aggregate Intrinsic Value Options outstanding as of December 31, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . Shares made available for grant . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . Exercised. . . . . . . . . . . . . . . . . . . . . . . Cancelled . . . . . . . . . . . . . . . . . . . . . . Options outstanding as of December 31, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . Shares made available for grant . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . Exercised. . . . . . . . . . . . . . . . . . . . . . . Cancelled . . . . . . . . . . . . . . . . . . . . . . Options outstanding as of December 31, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . Shares made available for grant . . . . . . . . Options assumed(a) . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . Cancelled/forfeited/expired . . . . . . . . . . . Options outstanding at December 31, 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . Options vested and expected to vest at December 31, 2006 . . . . . . . . . . . . . . . Options exercisable at December 31, 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . 2,174 1,625 (2,337) — 898 2,360 1,671 (1,750) — 589 2,870 1,710 (2,594) — 1,193 3,179 4,729 — 2,337 (510) (898) 5,658 — 1,750 (490) (589) 6,329 — 320 2,594 (888) (1,206) 7,149 6,553 3,768 $ 9.51 16.03 5.74 14.17 11.80 12.95 6.20 14.23 12.33 1.28 10.68 5.16 12.98 12.01 12.09 12.46 7.43 7.28 6.17 $21,390 $19,838 $12,951 (a) Represents activity related to options that were assumed as a result of the acquisition of Tacit in May 2006. See Note 2 for additional information. A-70 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) The following table summarizes significant ranges of outstanding and exercisable options as of December 31, 2006 (in thousands, except years and per-share amounts): Options Exercisable Options Outstanding WeightedAverage Number Remaining Outstanding Contractual Life (In years) WeightedAverage Exercise Price per Share WeightedAverage Exercise Price per Share Range of Exercise Prices Number Exercisable $ 0.19 - 4.71 . . . . . . . . . . . . 4.75 - 8.36 . . . . . . . . . . . . 8.37 - 9.51 . . . . . . . . . . . . 9.54 - 12.03 . . . . . . . . . . . . 12.05 - 13.81 . . . . . . . . . . . . 13.87 - 14.00 . . . . . . . . . . . . 14.01 - 18.10 . . . . . . . . . . . . 18.49 - 20.77 . . . . . . . . . . . . 48.06 . . . . . . . . . . . . . . . . . . .. .. .. .. .. .. .. .. .. 810 880 1,125 1,279 727 738 943 517 130 7,149 5.51 6.12 9.09 8.43 8.14 8.07 6.68 7.08 3.07 7.43 $ 3.67 7.52 9.43 11.53 12.71 14.00 16.03 19.39 48.06 12.01 751 695 18 316 358 384 731 385 130 3,768 $ 3.79 7.34 9.09 11.07 12.60 14.00 16.05 19.39 48.06 12.46 Total . . . . . . . . . . . . . . . . . . . As of December 31, 2006 and 2005, there were approximately 9,000 non-plan options outstanding with a weighted average exercise price of $0.25 per share, all of which expire in October 2007. 1999 EMPLOYEE STOCK PURCHASE PLAN In May 1999, the Company’s Board of Directors adopted the 1999 Employee Stock Purchase Plan (ESPP). The ESPP became effective July 27, 1999. The number of shares reserved under the ESPP automatically increases annually beginning on January 1, 2000 by the lesser of one million shares or 2% of the total number of shares of common stock outstanding. The ESPP permits participants to purchase common stock through payroll deductions of up to 15% of an employee’s compensation, including commissions, overtime, bonuses and other incentive compensation. Purchases are limited to a maximum of 1,000 shares for an individual employee for each purchase period. The purchase price per share is equal to 85% of the fair market value per share on the participant’s entry date into the offering period or, if lower, 85% of the fair market value per share on the semi-annual purchase date. As of December 31, 2006, approximately 4.8 million shares had been reserved under the plan and approximately 3.2 million were available for future issuance. During 2006, 2005 and 2004, approximately 315,000, 299,000 and 297,000 shares were issued under the ESPP during 2006. RESTRICTED STOCK ISSUED IN ACQUISITION In connection with the acquisition of Mentat, the Company issued approximately 114,000 restricted shares valued at $1.7 million, however, approximately 