form10q.htm

PART I. FINANCIAL INFORMATION

Item 1.

Consolidated Financial Statements

Procera Networks, Inc.

	March 31,			December 31,
	2011			2010
	(Unaudited)
ASSETS
Current Assets:
Cash and cash equivalents	$	9,366,105		$	7,875,798
Accounts receivable, less allowance of $318,286 and $321,823 at March 31, 2011 and December 31, 2010, respectively		9,037,777			11,407,220
Inventories, net		2,678,339			2,549,695
Prepaid expenses and other		480,618			831,737
Total current assets		21,562,839			22,664,450

Property and equipment, net		884,527			873,173
Goodwill		960,209			960,209
Other non-current assets		27,192			19,150
Total assets	$	23,434,767		$	24,516,982

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Line of credit	$	716,656		$	1,718,732
Accounts payable		1,753,129			1,943,799
Deferred revenue		3,764,538			3,732,756
Accrued liabilities		2,578,707			2,662,564
Total current liabilities		8,813,030			10,057,851

Non-current liabilities:
Deferred revenue		634,770			704,735
Total liabilities		9,447,800			10,762,586

Commitments and contingencies (Note 12)		---			---


Stockholders’ equity:
Common stock, $0.001 par value; 32,500,000 shares authorized; 11,364,222 and 11,314,965 shares issued and outstanding at March 31, 2011 and December 31, 2010, respectively		11,364			11,315
Additional paid-in capital		76,467,370			76,093,272
Accumulated other comprehensive loss		(243,790	)		(331,883	)
Accumulated deficit		(62,247,977	)		(62,018,308	)
Total stockholders’ equity		13,986,967			13,754,396
Total liabilities and stockholders’ equity	$	23,434,767		$	24,516,982

See accompanying notes to condensed consolidated financial statements.

Index

Procera Networks, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	Three Months Ended March 31,
	2011			2010

Sales:
Product sales	$	5,615,542		$	2,382,964
Support sales		1,307,351			910,646
Total net sales		6,922,893			3,293,610
Cost of sales:
Product cost of sales		2,583,452			1,451,935
Support cost of sales		136,036			127,485
Total cost of sales		2,719,488			1,579,420

Gross profit		4,203,405			1,714,190

Operating expenses:
Research and development		1,037,982			620,495
Sales and marketing		2,064,485			1,457,497
General and administrative		1,276,185			1,107,374
Total operating expenses		4,378,652			3,185,366

Loss from operations		(175,247	)		(1,471,176	)
Interest and other income (expense), net		(30,222	)		(42,972	)

Loss before income taxes		(205,469	)		(1,514,148	)
Income tax provision		24,200			1,256
Net loss	$	(229,669	)	$	(1,515,404	)

Net loss per share - basic and diluted	$	(0.02	)	$	(0.15	)
Shares used in computing net loss per share - basic and diluted		11,276,927			9,948,272

See accompanying notes to condensed consolidated financial statements.

Index

Procera Networks, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Three Months Ended March 31,
	2011			2010
Cash flows from operating activities:
Net loss	$	(229,669	)	$	(1,515,404	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation		91,718			115,113
Compensation related to stock-based awards		365,419			304,602
Provision for excess and obsolete inventory		82,437			18,687
Changes in assets and liabilities:
Accounts receivable		2,531,459			5,450,936
Inventories		(148,214	)		(248,454	)
Prepaid expenses and other current assets		150,125			(112,963	)
Accounts payable		(199,779	)		(305,639	)
Accrued liabilities and deferred rent		(148,348	)		(551,427	)
Deferred revenue		(100,921	)		(119,854	)
Net cash provided by operating activities		2,394,227			3,035,597

Cash flows from investing activities:
Purchase of property and equipment		(70,734	)		(115,038	)
Net cash used in investing activities		(70,734	)		(115,038	)

Cash flows from financing activities:
Proceeds from issuance of common stock		---			6,471,203
Proceeds from issuance of common stock – exercise of options		217,294			---
Cash paid for fractional shares		(566	)		—
Proceeds from line of credit		716,656			—
Payments on line of credit		(1,718,732	)		(1,917,088	)
Payments on notes payable		---			(500,000	)
Net cash provided by (used in) financing activities		(785,348	)		4,054,115

Effect of exchange rates on cash and cash equivalents		(47,838	)		(20,243	)

Net increase in cash and cash equivalents		1,490,307			6,954,431

Cash and cash equivalents, beginning of period		7,875,798			3,191,896

Cash and cash equivalents, end of period	$	9,366,105		$	10,146,327

See accompanying notes to condensed consolidated financial statements.

Index

Procera Networks, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

1.	DESCRIPTION OF BUSINESS

Procera Networks, Inc. ("Procera" or the "Company") is a leading provider of Intelligent Policy Enforcement solutions based on Deep Packet Inspection technology, that enable mobile and broadband network operators and entities managing private networks including higher education institutions, businesses and government entities (collectively referred to as network operators) to gain enhanced visibility into, and control of, their networks and to create and deploy new services for their end user subscribers. The Company sells its products through its direct sales force, resellers, distributors and system integrators in the Americas, Asia Pacific and Europe.

Procera was incorporated in 2002 and trades on the NYSE Amex Equities under the trading symbol “PKT”.

2.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

Procera has prepared the consolidated financial statements included herein pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) applicable to interim financial information. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. However, Procera believes that the disclosures are adequate to ensure the information presented is not misleading. The consolidated balance sheet at December 31, 2010 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by United States generally accepted accounting principles (“GAAP”) for complete financial statements. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in Procera’s Annual Report on Form 10-K for the year ended December 31, 2010, filed with the SEC on March 16, 2011.

Certain amounts from prior periods have been reclassified to conform to the current period presentation. These reclassifications had no impact on stockholders' equity, previously reported net loss, or the net change in cash and cash equivalents.

The consolidated financial statements present the accounts of Procera and its wholly-owned subsidiaries, Netintact AB and Netintact PTY. All significant inter-company balances and transactions have been eliminated.

Reverse Stock Split

Effective February 4, 2011, Procera implemented a 1-for-10 reverse split of its common stock and reduced the number of authorized shares of common stock from 130,000,000 to 32,500,000 shares, as previously authorized and approved by the Company’s stockholders at the June 14, 2010 annual meeting. The Company’s common stock began trading on the NYSE Amex Equities on a post-split basis on February 7, 2011. As a result, the Company’s issued and outstanding common stock as of February 4, 2011 was reduced from approximately 113 million to approximately 11.3 million shares. The Company paid cash in lieu of any fractional shares to the holders of fractional shares of common stock. The par value of the common stock was not affected by the reverse stock split and remains at $0.001 per share. Consequently, the aggregate par value of the issued common stock was reduced by reclassifying the par value amount of the eliminated shares of common stock to “Additional paid-in capital” in the Company’s Consolidated Balance Sheets. The reverse split also effected a reduction in the number of shares of common stock issuable upon the exercise of stock options, restricted stock and warrants under the Company’s 2007 Equity Incentive Plan. All shares and per share amounts, including all common stock equivalents (stock options, restricted stock and warrants) in the Consolidated Financial Statements and Notes to the Consolidated Financial Statements have been retroactively adjusted, for all periods presented to reflect the reverse stock split.

Significant Accounting Policies

The accounting and reporting policies of the Company conform to GAAP and to the practices within the telecommunications industry. There have been no significant changes in the Company's significant accounting policies during the three months ended March 31, 2011 compared to what was previously disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2010, except for changes in the accounting for revenue recognition as a result of the new accounting standards and updates to the Company’s revenue recognition policy as described below.

Revenue Recognition

In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2009-13, “Multiple-Deliverable Revenue Arrangements” and ASU No. 2009-14, “Certain Revenue Arrangements that Include Software Elements.” The Company adopted the new guidance on a prospective basis for new or materially modified revenue arrangements as of January 1, 2011. The adoption of this guidance did not have a material impact on the Company’s financial statements and is not expected to have a material impact in the future.

Index

The Company’s most common sale involves the integration of software and a hardware appliance, where the hardware and software work together to deliver the essential functionality of the product. The Company recognizes product revenue when all of the following have occurred: (1) the Company has entered into a legally binding arrangement with a customer resulting in the existence of persuasive evidence of an arrangement; (2) delivery has occurred, evidenced when product title transfers to the customer; (3) customer payment is deemed fixed or determinable and free of contingencies and significant uncertainties; and (4) collection is probable.

Product revenue consists of revenue from sales of appliances and software licenses. Product sales include a perpetual license to the Company’s software that is essential to the functionality of the hardware, and on occasion include licenses to additional software. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue. Virtually all sales include post-contract support (“PCS”) services (included in support revenue) which consist of software updates and customer support. Software updates provide customers access to a constantly growing library of electronic internet traffic identifiers (signatures) and rights to non-specific software product upgrades, maintenance releases and patches released during the term of the support period. Support includes internet access to technical content, telephone and internet access to technical support personnel and hardware support.

Receipt of a customer purchase order is the primary method of determining that persuasive evidence of an arrangement exists.

Delivery generally occurs when a product is delivered to a common carrier F.O.B. shipping point. However, product revenue based on channel partner purchase orders are recorded based on sell-through to the end user customers until such time as the Company has established significant experience with the channel partner’s ability to complete the sales process. Additionally, when the Company introduces new products for which there is no historical evidence of acceptance history, revenue is recognized on the basis of end-user acceptance until such history has been established.

Fees are typically considered to be fixed or determinable at the inception of an arrangement, generally based on specific products and quantities to be delivered. Substantially all of the Company’s contracts do not include rights of return or acceptance provisions. To the extent that agreements contain such terms, the Company recognizes revenue once the acceptance provisions or right of return lapses. Payment terms to customers generally range from net 30 to 90 days. In the event payment terms are provided that differ from the Company’s standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized when the payments become due, provided the remaining criteria for revenue recognition have been met.

Procera assesses the ability to collect from its customers based on a number of factors, including credit worthiness of the customer and past transaction history of the customer. If the customer is not deemed credit worthy, the Company defers all revenue from the arrangement until payment is received and all other revenue recognition criteria have been met.

Customer orders normally contain multiple items. The initial product delivery consists of the hardware and software elements, and these elements have standalone value to the customer. Through March 31, 2011, in virtually all of the Company’s contracts, the only elements that remained undelivered at the time of product delivery were PCS services. Prior to January 1, 2011, the majority of the Company’s transactions were within the scope of the software revenue recognition guidance. The Company accordingly recognized revenue for delivered items using the residual method, after allocating revenue to PCS services based on vendor specific objective evidence of fair value (“VSOE”).