4,000 shares valued at $59,000 were repurchased on the date of acquisition due to employee terminations. The value of the shares was determined based on the fair value of the Company’s stock at the date of issuance. Under the terms of the related shareholder agreements, the shares vest in equal installments, one-third one year from the date of acquisition, one-third on the second anniversary of the acquisition and one-third on the third anniversary of the acquisition, so long as the employee is still employed by Packeteer on the anniversary date. During 2005, approximately 10,000 of these restricted shares were repurchased by the Company due to terminations, according to the terms of the shareholder agreements. In 2006 and 2005, approximately 48,000 and approximately 34,000 shares vested, respectively, including approximately 29,000 shares in 2006 that became immediately vested upon employee terminations. At December 31, 2006, there were approximately 18,000 restricted shares outstanding. A-71 PACKETEER, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) 8. 401(k) PLAN In 1997, the Company adopted a 401(k) plan (“401(k)”). Participation in the 401(k) is available to all employees. Entry date to the 401(k) is the first day of each month. Each participant may elect to contribute an amount up to 100% of his or her annual base salary plus commission and bonus, but not to exceed the statutory limit as prescribed by the Internal Revenue Code. The Company may make discretionary contributions to the 401(k). To date, no contributions have been made by the Company. 9. SEGMENT REPORTING The Company’s chief operating decision maker is considered to be the Company’s CEO. The CEO reviews financial information presented on a consolidated basis substantially similar to the consolidated financial statements. Therefore, the Company has concluded that it operates in one segment and accordingly has provided only the required enterprise-wide disclosures. The Company operates in the United States and internationally and derives its revenue from the sale of products and software licenses and maintenance contracts related to the Company’s products. Sales outside of the Americas accounted for 53%, 53% and 59% of net revenues in 2006, 2005, and 2004, respectively. Geographic information is as follows (in thousands): Years Ended December 31, 2006 2005 2004 Net revenues: Americas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 67,614 Asia Pacific . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,284 Europe, Middle East, Africa . . . . . . . . . . . . . . . . . . . . . . . . . . 42,225 Total net revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $145,123 $ 52,604 27,715 32,622 $112,941 $37,934 24,963 29,540 $92,437 Net revenues reflect the destination of the product shipped. The Americas net revenue includes sales into Canada, Latin America and South America, which in total accounted for 3%, 5% and 3% of total net revenues in 2006, 2005 and 2004, respectively. Long-lived assets are primarily located in North America. Long-lived assets located outside North America are not significant. 10. SUBSEQUENT EVENT In January 2007, the Company entered into an amendment to the facility lease for its headquarters in Cupertino, California that extends the term of the lease to December 2014 (with certain options to extend). Under the terms of this amendment, the premises subject to the lease will be expanded in December 2007. The lease payments under the amended lease will be approximately $2.6 million per year, with a total commitment of $19 million over the extended lease term. A-72 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. ITEM 9A. CONTROLS AND PROCEDURES (a) Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based on this evaluation, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures as of December 31, 2006, were ineffective to ensure that the information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. (b) Management’s Report on Internal Control Over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. A material weakness (within the meaning of PCAOB Auditing Standard No. 2) is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2006, and this assessment identified material weaknesses in our internal control over