Under the new guidance, the Company allocates revenue to each element in an arrangement based on relative selling price using a selling price hierarchy. The selling price for a deliverable is based on its VSOE if available, third party evidence ("TPE") if VSOE is not available, or the Company’s best estimate of selling price ("ESP") if neither VSOE nor TPE is available. The maximum revenue recognized on a delivered element is limited to the amount that is not contingent upon the delivery of additional items. In arrangements that include non-essential software (“software deliverables”), revenue is allocated to each separate unit of accounting for the non-software deliverables and to the software deliverables as a group using the relative selling prices of each of the deliverables in the arrangement. Revenue allocated to the software deliverables as a group is then allocated first to the PCS services based on VSOE, and then to the software, using the residual method under the software revenue recognition guidance.

The Company determines VSOE for PCS based on the rate charged to customers based upon renewal pricing for PCS. Each contract or purchase order entered into includes a stated rate for PCS. The renewal rate is generally equal to the stated rate in the original contract. The Company has a history of such renewals, the vast majority of which are at the stated renewal rate on a customer by customer basis. PCS revenue is recognized under a proportional performance method, ratably over the life of the contract. A small portion of service revenue is derived from providing training on products and the Company uses the completed-contract method to recognize such revenue.

Index

As the hardware and software products are rarely sold separately, the Company generally does not have VSOE for these products, and TPE is not available. The Company determines the ESP for hardware and software deliverables considering internal factors such as discounting and pricing policies, and external factors such as market conditions in different geographies and competitive positioning.

In certain contracts, billing terms may be agreed upon based on performance milestones such as the execution of measurement test, a partial delivery or the completion of a specified service. Payments received before the unconditional acceptance of a specific set of deliverables are recorded as deferred revenue until the conditional acceptance has been waived.

3.	RECENT ACCOUNTING PRONOUNCEMENTS

There have been no recent accounting pronouncements during the three months ended March 31, 2011, that management believes are of significance, or potential significance, to the Company.

4.	STOCK-BASED COMPENSATION

The Company has an equity incentive plan that provides for the grant of incentive stock options to eligible employees. Stock-based employee compensation expense recognized pursuant to this plan on the Company’s condensed consolidated statements of operations for the three-month periods ended March 31, 2011 and 2010 was as follows:

	Three Months Ended March 31,
	2011		2010

Cost of goods sold	$	24,759	$	21,727
Research and development		42,772		5,247
Sales and marketing		109,663		62,946
General and administrative		188,225		214,682
Total stock-based compensation expense, net of income tax	$	365,419	$	304,602

No income tax benefits were recognized in the three months ended March 31, 2011 and 2010 due to the Company’s continuing losses. No stock-based compensation has been capitalized in inventory due to the immateriality of such amounts.

As of March 31, 2011, total unrecognized compensation cost related to unvested stock options was $1,637,254, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average amortization period of 2.14 years. As of March 31, 2011, total unrecognized compensation cost related to unvested restricted stock awards was $279,975, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average amortization period of 2.36 years.

General Share-Based Award Information

Stock Options

The following table summarizes the Company’s stock option activity for the three months ended March 31, 2011:

	Number of Options			Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (in years)		Aggregate Intrinsic Value

Outstanding at December 31, 2010		975,153		$	8.93
Granted		52,600		$	9.18
Exercised		(1,875	)	$	4.96
Cancelled		(9,531	)	$	4.79

Outstanding at March 31, 2011		1,016,347		$	9.01		7.20		$	2,774,053

Vested and expected to vest at March 31, 2011		978,674		$	9.10		7.13		$	2,630,328

Exercisable at March 31, 2011		639,962		$	9.91		6.45		$	1,502,320

Index

The total intrinsic value of options exercised during the three months ended March 31, 2011 was $9,252. The Company settles employee stock option exercises with newly issued common shares approved by stockholders for inclusion in its stock option plan.

Restricted Stock

The following is a summary of the Company’s restricted stock award activity for the three months ended March 31, 2011.

	Number of Shares		Weighted Average Grant Date Fair Value
Non-vested at December 31, 2010		60,000	$	5.30
Granted		10,332	$	6.40
Non-vested at March 31, 2011		70,332	$	5.46

No restricted stock awards vested during the three months ended March 31, 2011.

Valuation Assumptions

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option valuation model. The fair value of each restricted stock grant is calculated based upon the closing stock price of the Company’s common stock on the date of the grant. The expense for stock-based awards is recognized over the requisite service period using the straight-line attribution approach.

The following assumptions were used in determining the fair value of stock options granted during the three months ended March 31, 2011 and 2010:

	Three Months Ended March 31,
	2011			2010
Expected term (years)		4.80			4.60
Expected volatility		68.1	%		96.4	%
Risk-free interest rate		1.52	%		2.17	%
Expected dividend yield		0	%		0	%

The weighted average grant date fair value of options granted during the three months ended March 31, 2011and 2010 was $3.98 and $3.30, respectively

The Company calculated the expected term of stock options granted using historical exercise data. The Company used the exact number of days between the grant and the exercise dates to calculate a weighted average of the holding periods for all awards (i.e., the average interval between the grant and exercise or post-vesting cancellation dates) adjusted as appropriate. Expected volatilities were estimated using the historical share price performance over a period equivalent to the expected term of the option. The risk-free interest rate for a period equivalent to the expected term of the option was extrapolated from the U.S. Treasury yield curve in effect at the time of the grant. The Company has never paid cash dividends and does not anticipate paying cash dividends in the foreseeable future.

5.	EARNINGS (LOSS) PER SHARE

Basic earnings (loss) per share is computed by dividing net loss by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur from common shares issuable upon the exercise of outstanding stock options or warrants and the vesting of restricted stock awards, which are reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, the amount that the employee must pay for exercising stock options or warrants, the amount of stock-based compensation cost for future services that the Company has not yet recognized, and the amount of tax benefit that would be recorded in additional paid-in capital upon exercise are assumed to be used to repurchase shares.

The following table is a reconciliation of the numerator (net loss) and the denominator (number of shares) used in the basic and diluted earnings (loss) per share calculations and sets forth potential shares of common stock that are not included in the diluted earnings (loss) per share calculation because their effect is antidilutive:

Index

	Three Months Ended March 31,
	2011			2010
Numerator - basic and diluted	$	(229,669	)	$	(1,515,404	)
Denominator - basic and diluted
Weighted average common shares outstanding		11,276,927			9,948,272
Total		11,276,927			9,948,272
Earnings (Loss) per share - basic and diluted	$	(0.02	)	$	(0.15	)
Antidilutive securities:
Options outstanding		1,016,347			948,643
Warrants		305,574			416,460
Total		1,321,921			1,365,103

6.	COMPREHENSIVE INCOME (LOSS)

The components of comprehensive income (loss) for the three months ended March 31, 2011 and 2010 are as follows:

	Three Months Ended March 31,
	2011			2010
Net loss	$	(229,669	)	$	(1,515,404	)
Foreign currency translation adjustments		88,093			6,751
Comprehensive loss	$	(141,576	)	$	(1,508,653	)

7.	INVENTORIES

Inventories are stated at the lower of cost, which approximates actual costs on a first in, first out basis, or market. Inventories at March 31, 2011 and December 31, 2010 consisted of the following:

	March 31, 2011		December 31, 2010
Finished goods	$	2,594,113	$	2,429,846
Raw materials		84,226		119,849
Inventories, net	$	2,678,339	$	2,549,695

8.	ACCRUED LIABILITIES

Accrued liabilities at March 31, 2011 and December 31, 2010 consisted of the following:

	March 31, 2011		December 31, 2010
Payroll and related	$	843,895	$	973,970
Audit and legal services		177,241		92,946
Sales and VAT taxes		56,246		175,462
Sales commissions		416,857		461,407
Warranty		589,387		530,758
Other		495,081		428,021
Total	$	2,578,707	$	2,662,564

Warranty Accrual

The Company warrants its products against material defects for a specific period of time, generally twelve months. The Company provides for the estimated future costs of warranty obligations in cost of sales when the related revenue is recognized. The accrued warranty costs represent the best estimate at the time of sale of the total costs that the Company expects to incur to repair or replace product parts which fail while still under warranty. The amount of accrued estimated warranty costs are primarily based on current information on repair costs. The Company periodically reviews the accrued balances and updates the historical warranty cost trends.

Index

Changes in the warranty accrual during the three months ended March 31, 2011 were as follows:

Warranty accrual at December 31, 2010	$	530,758
Provision for current period sales		58,629
Deductions for warranty claims processed during the period		—
Warranty accrual at March 31, 2011	$	589,387

9.	RELATED PARTY TRANSACTIONS

On July 19, 2010, the Company entered into a Master OEM Purchase and Sales Agreement with GENBAND US LLC and GENBAND Ireland Ltd. (collectively, “GENBAND”) pursuant to which GENBAND may purchase any of the Company’s existing software and hardware products, as well as procure licenses and services related to such products from Procera. In conjunction with this agreement, the Company’s Board of Directors appointed Charles D. Vogt, President and Chief Executive Officer of GENBAND, as a director of the Company.

During the three months ended March 31, 2011, the Company recognized revenue of approximately $0.5 million on sales to GENBAND. At March 31, 2011 and December 31, 2010, the Company had accounts receivable of approximately $0.5 million and $1.2 million, respectively, from GENBAND.

10.	STOCKHOLDERS’ EQUITY

On March 4, 2010, the Company closed a registered placement of its common stock primarily to institutional investors. The offering price of the Company’s common stock was $4.00 per share. The Company sold 1.8 million shares of common stock at a gross sales price of $7.2 million, and received net proceeds of approximately $6.5 million after deducting the placement agent’s commission and legal and other offering costs. The placement agent also received a warrant to purchase 18,000 shares of the Company’s common stock at an exercise price of $4.00 per share which expires on March 4, 2013. The warrant had an estimated fair value of $44,547 calculated using the Black-Scholes option pricing model.

Warrants

A summary of warrant activity for the three months ended March 31, 2011 is as follows:

	Warrants
	Number of Shares			Weighted Average Purchase Price
Outstanding December 31, 2010		409,462		$	8.39
Issued		—			—
Exercised		(102,688	)		4.00
Cancelled/expired		(1,200	)		4.00
Outstanding March 31, 2011		305,574		$	9.88

The chart below shows the outstanding warrants as of March 31, 2011 by exercise price and the average contractual life before expiration.

Exercise Price		Number Outstanding		Weighted Average Remaining Contractual Life (Years)		Number Exercisable
$	4.00		88,888		3.87		88,888
	6.00		56,912		.38		56,912
	10.00		36,000		.67		36,000
	15.00		102,000		.67		102,000
	17.50		1,775		.46		1,775
	20.00		19,999		1.30		19,999

$	9.88		305,574		1.59		305,574

11.	INCOME TAXES

At March 31, 2011 and December 31, 2010, the Company had $238,338 of unrecognized tax benefits, a total of $204,975 which would affect the Company’s effective tax rate if recognized.

Index

The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. As of March 31, 2011, the Company had no accrued interest or penalties related to uncertain tax positions. The federal returns for the years ended 2007 through the current period and most state returns for the years ended 2006 through the current period remain open to examination. In addition, all of the net operating losses and research and development credit carry-forwards that may be used in future years are still subject to adjustment. The Company's Australian and Swedish income tax returns for the years ended 2005 and 2004, respectively, through the current period are still open to examination.

The Company does not anticipate that the total unrecognized tax benefits will significantly change due to the settlement of audits and the expiration of statutes of limitations prior to March 31, 2012.

In 2002, the Company established a valuation allowance for substantially all of its deferred tax assets. Since that time, the Company has continued to record a valuation allowance. A valuation allowance is required to be established or maintained when it is more likely than not that all or a portion of deferred tax assets will not be realized. The Company will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal.

12.	COMMITMENTS AND CONTINGENCIES

Legal

The Company is periodically involved in legal actions and claims that arise as a result of events that occur in the normal course of operations. The Company does not believe that any of its legal actions and claims will have, individually or in the aggregate, a material adverse effect on the Company's financial position or results of operations.

Operating Leases

The Company leases its operating and office facilities for various terms under long-term, non-cancelable operating lease agreements. The leases expire at various dates through 2014 and provide for renewal options ranging from month-to-month to 3 year terms. In the normal course of business, it is expected that these leases will be renewed or replaced by leases on other properties. The leases provide for increases in future minimum annual rental payments based on defined increases which are generally meant to correlate with the Consumer Price Index, subject to certain minimum increases. Also, the agreements generally

require the Company to pay executory costs (real estate taxes, insurance and repairs).

The Company and its subsidiaries have entered into office lease agreements for its headquarters in Fremont, California; Netintact, AB offices in Varberg, Sweden; and Netintact PTY offices in Melbourne, Australia.

As of March 31, 2011, future minimum lease payments under operating leases are as follows:

Nine months ending December 31, 2011	$	218,601
Years ending December 31,
2012		253,891
2013		108,834
2014		19,029
Total minimum lease payments	$	600,355

Secured Line of Credit

The Company has a secured line of credit facility (the“Secured Credit Facility”) for short-term working capital purposes with Silicon Valley Bank. The Secured Credit Facility provides borrowings of up to $2.0 million through December 10, 2011. Borrowings under the facility bear interest at the prime rate plus 1%, but not less than 5% per annum. If the Company’s cash balance falls below $2,000,000, outstanding borrowings will bear an additional interest charge of 0.6875% per month, or 8.25% per annum. Under the terms of the Secured Credit Facility, the Company will pay Silicon Valley Bank a $17,000 fee in each of the two years of the agreement and will pay a minimum monthly interest charge of $3,000 per month. The Company also issued a warrant to Silicon Valley Bank for the purchase of 50,000 shares of the Company’s common stock with an exercise price of $4.00 per share and a fair value of $166,302, which is being amortized to interest expense over the two-year term of the Secured Credit Facility. The Secured Credit Facility is secured by substantially all of the Company’s assets. The terms of the Secured Credit Facility include financial covenants requiring minimum quarterly revenue and restrictions on the Company’s ability to incur certain additional indebtedness, pay dividends, create or permit liens on assets or engage in mergers, consolidations or dispositions. At March 31, 2011, the Company had $0.7 million outstanding on its Secured Credit Facility.

Index

13.	SEGMENT INFORMATION

The Company operates in one segment, using one measure of profitability to manage its business. Sales for geographic regions were based upon the customer’s location. The location of long-lived assets is based on the physical location of the Company’s regional offices. The following are summaries of sales and long-lived assets by geographical region:

	Three Months Ended
	March 31,
	2011		2010
Sales:
United States	$	3,683,414	$	1,964,891
Europe, Middle East and Africa		1,048,464		414,680
Asia Pacific		2,191,015		914,039
Total	$	6,922,893	$	3,293,610

	March 31, 2011		December 31, 2010
Long-lived assets:
United States	$	396,872	$	416,791
Europe		493,583		458,580
Australia		21,264		16,952
Total	$	911,719	$	892,323

Sales made to customers located outside the United States as a percentage of total net revenues were 47% and 40% for the three months ended March 31, 2011 and 2010, respectively.

For the three months ended March 31, 2011, revenue from two customers represented 28% and 22% of net revenue, respectively, with no other single customer representing more than 10% of net revenue. For the three months ended March 31, 2010, revenue from one customer (Cox Communications) represented 18% of net revenue, revenue from a second customer also represented 18% of net revenue, and revenue from a third customer represented 14% of net revenue, with no other single customer representing more than 10% of net revenue.

At March 31, 2011, accounts receivable from three customers represented 23%, 13% and 11%, respectively, of total accounts receivable, with no other single customer accounting for more than 10% of the accounts receivable balance. At December 31, 2010, accounts receivable from two customers represented 23% and 11%, respectively, of total accounts receivable with no other single customer accounting for more than 10% of the accounts receivable balance. As of March 31, 2011 and December 31, 2010, approximately 32% and 51%, respectively, of the Company’s total accounts receivable were due from customers outside the United States.

Index

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following is a discussion of our results of operations and current financial position. This discussion should be read in conjunction with our unaudited consolidated financial statements and related notes included elsewhere in this report and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2010.

As used in this quarterly report on Form 10-Q, references to the “Company,” “we,” “us,” “our” or similar terms include Procera Networks, Inc. and its consolidated subsidiaries.

Cautionary Note Regarding Forward-Looking Statements

Our disclosure and analysis in this quarterly report on Form 10-Q contain certain “forward-looking statements,” as such term is defined in Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These statements set forth anticipated results based on management’s plans and assumptions. From time to time, we also provide forward-looking statements in other materials we release to the public as well as oral forward-looking statements. Such statements give our current expectations or forecasts of future events; they do not relate strictly to historical or current facts. We have attempted to identify such statements by using words such as “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe,” “will,” “could”, “initial” and similar expressions in connection with any discussion of future events or future operating or financial performance or strategies. Such forward-looking statements include, but are not limited to, statements regarding:

●

our services, including the development and deployment of products and services and strategies to expand our targeted customer base and broaden our sales channels;

●

the operation of our company with respect to the development of products and services;

●

our liquidity and financial resources, including anticipated capital expenditures, funding of capital expenditures and anticipated levels of indebtedness and the ability to raise capital through financing activities;

●

trends related to and management’s expectations regarding results of operations, required capital expenditures, revenues from existing and new products and sales channels, and cash flows, including but not limited to those statements set forth below in this Item 2; and

●

sales efforts, expenses, interest rates, foreign exchange rates, and the outcome of contingencies, such as legal proceedings.

We cannot guarantee that any forward-looking statement will be realized. Achievement of future results is subject to risks, uncertainties and potentially inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from past results and those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements.

We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. We also provide the following cautionary discussion of risks and uncertainties related to our businesses. These are factors that we believe, individually or in the aggregate, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Exchange Act. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties.

Our forward-looking statements are subject to a variety of factors that could cause actual results to differ significantly from current beliefs and expectations, identified under the caption "Risk Factors" and elsewhere in this quarterly report on Form 10-Q, as well as general risks and uncertainties such as those relating to general economic conditions and demand for our products and services.

Overview

We are a leading provider of Intelligent Policy Enforcement (“IPE”) solutions that enable mobile and broadband network operators and entities managing private networks including higher education institutions, businesses and government entities (collectively referred to as network operators) to gain enhanced visibility into, and control of, their networks. Our solutions provide granular network intelligence to enable network operators to improve the quality and longevity of their networks, better monetize their network infrastructure investments, control security hazards and create and deploy new services for their users. The intelligence we provide about users and their usage enables qualified business decisions. Our network operator customers include mobile service providers, broadband service providers, cable multiple system operators (“MSOs”), Internet Service Providers (“ISPs”), educational institutions, enterprises and government agencies.

Index

Our IPE products are part of the high-growth market for mobile packet and broadband core products. The market for IPE products is expected to grow from $249 million in 2009 to $1.5 billion in 2014 according to Infonetics Research, a compound annual growth rate of 44%. Our bundled products deliver a solution that is a key element of the mobile packet and broadband core ecosystems. Our solutions are often integrated with additional elements in the mobile packet and broadband core including Policy Management and Charging functions and are compliant with the widely adopted 3rd Generation Partnership Program, or 3GPP, standard. In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, network operators are seeking higher degrees of intelligence, optimization, network management, service creation and delivery in order to differentiate their offerings and deliver a high quality of experience to their subscribers. We believe the need to create more intelligent and innovative mobile and broadband networks will continue to drive demand for our products.

Our products are marketed under the PacketLogic brand name. We have a broad spectrum of products delivering IPE at the access, edge and core layers of the network. Our products are designed to offer maximum flexibility to our customers and enable differentiated services and revenue-enhancing applications, all while delivering a high quality of service for subscribers.

We face competition from suppliers of standalone IPE and deep packet inspection (“DPI”) products including Allot Communications, Arbor Networks, Blue Coat Systems, Brocade Communications Systems, Cisco Systems, Cloudshield Technologies, Ericsson, Huawei Technologies Company, Juniper Networks, and Sandvine Corporation. Some of our competitors supply platform products with different degrees of DPI functionality, such as switch/routers, routers, session border controllers and VoIP switches.

Most of our competitors are larger and more established enterprises with substantially greater financial and other resources. Some competitors may be willing to reduce prices and accept lower profit margins to compete with us. As a result of such competition, we could lose market share and sales, or be forced to reduce our prices to meet competition. However, we do not believe there is a dominant supplier in our market. Based on our belief in the superiority of our technology, we believe that we have an opportunity to capture meaningful market share and benefit from what we believe will be growth in the DPI market.

We were founded in 2002 and became a public company in October 2003 following our merger with Zowcom, Inc., a publicly-traded Nevada corporation. In 2006, we completed acquisitions of the Netintact entities. Our Company is headquartered in Fremont, California with regional headquarters in Varberg, Sweden and Singapore. We sell our products through our direct sales force, resellers, distributors and systems integrators in the Americas, Asia Pacific and Europe.

Critical Accounting Estimates

Our discussion and analysis of our financial condition and results of operations are based upon financial statements which have been prepared in accordance with Generally Accepted Accounting Principles in the United States (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate these estimates. We base our estimates on historical experience and on assumptions that are believed to be reasonable. These estimates and assumptions provide a basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, and these differences may be material.

The Company believes the following critical accounting policies reflect our most significant estimates, judgments and assumptions used in the preparation of our consolidated financial statements:

●

Revenue Recognition;

●

Valuation of Goodwill, Intangible and Long-Lived Assets;

●

Allowance for Doubtful Account;

●

Stock-Based Compensation; and

●

Accounting for Income Taxes.

These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2010, updated for changes in accounting for revenue recognition as a result of the new accounting standards as described below.