financial reporting related to our (1) accounting for income taxes and (2) rebate reserves. Specifically, (i) we did not maintain effective controls to provide for the reconciliation of the income taxes payable account to supporting detail and the review of the income taxes payable account reconciliation by someone other than the preparer; and (ii) we did not maintain effective controls over the review of the rebate reserves as the review was not appropriately designed, nor was the review conducted in sufficient detail. These deficiencies resulted in a material misstatement of our income taxes payable and the rebate reserves, which were adjusted prior to the issuance of our 2006 consolidated financial statements. In making its assessment of internal control over financial reporting, management used the criteria issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, in “Internal ControlIntegrated Framework”. Because of the material weaknesses described above, management’s conclusion is that we did not maintain effective internal control over financial reporting as of December 31, 2006. Our independent registered public accounting firm has issued an attestation report on management’s assessment of our internal control over financial reporting. That report is included herein under Item 8. (c) Changes in Internal Control Over Financial Reporting There has been no change in our internal control over financial reporting during the three months ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. In order to remediate the material weaknesses described above, we are implementing revised policies and procedures pertaining to income taxes payable and rebate accruals and increasing the size and training of our financial staff. ITEM 9B. OTHER INFORMATION Not Applicable. A-73 Stockholder Information Board of Directors Steven J. Campbell Chairman of the Board Packeteer, Inc. Dave Côté President and Chief Executive Officer Packeteer, Inc. Craig W. Elliott Former President and Chief Executive Officer Packeteer, Inc. Joseph A. Graziano Former Chief Financial Officer, Apple, Inc. and Sun Microsystems, Inc. L. William Krause Retired Chairman and Chief Executive Officer of 3Com Corporation Bernard F. Mathaisel Former Senior Vice President and Chief Information Officer, Solectron Corporation Peter Van Camp Executive Chairman Equinix, Inc. Gregory E. Myers Former Vice President and Chief Financial Officer of Symantec Corporation Executive Officers Dave Côté President and Chief Executive Officer Arturo Cázares Vice President, Worldwide Sales Manuel R. Freitas Vice President, Worldwide Operations and Customer Support Alan Menezes Vice President, Marketing Nelu Mihai Vice President, Engineering Greg Pappas Vice President, Human Resources David C. Yntema Chief Financial Officer Stock Listing Traded on the Nasdaq Global Select Market under the symbol: PKTR World Wide Web www.packeteer.com Transfer Agent and Registrar Computershare Investor Services P.O. Box 43078 Providence, RI 02940-3078 Tel: 781-575-2879 http://www.computershare.com Independent Registered Public Accounting Firm KPMG LLP Mountain View, California Legal Counsel DLA Piper US LLP Palo Alto, California Copyrights Copyright 2007 Packeteer, Inc. All rights reserved. Packeteer, the Packeteer logo, combinations of Packeteer and the Packeteer logo, as well as PacketWise, PacketShaper, PacketShaper Xpress, PacketSeeker, PolicyCenter, Report Center, Mobiliti, iShared and SkyX are trademarks or registered trademarks of Packeteer, Inc. in the United States and other countries. All other trademarks are the property of their respective owners. Packeteer Headquarters Packeteer, Inc. 10201 N. De Anza Blvd. Cupertino, CA 95014 USA Tel: +1 408 873 4400 +1 800 697 2253 Fax: +1 408 873 4410 Packeteer Europe Packeteer Europe B.V. Louis Braillelaan 80 2719 EK Zoetermeer The Netherlands Tel: +31 (0) 88 742 7377 Fax: +31 (0) 88 742 7300 Packeteer Japan Packeteer Japan Inc YK Shinjuku Daiichi Seimei Building 4F 2-7-1, Nishi-Shinjuku Shinjuku-ku Tokyo 163-0704 Japan Tel: +81 (0) 3 5339 7970 Fax: +81 (0) 3 5339 7979 Packeteer Asia Pacific Packeteer Asia Pacific Ltd. Suite 1507, 15/F Cityplaza Four 12 Taikoo Wan Road Taikoo Shing Hong Kong Tel: +852 2850 5048 Fax: +852 2850 5648 www.packeteer.com PKT-AR2006-0307