Revenue Recognition

Index

Receipt of a customer purchase order is the primary method of determining that persuasive evidence of an arrangement exists.

Customer orders normally contain multiple items. The initial product delivery consists of the hardware and software elements, and these elements have standalone value to the customer. Through March 31, 2011, in virtually all of the Company’s contracts, the only elements that remained undelivered at the time of product delivery were PCS services. Prior to January 1, 2011, the majority of the Company’s transactions were within the scope of the software revenue recognition guidance. The company accordingly recognized revenue for delivered items using the residual method, after allocating revenue to PCS services based on vendor specific objective evidence of fair value (“VSOE”).

Index

Recent Accounting Pronouncements

There have been no recent accounting pronouncements during the three months ended March 31, 2011, that management believes are of significance, or potential significance, to the Company.

Results of Operations

Comparison of Three Months Ended March 31, 2011 and 2010

Revenue

	Three Months Ended
	March 31,
	2011		2010		Increase
	($ in thousands)

Net product revenue	$	5,616	$	2,383		136	%
Net support revenue		1,307		911		44	%
Total revenue	$	6,923	$	3,294		110	%

Our revenue is derived from two sources: product revenue, which includes sales of our hardware appliances bundled with software licenses, and service revenue, which includes revenue from support and services.

The increase in product revenue of 136% for the three months ended March 31, 2011, compared with the same period in 2010, reflected increased sales of our high-end PL8000 series products. A majority of the increase in product revenue resulted from follow-on sales to one multisystem cable operator customer that had purchased product in 2010, as this customer pursues plans to expand the deployment of our product within their network.

The increase in support revenue of 44% for the three months ended March 31, 2011, compared with the same period in 2010, reflected the continued expansion of the installed base of our product to which we have sold ongoing support services.

We believe that our revenue will continue to grow in each of the remaining quarters of the fiscal year ending December 31, 2011, as compared with the same periods in 2010.

Index

Cost of Sales

Cost of sales includes: (i) direct labor and material costs for products sold, (ii) costs expected to be incurred for warranty and (iii) adjustments to inventory values, including the write-down of slow moving or obsolete inventory.

The following table presents the breakdown of cost of sales by category:

	Three Months Ended
	March 31,
	2011			2010			Change
	($ in thousands)

Materials and per-use licenses	$	1,958		$	1,185
Percent of net product revenue		35	%		50	%		65	%
Applied labor and overhead		450			212
Percent of net product revenue		8	%		9	%		112	%
Other indirect costs		175			55
Percent of net product revenue		3	%		2	%		218	%
Product costs		2,583			1,452
Percent of net product revenue		46	%		61	%		78	%

Support costs		136			127
Percent of net support revenue		10	%		14	%		7	%

Total costs of sales	$	2,719		$	1,579
Percent of total net revenue		39	%		48	%		72	%

Total cost of sales during the three months ended March 31, 2011 increased by approximately $1.1 million and decreased as a percentage of sales by 9 percentage points, compared to the same period in 2010. The increase in cost of sales primarily reflected higher material costs associated with increased product revenue. The decrease in cost of sales as a percentage of revenue primary reflected increased sales of our PL8000 series products, which have a lower material cost compared with our other products, and an increase in support revenue which increased at a higher rate than corresponding support costs.

Gross Profit

Gross profit for the three-month periods ended March 31, 2011 and 2010 was as follows:

	Three Months Ended
	March 31,
	2011			2010			Increase
	($ in thousands)
Gross profit	$	4,203		$	1,714			145	%
Percent of total net revenue		61	%		52	%

Gross profit margin for the three months ended March 31, 2011 increased by 9 percentage points to 61% from 52% in the comparable period in the prior year. This increase reflected the ramp in sales of our PL8000 series products, introduced in mid-2010, which have a higher margin compared with our other products, and a higher margin earned on support revenue, as support revenue increased while related support costs remained flat.

Index

Operating Expense

Operating expenses for the three-month periods ended March 31, 2011 and 2010 were as follows:

	Three Months Ended
	March 31,
	2011			2010			Increase
	($ in thousands)

Research and development		$	1,038		$	620		67	%
Sales and marketing			2,064			1,457		42	%
General and administrative			1,276			1,107		15	%
Total		$	4,379		$	3,185		37	%

Research and Development

Research and development expenses include costs associated with personnel focused on the development or improvement of our products, prototype materials, initial product certifications and equipment costs. Research and development costs include sustaining and enhancement efforts for products already released and development costs associated with planned new products.

	Three Months Ended
	March 31,
	2011			2010			Increase
	($ in thousands)

Research and development	$	1,038		$	620			67	%
Percentage of total net revenue		15	%		19	%

Research and development expenses for the three months ended March 31, 2011 increased significantly compared to the same period in 2010 as a result of increased hires of research and development personnel in 2010 and the corresponding additional employee compensation costs. Additional personnel are expected to allow us to expand upon our core product features and functionality in order to support new sales and to achieve follow-on sales to our current customers. Stock-based compensation recorded to research and development expenses in the three months ended March 31, 2011 and 2010 was $42,772 and $5,247, respectively. As a percentage of revenue, research and development expenses decreased by 4 percentage points compared to the same period in 2010 because revenue increased at a faster rate than research and development expenses.

Sales and Marketing

Sales and marketing expenses primarily include personnel costs, sales commissions and marketing expenses, such as trade shows, channel development and literature.

	Three Months Ended
	March 31,
	2011			2010			Increase
	($ in thousands)

Sales and marketing	$	2,064		$	1,457			42	%
Percentage of total net revenue		30	%		44	%

Sales and marketing expenses for the three months ended March 31, 2011 increased by $606,988 compared to the same period in 2010. This increase in sales and marketing expenses reflected increased commission costs as a result of the increase in revenue, and the cost of increased headcount, resulting from the hiring of additional sales personnel. Stock-based compensation recorded to sales and marketing expense in the three months ended March 31, 2011 and 2010 was $109,663 and $62,946, respectively.

General and Administrative

General and administrative expenses consist primarily of personnel and facilities costs related to our executive, finance function, service fees for professional services and amortization of intangible assets. Professional services include costs for legal advice and services, independent auditors and investor relations.

Index

	Three Months Ended
	March 31,
	2011			2010			Increase
	($ in thousands)

General and administrative	$	1,276		$	1,107			15	%
Percentage of total net revenue		18	%		34	%

General and administrative expenses for the three months ended March 31, 2011 increased by $168,811 compared to the same period in 2010. This increase in general and administrative expenses reflected higher accrued bonuses connected with the increase in revenue and higher legal spending. Stock-based compensation recorded to general and administrative expense in the three months ended March 31, 2011 and 2010 was $188,225 and $214,682, respectively.

Interest and Other Income (Expense), Net

	Three Months Ended
	March 31,
	2011			2010			Decrease
	($ in thousands)

Interest and other income (expense), net	$	(30	)	$	(43	)		(30)	%

Interest and other income (expense), net decreased during the three months ended March 31, 2011 as a result of lower interest expense following the repayment of $500,000 of notes payable during the three months ended March 31, 2010. Interest and other income (expense), net currently primarily reflects interest costs connected with our 2-year secured credit facility with Silicon Valley Bank entered into on December 10, 2009.

Provision for Income Taxes

	Three Months Ended
	March 31,
	2011		2010		Increase
	($ in thousands)

Provision for income taxes	$	24	$	1		2300	%

The Company is subject to taxation primarily in the U.S., Sweden, and Australia, as well as in a number of states, including California. The increase in the tax provision for the three months ended March 31, 2011 reflects higher state and foreign taxes as a result of the increase in revenues.

Liquidity and Capital Resources

Cash and Cash Equivalents and Investments

The following table summarizes the changes in our cash balance for the periods indicated:

	Three Months Ended
	March 31,
	2011			2010
	(in thousands)

Net cash provided by operating activities	$	2,394		$	3,036
Net cash used in investing activities		(71	)		(115	)
Net cash provided by (used in) financing activities		(785	)		4,054
Effect of exchange rate changes on cash and cash equivalents		(48	)		(20	)
Net increase in cash and cash equivalents	$	1,490		$	6,954

Index

During the three months ended March 31, 2011 and 2010, our operations provided $2.4 million and $3.0 million of cash, respectively. The $2.4 million of cash provided by our operating activities during the three months ended March 31, 2011 reflected $2.5 million of cash provided by the collection of accounts receivable, partially offset by other net uses of cash. The $3.0 million of cash provided by our operating activities during the three months ended March 31, 2010 reflected $5.5 million of cash provided by the collection of accounts receivable, partially offset by our use of cash connected with our $1.5 million net loss for the period and in buying inventory and payments made for accounts payable and accrued liabilities. The net cash used by our financing activities during the three months ended March 31, 2011 was $0.8 million, which included a $1.0 million net repayment of borrowings on our credit line, partially offset by $0.2 million of proceeds from the exercise of stock options. The net cash provided by our financing activities during the three months ended March 31, 2010 was $4.1 million, which included proceeds from the issuance of common stock of $6.5 million, a $1.9 million repayment of the borrowings against our secured credit facility and a $500,000 repayment of notes.

Based on our current cash balances and anticipated cash flow from operations, we believe our working capital will be sufficient to meet the cash needs of our business for at least the next twelve months. Our future capital requirements will depend on many factors, including our rate of growth, the expansion of our sales and marketing activities, development of additional channel partners and sales territories, the infrastructure costs associated with supporting a growing business and greater installed base of customers, introduction of new products, enhancement of existing products and the continued acceptance of our products. We may also enter into arrangements that require investment such as complimentary businesses, service expansion, technology partnerships or acquisitions.

On December 10, 2009, we entered into a two-year loan and security agreement for a secured credit facility of $2.0 million for short-term working capital purposes with Silicon Valley Bank. At March 31, 2011 and December 31, 2010, we had $0.7 million and $1.7 million outstanding, respectively, under our credit facility with Silicon Valley Bank. Borrowings under this facility bear interest at the prime rate plus 1%, but not less than 5% on an annual basis. If our cash balance falls below $2,000,000, outstanding borrowings will bear an additional interest charge of 0.6875% per month, or 8.25% per annum.

Off-Balance Sheet Arrangements

As of March 31, 2011, we had no off-balance sheet items as described in Item 303(a)(4)(ii) of SEC Regulation S-K. We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose us to material continuing risks, contingent liabilities or any other obligations under a variable interest in an unconsolidated entity that provides us with financing, liquidity, market risk or credit risk support.

Contractual Obligations

We lease facility space under non-cancelable operating leases in California, Sweden and Australia that extend through 2014. The details of these contractual obligations are further explained in Note 12 of the Notes to Condensed Consolidated Financial Statements.

We use third-party contract manufacturers to assemble and test our hardware products. In order to reduce manufacturing lead-times and ensure an adequate supply of inventories, our agreements with some of these manufacturers allow them to procure long lead-time component inventory based on rolling production forecasts provided by us. We may be contractually obligated to purchase long lead-time component inventory procured by certain manufacturers in accordance with our forecasts. In addition, we issue purchase orders to our third-party manufacturers that may not be cancelable at any time. As of March 31, 2011, we had open non-cancelable purchase orders amounting to $2.3 million, primarily with our third-party contract manufacturers.

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

Foreign Currency Risk

Our sales contracts are denominated predominantly in U.S. Dollars, Swedish Krona, Australian Dollars and the Euro. We incur operating expenses in U.S. Dollars, Swedish Krona and Australian Dollars. Therefore, we are subject to fluctuations in these foreign currency exchange rates. However, to date, exchange rate fluctuations have had minimal impact on our operating results and cash flows, and we have not used derivative instruments to hedge our foreign currency exposures.

Interest Rate Sensitivity

We had unrestricted cash totaling approximately $9.4 million at March 31, 2011. The unrestricted cash is held for working capital purposes. All of our cash is currently held in demand deposit and savings accounts. Therefore, we do not believe that we have any material exposure to changes in the fair market value as a result of changes in interest rates. We do not enter into investments for trading or speculative purposes.

Item 4.

Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We have adopted and maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that controls and procedures, no matter how well designed and operated, cannot provide absolute assurance of achieving the desired control objectives.

Index

As required by Rule 13a-15(b), under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during the period ended March 31, 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.

Legal Proceedings

We are at times involved in litigation and other legal claims in the ordinary course of business. When appropriate in management’s estimation, we may record reserves in our financial statements for pending litigation and other claims. Although it is not possible to predict with certainty the outcome of litigation, we do not believe that any of the current pending legal proceedings to which we are a party or to which any of our property is subject will have a material impact on our results of operations or financial condition.

Item 1A.

Risk Factors

We have marked with an asterisk (*) those risk factors below that reflect material changes from the risk factors included in our Annual Report on Form 10-K for the year ended December 31, 2010 filed with the Securities and Exchange Commission on March 16, 2011.

You should carefully consider the risks described below, together with all of the other information included in this Quarterly Report on Form 10-Q, in considering our business and prospects. Set forth below and elsewhere in this report and in other documents we file with the SEC are descriptions of the risks and uncertainties that could cause our actual results to differ materially from the results contemplated by the forward-looking statements contained in this report. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. Each of these risk factors could adversely affect our business, operating results and financial condition, as well as adversely affect the value of an investment in our common stock.

Risks Related to Our Business

*We expect to incur losses in future periods.

For the quarters ended March 31, 2011 and 2010, we incurred losses from operations of approximately $0.2 million and $1.5 million, respectively. For the years ended December 31, 2010 and 2009, we incurred losses from operations of approximately $2.7 million and $6.2 million, respectively. We expect to continue to incur losses from operations in future periods. Any profitability we may achieve in the future may not be indicative of sustained profitability. Any losses incurred in the future may result primarily from increased costs related to continued investments in sales and marketing, product development and administrative expenses. If our revenue growth does not occur or is slower than anticipated or our operating expenses exceed expectations, our losses will be greater. We may never achieve profitability.

Our PacketLogic family of products is our only product line. All of our current revenues and a significant portion of our future growth depend on our ability to continue its commercialization.

All of our current revenues and much of our anticipated future growth depend on the development, introduction and market acceptance of new and enhanced products in our PacketLogic product line that address additional market requirements in a timely and cost-effective manner. In the past, we have experienced delays in product development and such delays may occur in the future. We do not currently have plans or resources to develop additional product lines, and as a result, our future growth will largely be determined by market acceptance of our PacketLogic product line.

If additional customers do not adopt, purchase and deploy our PacketLogic products, our revenues will not grow and may decline. In addition, 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 and exposing us to greater risk of product obsolescence.

Index

We need to increase the functionality of our products and offer additional features in order to be competitive.

The market in which we operate is highly competitive and unless we continue to enhance the functionality of our products and add additional features, our competitive position may deteriorate and the average selling prices for our products may decrease over time. Such a decrease could result from the introduction of competing products and from the standardization of DPI technology. To counter this trend, we endeavor to enhance our products by offering higher system speeds and additional features, such as additional protection functionality, supporting additional applications and enhanced reporting tools. We may also need to reduce our per unit manufacturing costs at a rate equal to or faster than the rate at which selling prices decline. If we are unable to reduce these costs or to offer increased functionally and features, our results of operations and financial condition may be adversely affected.

If our products contain undetected software or hardware errors or performance deficiencies, we could incur significant unexpected expenses, experience purchase order cancellations and lose sales.

Network products frequently contain undetected software or hardware errors, failures or bugs when new products or new versions or updates of existing products are first released to the marketplace. Because we frequently introduce new versions and updates to our product line, previously unaddressed errors in the accuracy or reliability of our products, or issues with their performance, may arise. We expect that such errors or performance deficiencies will be found from time to time in the future in new or existing products, including the components incorporated therein, after the commencement of commercial shipments. These problems may have a material adverse effect on our business by requiring us to incur significant warranty repair costs and support related replacement costs, diverting the attention of our engineering personnel from new product development efforts, delaying the recognition of revenue and causing significant customer relations problems.

In addition, if our products are not accepted by customers due to software or hardware defects or performance deficiencies, orders contingent upon acceptance may be cancelled, which could result in lost sales opportunities. In this circumstance, or if warranty returns exceed the amount we have accrued for defect returns based on our historical experience, our results of operations and financial condition may be adversely affected.

Our products must properly interface with products from other vendors. As a result, when problems occur in a computer or communications network, it may be difficult to identify the sources of these problems. The occurrence of hardware and software errors, whether or not caused by our products, could result in the delay or loss of market acceptance of our products and any necessary revisions may cause us to incur significant expenses. The occurrence of any such problems would likely have a material adverse effect on our results of operations and financial condition.

We may need to raise further capital, which could dilute or otherwise adversely affect your interest in our Company.

We believe that our existing cash, cash equivalents and short term investments, along with the cash that we expect to generate from operations and any required debt financing that management currently believes is available, will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for the next twelve months.

However, a number of factors may negatively impact our level of cash availability and working capital requirements, including, without limitation:

●

lower than anticipated revenues;

●

higher than expected cost of goods sold or operating expenses; or

●

the inability of our customers to pay for the goods and services ordered.

We believe that current general economic conditions and the recent global credit market crisis have created a significantly more difficult environment for obtaining both equity and debt financing. If additional funds are raised through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced, stockholders may experience additional dilution and such securities may have rights, preferences and privileges senior to those of our common stock. There can be no assurance that additional financing will be available on terms favorable to us or at all, especially in light of the current economic environment. If adequate funds are not available on acceptable terms, we may not be able to fund expansion, take advantage of unanticipated growth or acquisition opportunities, develop or enhance services or products or respond to competitive pressures. In addition, we may be required to defer or cancel product development programs, lay-off employees and/or take other steps to reduce our operating expenses. Our inability to raise additional financing or the terms of any financing we do raise could have a material adverse effect on our business, results of operations and financial condition.

*We have a limited operating history on which to evaluate our company.

The products we sell today are derived primarily from the acquisition of the Netintact companies in 2006. While we have the experience of Netintact operations on a stand-alone basis, we are continuing to improve our operations on a combined basis.

Index

Furthermore, we have only recently launched many of our products and services on a worldwide basis, and we are continuing to develop relationships with distribution partners and otherwise exploit sales channels in new markets. Therefore, investors should consider the risks and uncertainties frequently encountered by companies in new and rapidly evolving markets, which include the following:

●

successfully introducing new products and entering new markets;

●

successfully servicing and upgrading new products once introduced;

●

increasing brand recognition;

●

developing strategic relationships and alliances;

●

managing expanding operations and sales channels;

●

successfully responding to competition; and

●

attracting, retaining and motivating qualified personnel.

If we are unable to address these risks and uncertainties, our results of operations and financial condition may be adversely affected.

Competition for experienced and skilled personnel is intense and our inability to attract and retain qualified personnel could significantly damage our business.

Our future performance 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, retain and motivate high caliber key personnel. We have recently hired new employees and our plans to expand in all areas will require experienced personnel to augment our current staff. We expect to recruit experienced professionals in such areas as software and hardware development, sales, technical support, product marketing and management. We currently plan to expand our indirect channel partner program and we need to attract qualified business partners to broaden these sales channels. Economic conditions may result in significant competition for qualified personnel and we may not be able to attract and retain such personnel. Our business may suffer if we encounter material delays in hiring additional personnel.

Our performance is substantially dependent on the continued services and on the performance of our executive officers and other key employees, including our Chief Executive Officer, James Brear, and our Chief Technical Officer, Alexander Haväng. The loss of the services of any of our executive officers or other key employees could materially and adversely affect our business. We believe we will need to attract, retain and motivate talented management and other highly skilled employees in order to execute on our business plan. We may be unable to retain our key employees or attract, assimilate and retain other highly qualified employees in the future. Competitors and others have in the past, and may in the future, attempt to recruit our employees. In California, where we are headquartered, non-competition agreements with employees generally are unenforceable. As a result, if an employee based in California leaves the Company for any reason, he or she will generally be able to begin employment with one of our competitors or otherwise to compete immediately against us.

We currently do not have key person insurance in place. If we lose one of our key officers, we must attract, hire, and retain an equally competent person to take his or her place. There is no assurance that we would be able to find such an employee in a timely fashion. If we fail to recruit an equally qualified replacement or incur a significant delay, our business plans may slow down. We could fail to implement our strategy or lose sales and marketing and development momentum.

Failure to expand our sales teams or educate them about technologies and our product families may harm our operating results.

The sale of our products requires a multi-faceted approach directed at several levels within a prospective customer’s organization. We may not be able to increase net revenue unless we expand our sales teams to address all of the customer requirements necessary to sell our products. We expect to continue hiring in sales and marketing, but there can be no assurance that personnel additions will have a positive effect on our business.

We cannot assure you that we will be able to successfully integrate new employees into the Company or to educate current and future employees with regard to rapidly evolving technologies and our product families. Failure to do so may hurt our revenue growth and operating results.

Index

Increased customer demands on our technical support services may adversely affect our relationships with our customers and our financial results.

We offer technical support services with our products. We may be unable to respond quickly enough to accommodate short-term increases in customer demand for support services. We also may be unable to modify the format of our support services to compete with changes in support services offered by our competitors. Further customer demand for these services, without corresponding revenues, could increase costs and adversely affect our operating results. If we experience financial difficulties, do not maintain sufficiently skilled workers and resources to satisfy our contracts, or otherwise fail to perform at a sufficient level under these contracts, the level of support services to our customers may be significantly disrupted, which could materially harm our relationships with these customers and our results of operations.

We must continue to develop and increase the productivity of our indirect distribution channels to increase net revenue and improve our operating results.

A key focus of our distribution strategy is developing and increasing the productivity of our indirect distribution channels through resellers and distributors. If we fail to develop and cultivate relationships with significant resellers, or if these resellers are not able to execute on their sales efforts, sales of our products may decrease and our operating results could suffer. Many of our resellers also sell products from other vendors that compete with our products. We cannot assure you that we will be able to enter into additional reseller and/or distribution agreements or that we will be able to manage our product sales channels. Our failure to do any of these could limit our ability to grow or sustain revenue. In addition, our operating results will likely fluctuate significantly depending on the timing and amount of orders from our resellers. We cannot assure you that our resellers and/or distributors will continue to market or sell our products effectively or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. Such failure would negatively affect revenue and our potential to achieve profitability.

We may be unable to compete effectively with competitors which are substantially larger and more established and have greater resources.

In our rapidly evolving and highly competitive market, we compete on the price as well as the performance of our products. We expect competition to remain intense in the future. 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 have a negative financial impact on our business. We compete with Allot Communications, Arbor Networks, Blue Coat Systems, Brocade Communications Systems, Cisco Systems, Cloudshield Technologies, Ericsson, Huawei Technologies Company, Juniper Networks, and Sandvine Corporation, as well as other companies which sell products incorporating competing technologies. In addition, our products and technology compete with other types of products that offer monitoring capabilities, such as probes and related software. We also face indirect competition from companies that offer broadband service providers increased bandwidth and infrastructure upgrades that increase the capacity of their networks, which may lessen or delay the need for bandwidth management solutions.

Most of our competitors are substantially larger than we are and have significantly greater name recognition and financial, sales and marketing, technical, manufacturing and other resources and more established distribution channels than we do. In addition, some potential customers have in the past advised us that we were not able to compete for their business due to concerns about our financial condition. While we have attempted to address balance sheet concerns with our recent financing activities, it is possible that a potential customer could raise similar concerns in the future. Our 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. Furthermore, prospective customers often have expressed greater confidence in the product offerings of our competitors. Some of our competitors may make acquisitions or establish strategic relationships that may increase their ability to rapidly gain market share by addressing the needs of our prospective customers. Competitors may enter our existing or future markets with solutions that may be less expensive, provide higher performance or provide additional features than our solutions. Given the opportunities in the bandwidth management solutions market, we also expect that other companies may enter 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.

*A substantial portion of our revenues may be dependent on a small number of Tier 1 service providers that purchase in large quantities. If we are unable to maintain or replace our relationships with these customers, our revenues may fluctuate and our growth may be limited.

Since 2008, when we first established customer relations with Tier 1 service providers, a significant portion of our revenues has come from a limited number of customers. There can be no guarantee that we will be able to sustain our revenue levels from these customers because their capacity requirements have become or will become fulfilled. For this reason, we do not expect that any single customer will generally remain a significant customer from year to year, and we will need to attract new customers in order to sustain our revenues.

Index

In the quarter ended March 31, 2011, revenues from two customers represented 28% and 22% of net revenues, respectively, with no other single customer accounting for more than 10% of net revenue. In the quarter ended March 31, 2010, revenues from two customers each represented 18% of net revenues and a third represented 14% of net revenue, with no other single customer accounting for more than 10% of net revenue. In the years ended December 31, 2010 and 2009, revenue from one customer represented 11% and 44% of net revenues, respectively, with no other single customer accounting for more than 10% of net revenue. The proportion of our revenues derived from a limited number of customers may be even higher in any future year or quarter. If we cannot maintain or replace the customers that purchase large amounts of our products, or if they do not purchase products at the levels or at the times that we anticipate, our ability to maintain or grow our revenues will be adversely affected.

If we are unable to effectively manage our anticipated growth, we may experience operating inefficiencies and have difficulty meeting demand for our products.

We seek to manage our growth so as not to exceed our available capital resources. If our customer base and market grow rapidly, we would need to expand to meet this demand. 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.

If demand for our products and services grows rapidly, we may experience difficulties meeting the demand. For example, the installation and use of our products requires customer training. If we are unable to provide adequate training and support for our products, the implementation process will be longer and customer satisfaction may be lower. In addition, we may not be able to exploit fully the growing 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. The failure to meet the challenges presented by rapid customer and market expansion could cause us to miss sales opportunities and otherwise have a negative impact on our sales and profitability.

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.

Unstable market and economic conditions may have serious adverse consequences on our business.

Our general business strategy may be adversely affected by the current volatile global business environment and continued unpredictable and unstable market conditions. If financial markets continue to experience volatility or deterioration, it may make any debt or equity financing that we require more difficult, more costly, and more dilutive. In addition, a renewed or deeper economic downturn may result in reduced demand for our products, or adversely impact our customers’ ability to pay for our products, which would harm our operating results. There is also a risk that one or more of our current service providers, manufacturers and other partners may not survive in the current economic environment, which would directly affect our ability to attain our operating goals on schedule and on budget. Failure to secure any necessary financing in a timely manner and on favorable terms could have a material adverse effect on our results of operations and financial condition.

We have limited ability to protect our intellectual property and defend against claims which may adversely affect our ability to compete.

We rely primarily on patents, trade secrets, contractual rights and trademark law to protect our intellectual property rights in our PacketLogic product line. We cannot assure you that the actions we have taken will adequately protect our intellectual property rights or that other parties will not independently develop similar or competing products that do not infringe on our patents. We enter into confidentiality or license agreements with our employees, consultants and corporate partners, and take appropriate measures to control access to and distribution of our software, documentation and other proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise misappropriate or use our products or technology.

In an effort to protect our unpatented proprietary technology, processes and know-how, we require our employees, consultants, collaborators and advisors to execute confidentiality agreements. These agreements, however, may not provide us with adequate protection against improper use or disclosure of confidential information. These agreements may be breached, and we may not become aware of, or have adequate remedies in the event of, any such breach. In addition, in some situations, these agreements may conflict with, or be subject to, the rights of third parties with whom our employees, consultants, collaborators or advisors have previous employment or consulting relationships. Furthermore, others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets.

Our industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent and other intellectual property rights. If we are found to infringe on the proprietary rights of others, or if we agree to settle any such claims, we could be compelled to pay damages or royalties and either obtain a license to those intellectual property rights or alter our products so that they no longer infringe upon such proprietary rights. Any license could be very expensive to obtain or may not be available at all. Similarly, changing our products or processes to avoid any claims of infringement may be costly or impractical. Litigation resulting from claims that we are infringing the proprietary rights of others could result in substantial costs and a diversion of resources, and could have a material adverse effect on our results of operations and financial condition.

Index

We rely on a small number of contract manufacturers to build our hardware products. If we are unable to have our products manufactured quickly enough to keep up with demand or we experience manufacturing quality problems, our operating results could be harmed.

If the demand for our products grows, we will need to increase our capacity for material purchases, production, testing and quality control functions. Any disruptions in product flow could limit our revenue growth and adversely affect our competitive position and reputation, and result in additional costs or cancellation of orders under agreements with our customers.

While our PacketLogic products are software based, we rely on independent contract manufacturers to manufacture the hardware components on which are products are installed and operate. In certain circumstances, these contract manufacturers also provide logistics services, which may include loading our software products onto the hardware platforms, testing and inspecting the products, and then shipping them directly to our customers. If these contract manufacturers are unable to meet our demand, or fail to provide such logistics services as we may request in a timely manner, we may experience delays in product shipments. Other performance problems with contract manufacturers may arise in the future, such as inferior quality, insufficient quantity of products, or the interruption or discontinuance of operations of a manufacturer, any of which could have a material adverse effect on our business and operating results.

We do not know whether we will effectively manage our contract manufacturers or that these manufacturers will meet our future requirements for timely delivery of product components of sufficient quality and quantity. If one or more of our contract manufacturers were to experience financial difficulties or decide not to continue its business relationship with us, we would need to identify other contract manufacturers to perform these services, and there could be product delivery delays while we seek to establish and implement the new relationship. We also plan to introduce new products and product enhancements, which will require that we rapidly achieve volume production by coordinating our efforts with those of our suppliers and contract manufacturers. Any delays in meeting customer demand or quality problems resulting from the inability of our contract manufacturers to provide us with adequate supplies of high-quality product components, including problems relating to logistic services, could result in lost or reduced future sales to key customers and could have a material adverse effect on our sales and results of operations.

As part of our cost management efforts, we endeavor to lower per unit product costs from our contract manufacturers by means of volume efficiencies and the utilization of manufacturing sites in lower-cost geographies. However, we cannot be certain when or if such cost reductions will occur. The failure to obtain such cost reductions would adversely affect our gross margins and operating results.

If our suppliers fail to adequately supply us with certain original equipment manufacturer, or OEM, sourced components, our product sales may suffer.

Reliance upon OEMs, as well as industry supply conditions, generally involves several additional risks, including the possibility of a shortage of components and reduced control over delivery schedules (which can adversely affect our distribution schedules), and increases in component costs (which can adversely affect our profitability). Most of our hardware products, or the components of our hardware components, are based on industry standards and are therefore available from multiple manufacturers. If our supplier were to fail to deliver, alternative suppliers should be available, although qualification of the alternative manufacturers and establishment of reliable suppliers could result in delays and a possible loss of sales, which could affect operating results adversely. However, in some specific cases we have single-sourced components, because alternative sources are not currently available. If these components were not available for a period of time, we could experience product supply interruptions, delays or inefficiencies, which could have a material adverse effect on our results of operations and financial condition.

Sales of our products to large broadband service providers often involve a lengthy sales cycle, which may cause our revenues to fluctuate from period to period and could result in us expending significant resources without making any sales.

Our sales cycles often are lengthy, because our prospective customers undertake significant testing to assess the performance of our products within their networks. As a result, we may invest significant time from initial contact with a customer before that end-customer decides to purchase and incorporate our products in its network. We may also expend significant resources attempting to persuade large broadband service providers to incorporate our products into their networks without any measure of success. Even after deciding to purchase our products, initial network deployment and acceptance testing of our products by a large broadband service provider may last several years. Carriers, especially in North America, often require that products they purchase meet Network Equipment Building System, or NEBS, certification requirements, which relate the reliability of telecommunications equipment. While our PacketLogic products and future products are and are expected to be designed to meet NEBS certification requirements, they may fail to do so.

Index

Due to our lengthy sales cycle, particularly to larger customers, and our revenue recognition practices, we expect our revenue may fluctuate significantly from period to period. In pursuing sales opportunities with larger enterprises, we expect that we will make fewer sales to larger entities, but that the magnitude of individual sales will be greater. We may report substantial revenue growth in the period that we recognize the revenue from a large sale, which may not be repeated in an immediately subsequent period. Because our revenues may fluctuate materially from period to period, the price of our common stock may decline. In addition, even after we have received commitments from a customer to purchase our products, in accordance with our revenue recognition practices we may not be able to recognize and report the revenue from that purchase for months or years after the time of purchase. As a result, there could be significant delays in our receipt and recognition of revenue following sales orders for our products.

In addition, if a competitor succeeds in convincing a large broadband service provider to adopt that competitor’s product, it may be difficult for us to displace the competitor at a later time because of the cost, time, effort and perceived risk to network stability involved in changing solutions. As a result, we may incur significant sales and marketing expenses without generating any sales.

Our operating results could be adversely affected by product sales occurring outside the United States and fluctuations in the value of the United States Dollar against foreign currencies.

A significant percentage of PacketLogic sales are generated outside of the United States. PacketLogic sales and operating expenses denominated in foreign currencies could affect our operating results as foreign currency exchange rates fluctuate. Changes in exchange rates between these foreign currencies and the U.S. Dollar will affect the recorded levels of our assets and liabilities because we translate foreign net sales, costs of goods, assets and liabilities into U.S. Dollars for presentation in our financial statements. The primary foreign currencies for which we have exchange rate fluctuation exposure are the European Union Euro, the Swedish Krona and the Australian Dollar. If our revenues continue to grow, we could be exposed to exchange rate fluctuations in other currencies. Exchange rates between these currencies and U.S. Dollars have fluctuated significantly in recent years and may do so in the future. Hedging foreign currencies can be difficult. We cannot predict the impact of future exchange rate fluctuations on our operating results. We currently do not hedge our foreign currency risk.

Legislative actions, higher insurance costs and new accounting pronouncements are likely to impact our future financial position and results of operations.

Legislative and regulatory changes and future accounting pronouncements and regulatory changes have, and will continue to have, an impact on our future financial position and results of operations. In addition, insurance costs, including health and workers’ compensation insurance premiums, have been increasing on an historical basis and are likely to continue to increase in the future. Recent and future pronouncements related to the accounting treatment of executive compensation and employee stock options may also impact operating results. These and other potential changes could materially increase the expenses we report under generally accepted accounting principles, and adversely affect our operating results.

Our internal controls may be insufficient to ensure timely and reliable financial information.

Effective internal controls over financial reporting are necessary for us to provide reliable financial reports and effectively prevent fraud. 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 U.S. Generally Accepted Accounting Principles (“GAAP”). A company’s internal control over financial reporting includes those policies and procedures that:

●

pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;

●

provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and

●

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.

A material weakness 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.

For the years ended December 31, 2010 and 2009, we did not identify any material weaknesses in our internal controls.

Index

Under the supervision of our Audit Committee, we are continuing the process of identifying and implementing corrective actions where required to improve the design and effectiveness of our internal control over financial reporting, including the enhancement of systems and procedures. We have a small accounting staff and limited resources and expect that we will continue to be subject to the risk of additional material weaknesses and significant deficiencies.

Even after corrective actions are implemented, the effectiveness of our controls and procedures may be limited by a variety of risks including:

●

faulty human judgment and simple errors, omissions or mistakes;

●

collusion of two or more people;

●

inappropriate management override of procedures; and

●

the risk that enhanced controls and procedures may still not be adequate to assure timely and reliable financial information.

If we fail to have effective internal controls and procedures for financial reporting in place, we could be unable to provide timely and reliable financial information. Additionally, if we fail to have effective internal controls and procedures for financial reporting in place, it could adversely affect our ability to comply with financial reporting requirements under certain government contracts.

Accounting charges may cause fluctuations in our annual and quarterly financial results which could negatively impact the market price of our common stock.

Our financial results may be materially affected by non-cash and other accounting charges. Such accounting charges may include:

●

amortization of intangible assets, including acquired product rights;

●

impairment of goodwill;

●

stock-based compensation expense; and

●

impairment of long-lived assets.

The foregoing types of accounting charges may also be incurred in connection with or as a result of business acquisitions. The price of our common stock could decline to the extent that our financial results are materially affected by the foregoing accounting charges. Our effective tax rate may increase, which could increase our income tax expense and reduce our net income. Our effective tax rate could be adversely affected by several factors, many of which are outside of our control, including:

●

changes in the relative proportions of revenues and income before taxes in the various jurisdictions in which we operate that have differing statutory tax rates;

●

changing tax laws, regulations and interpretations in multiple jurisdictions in which we operate, as well as the requirements of certain tax rulings;

●

changes in accounting and tax treatment of stock-based compensation;

●

the tax effects of purchase accounting for acquisitions and restructuring charges that may cause fluctuations between reporting periods; and

●

tax assessments, or any related tax interest or penalties, which could significantly affect our income tax expense for the period in which the settlements take place.

The price of our common stock could decline if our financial results are materially affected by the foregoing.

Our headquarters are located in Northern California where disasters may occur that could disrupt our operations and harm our business.

Our corporate headquarters is located in Silicon Valley in Northern California. Historically, this region has been vulnerable to natural disasters and other risks, such as earthquakes, which at times have disrupted the local economy and posed physical risks to us and our local suppliers. In addition, terrorist acts or acts of war targeted at the United States, and specifically Silicon Valley, could cause damage or disruption to us, our employees, facilities, partners, suppliers, distributors and resellers, and customers, which could have a material adverse effect on our operations and financial results. Although we currently have significant redundant capacity in Sweden in the event of a natural disaster or other catastrophic event in Silicon Valley, our business could nonetheless suffer. Our operations in Sweden are subject to disruption by extreme winter weather.

Index

Acquisitions may disrupt or otherwise have a negative impact on our business.

We may seek to acquire or make investments in complementary businesses, products, services or technologies on an opportunistic basis when we believe they will assist us in executing our business strategy. Growth through acquisitions has been a viable strategy used by other network control and management technology companies. We acquired the Netintact entities in 2006. Any future acquisitions could distract our management and employees and increase our expenses.

Following any acquisition, the integration of the acquired business, product, service or technology is complex, time consuming and expensive, and may disrupt our business. These challenges include the timely and efficient execution of a number of post-transaction integration activities, including:

●

integrating the operations and technologies of the two companies;

●

retaining and assimilating the key personnel of each company;

●

retaining existing customers of both companies and attracting additional customers;

●

leveraging our existing sales channels to sell new products into new markets;

●

developing an appropriate sales and marketing organization and sales channels to sell new products into new markets;

●

retaining strategic partners of each company and attracting new strategic partners; and

●

implementing and maintaining uniform standards, internal controls, processes, procedures, policies and information systems.

The process of integrating operations and technology could cause an interruption of, or loss of momentum in, our business and the loss of key personnel. The diversion of management’s attention and any delays or difficulties encountered in connection with an acquisition and the integration of our operations and technology could have an adverse effect on our business, results of operations or financial condition. Furthermore, the execution of these post-transaction integration activities will involve considerable risks and may not come to pass as we envision. The inability to integrate the operations, technology and personnel of an acquired business with ours, or any significant delay in achieving integration, could have a material adverse effect on results of operations and financial condition and, as a result, on the market price of our common stock.

Furthermore, if we were to issue equity securities to pay for any future acquisitions, the issuance of such equity securities would have a dilutive effect on our existing shareholders.

Risks Related to Our Industry

Demand for our products depends, in part, on the rate of adoption of bandwidth-intensive broadband applications, such as peer-to-peer, and latency-sensitive applications, such as voice-over-Internet protocol, or VoIP, Internet video and online video gaming applications.

Our products are used by broadband service providers and enterprises to provide awareness, control and protection of Internet traffic by examining and identifying packets of data as they pass an inspection point in the network, particularly bandwidth-intensive applications that cause congestion in broadband networks and impact the quality of experience of users. In addition to the general increase in applications delivered over broadband networks that require large amounts of bandwidth, such as peer-to-peer applications, demand for our products is driven particularly by the growth in applications which are highly sensitive to network delays and therefore require efficient network management. These applications include VoIP, Internet video and online video gaming applications. If the rapid growth in adoption of VoIP and in the popularity of Internet video and online video gaming applications does not continue, the demand for our products may not grow as anticipated, which could have a material adverse effect on our results of operations and financial condition.

If the bandwidth management solutions market fails to grow, our business will be adversely affected.

We believe that the market for bandwidth management solutions is in an early stage of development. We cannot accurately predict the future 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 execute our strategy, 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. The growth of the bandwidth management solutions market also depends upon a number of factors, including the availability of inexpensive bandwidth, especially in international markets, and the growth of wide area networks. The failure of the market to rapidly grow would adversely affect our sales and sales prospects, which could have a material adverse effect on our results of operations and financial condition and cause a decline in the price of our common stock.

Index

The market for our products in the network provider market is still emerging and our growth may be harmed if carriers do not adopt DPI solutions.

The market for DPI technology is still emerging and the majority of our customers to date have been small and midsize broadband service providers and universities. We believe that the Tier 1 carriers, as well as cable and mobile operators, present a significant market opportunity and are an important element of our long term strategy, but they are still in the early stages of adopting and evaluating the benefits and applications of DPI technology. Carriers may decide that full visibility into their networks or highly granular control over content based applications is not critical to their business. They may also determine that certain applications, such as VoIP or Internet video, can be adequately prioritized in their networks by using router and switch infrastructure products without the use of DPI technology. They may also, in some instances, face regulatory constraints that could change the characteristics of the markets. Carriers may also seek an embedded DPI solution in capital equipment devices such as routers rather than the stand-alone solution offered by us. Furthermore, widespread adoption of our products by carriers will require that they migrate to a new business model based on offering subscriber and application-based tiered services. If carriers decide not to adopt DPI technology, our market opportunity would be reduced and our growth rate may be harmed, which could have a material adverse effect on our results of operations and financial condition.

The network equipment market is subject to rapid technological progress and to compete we must continually introduce new products or upgrades that achieve broad market acceptance.

The network equipment market is characterized by rapid technological progress, frequent new product introductions, changes in customer requirements and evolving industry standards. If we do not regularly introduce new products or upgrades in this dynamic environment, our product lines will become obsolete. Developments in routers and routing software could also significantly reduce demand for our products. Alternative technologies could achieve widespread market acceptance and displace the technology on which we have based our product architecture. We cannot assure you that our technological approach will achieve broad market acceptance or that other technology or devices will not supplant our products and technology.

Our products must comply with evolving industry standards and complex government regulations or else our products may not be widely accepted, which may prevent us from growing our net revenue or achieving profitability.

The market for network equipment products is characterized by the need to support new standards as they emerge, evolve and achieve acceptance. We will not be competitive unless we continually introduce new products and product enhancements that meet these emerging standards. 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. Our products must be compliant with various United States federal government requirements and regulations and standards defined by agencies such as the Federal Communications Commission, in addition to standards established by governmental authorities in various foreign countries and recommendations of the International Telecommunication Union. If we do not comply with existing or evolving industry standards or if we fail to obtain timely domestic or foreign regulatory approvals or certificates, we will not be able to sell our products where these standards or regulations apply, which may prevent us from sustaining our net revenue or achieving profitability.

Recently proposed regulatory actions may result in reduced capital spending by broadband service providers, which could adversely impact our opportunities for continued revenue growth.

The Federal Communications Commission (the “FCC”) has been considering different proposals for prohibiting or limiting broadband service providers from providing data prioritization services to their customers. These proposals are referred to generally as relating to "net neutrality". The FCC originally considered proposals that would require broadband service providers to treat all Internet content equally in all circumstances and to prohibit them from providing any data prioritization services. The FCC currently is considering the "Third Way" proposal that would include adopting a rule prohibiting any practice under which Internet access service is provided on unreasonably discriminatory terms and which could result in broad authority to regulate broadband service. It is very uncertain what rules, if any, may be adopted by the FCC regarding net neutrality. In the event that the FCC asserts broad regulatory authority, it is likely that there may be legislative and/or legal challenges to the FCC’s regulatory authority, and while the issue remains unresolved, broadband service providers may lessen their capital investments in their networks. In such a circumstance, we may have fewer opportunities to sell our products to both current and prospective customers, and our opportunity for continued revenue growth could be adversely impacted. If our revenue growth slows or our revenues decrease, our results of operations and our financial condition also may be adversely impacted.

Index

Risks Related to Ownership of Our Common Stock

Our common stock price is likely to continue to be highly volatile.

The market price of our common stock is likely to continue to be highly volatile. The market for small cap and micro cap technology companies, including us, has been particularly volatile in recent years. Because our stock is thinly traded, investors may not be able to resell their shares of our common stock following periods of volatility. We cannot assure you that our stock will trade at the same levels of other stocks in our industry or that in general, stocks in our industry will sustain their current market prices. Factors that could cause such volatility may include, among other things:

●

actual or anticipated fluctuations in our quarterly operating results;

●

announcements of technology innovations by our competitors;

●

changes in financial estimates by securities analysts;

●

conditions or trends in the network control and management industry;

●

changes in the market valuations of other such industry related companies;

●

the acceptance by institutional investors of our stock;

●

rumors, announcements or press articles regarding our operations, management, organization, financial condition or financial statements;

●

the gain or loss of a significant customer; or

●

the stock market in general, and the market prices of stocks of technology companies, in particular, have experienced extreme price volatility that has adversely affected, and may continue to adversely affect, the market price of our common stock for reasons unrelated to our business or operating results.

*Holders of our common stock may be diluted in the future.

We are authorized to issue up to 32,500,000 shares of common stock and 15,000,000 shares of preferred stock. Our Board of Directors has the authority, without seeking stockholder approval, to issue additional shares of common stock and/or preferred stock in the future for such consideration as our Board of Directors may consider sufficient. In addition, we recently implemented a reverse stock split of our common stock which had the effect of proportionately increasing the number of authorized but unissued shares available for future issuance. The issuance of additional common stock and/or preferred stock in the future will reduce the proportionate ownership and voting power of our common stock held by existing stockholders. At March 31, 2011, there were 11,364,222 shares of our common stock outstanding, outstanding warrants to purchase 305,574 shares of our common stock, and outstanding stock options to purchase 1,016,347 shares of our common stock. At March 31, 2011, we had an authorized reserve of 183,574 shares of common stock which we may grant as stock options or other equity awards pursuant to our existing stock option plan. These share figures reflect the 1-for-10 reverse stock split that became effective February 4, 2011. Any future issuances of our common stock would dilute the relative ownership interest of our current stockholders, and could also cause the trading price of our common stock to decline.

Nevada law and our articles of incorporation and bylaws contain provisions that may discourage, delay or prevent a change in our management team that our stockholders may consider favorable or otherwise have the potential to impact our stockholders’ ability to control our company.

Nevada law and our articles of incorporation and bylaws contain provisions that may have the effect of preserving our current management or may impact our stockholders’ ability to control our company, such as:

●

authorizing the issuance of “blank check” preferred stock without any need for action by stockholders;

●

eliminating the ability of stockholders to call special meetings of stockholders;

●

restricting the ability of stockholders to take action by written consent; and

Index

●

establishing advance notice requirements for nominations for election to the Board of Directors or for proposing matters that can be acted on by stockholders at stockholder meetings.

These provisions could allow our Board of Directors to affect your rights as a stockholder since our Board of Directors can make it more difficult for common stockholders to replace members of the Board. Because our Board of Directors is responsible for appointing the members of our management team, these provisions could in turn affect any attempt to replace our current management team. In addition, the issuance of preferred stock could make it more difficult for a third party to acquire us and may impact the rights of common stockholders. All of the foregoing could adversely impact the price of our common stock and your rights as a stockholder.

We do not pay and do not expect to pay cash dividends on our common stock.

We have not paid any cash dividends. We do not anticipate paying cash dividends on our common stock in the foreseeable future, and we cannot assure an investor that funds will be legally available to pay dividends, or that, even if the funds are legally available, the dividends will be paid.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3.

Defaults Upon Senior Securities

None.

Item 4.

(Removed and Reserved)

Item 5.

Other Information

None

Item 6.

Exhibits

3.1		Articles of Incorporation filed on July 16, 2001, filed as Exhibit 3.1 to our registration statement on Form SB-2 filed on February 11, 2002 and incorporated herein by reference.(1)

3.2		Certificate of Amendment to Articles of Incorporation filed on October 12, 2005, filed as Exhibit 99.1 to our current report on Form 8-K filed on October 13, 2005 and incorporated herein by reference.(1)

3.3		Certificate of Amendment to Articles of Incorporation filed on April 28, 2008, filed as Exhibit 3.3 to our quarterly report on Form 10-Q filed on May 12, 2008 and incorporated herein by reference.(1)

3.4		Certificate of Amendment to Articles of Incorporation effective February 4, 2011, filed as Exhibit 3.1 to our current report on Form 8-K filed on February 4, 2011 and incorporated herein by reference.(1)

3.5		Amended and Restated Bylaws adopted on August 16, 2007, filed as Exhibit 3.4 to our quarterly report on Form 10-Q filed on May 12, 2008 and incorporated herein by reference.(1)

4.1		Form of Common Stock Certificate, filed as Exhibit 4.1 to our current report on Form 8-K filed on February 4, 2011 and incorporated herein by reference.(1)

4.2		Form of Subscription Agreement for March 2010 offering, filed as Exhibit 1.2 to our current report on Form 8-K filed on March 2, 2010 and incorporated herein by reference.(1)

4.3		Form of Warrant for March 2010 offering, filed as Exhibit 4.1 to our current report on Form 8-K filed on March 2, 2010 and incorporated herein by reference.(1)

10.1		Third Amendment to Loan and Security Agreement by and between the Company and Silicon Valley Bank, dated January 17, 2011.

10.2		Form of Restricted Stock Bonus Grant Notice (2007 Equity Incentive Plan).

10.3		Form of Restricted Stock Bonus Agreement (2007 Equity Incentive Plan).

Index

31.1		Certification of James F. Brear, Principal Executive Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of Charles Constanti, Principal Financial Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, executed by James F. Brear, Principal Executive Officer, and Charles Constanti, Principal Financial Officer.

(1)	Previously filed

Index

SIGNATURES

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

	Procera Networks, Inc.

	By:	/s/ Charles Constanti
May 10, 2011		Charles Constanti, Chief Financial Officer
		(Principal Financial and Accounting Officer)

Index

Exhibit Index

3.1		Articles of Incorporation filed on July 16, 2001, filed as Exhibit 3.1 to our registration statement on Form SB-2 filed on February 11, 2002 and incorporated herein by reference.(1)

3.2		Certificate of Amendment to Articles of Incorporation filed on October 12, 2005, filed as Exhibit 99.1 to our current report on Form 8-K filed on October 13, 2005 and incorporated herein by reference.(1)

3.3		Certificate of Amendment to Articles of Incorporation filed on April 28, 2008, filed as Exhibit 3.3 to our quarterly report on Form 10-Q filed on May 12, 2008 and incorporated herein by reference.(1)

3.4		Certificate of Amendment to Articles of Incorporation effective February 4, 2011, filed as Exhibit 3.1 to our current report on Form 8-K filed on February 4, 2011 and incorporated herein by reference.(1)

3.5		Amended and Restated Bylaws adopted on August 16, 2007, filed as Exhibit 3.4 to our quarterly report on Form 10-Q filed on May 12, 2008 and incorporated herein by reference.(1)

4.1		Form of Common Stock Certificate, filed as Exhibit 4.1 to our current report on Form 8-K filed on February 4, 2011 and incorporated herein by reference.(1)

4.2		Form of Subscription Agreement for March 2010 offering, filed as Exhibit 1.2 to our current report on Form 8-K filed on March 2, 2010 and incorporated herein by reference.(1)

4.3		Form of Warrant for March 2010 offering, filed as Exhibit 4.1 to our current report on Form 8-K filed on March 2, 2010 and incorporated herein by reference.(1)

10.1		Third Amendment to Loan and Security Agreement by and between the Company and Silicon Valley Bank, dated January 17, 2011.

10.2		Form of Restricted Stock Bonus Grant Notice (2007 Equity Incentive Plan).

10.3		Form of Restricted Stock Bonus Agreement (2007 Equity Incentive Plan).

31.1		Certification of James F. Brear, Principal Executive Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of Charles Constanti, Principal Financial Officer, pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities and Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, executed by James F. Brear, Principal Executive Officer, and Charles Constanti, Principal Financial Officer.

(1)	Previously filed

Nevada		33-0974674
(State or other jurisdiction of incorporation or organization)		(I.R.S. employer identification number)

4121 Clipper Court, Fremont, California		94538
(Address of principal executive offices)		(Zip code)

Large accelerated filer £	Accelerated filer þ	Non-accelerated filer £	Smaller reporting company £
		(Do not check if a smaller reporting company)

			Page
PART I. FINANCIAL INFORMATION

	Item 1.	Consolidated Financial Statements

		Condensed Consolidated Balance Sheets as of March 31, 2011 (Unaudited) and December 31, 2010	3

		Condensed Consolidated Statements of Operations for the three months ended March 31, 2011 and 2010 (Unaudited)	4

		Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2011 and 2010 (Unaudited)	5

		Notes to Condensed Consolidated Financial Statements (Unaudited)	6

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14

	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	21

	Item 4.	Controls and Procedures	21

PART II. OTHER INFORMATION

	Item 1.	Legal Proceedings	22

	Item 1A.	Risk Factors	22

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	33

	Item 3.	Defaults Upon Senior Securities	33

	Item 4.	(Removed and Reserved)	33

	Item 5.	Other Information	33

	Item 6.	Exhibits	33

SIGNATURES			35