• Results of Operations. This section provides an analysis of our results of operations for the three months and nine months ended September 30, 2008 as compared to the three months and nine months ended September 30, 2007.

• Liquidity and Capital Resources. This section provides an analysis of our cash flows for the nine months ended September 30, 2008 and a discussion of our capital requirements and the resources available to us to meet those requirements.

• Critical Accounting Policies and Estimates. This section discusses accounting policies that are considered important to our financial condition and results of operations, require significant judgment or require estimates on our part in applying them. Our significant accounting policies, including those considered to be critical accounting policies, are summarized in Note 2 to the accompanying consolidated financial statements.

Overview
We are a leading provider of Enterprise Threat Management, or ETM, solutions for information technology infrastructures of commercial enterprises (such as healthcare, financial services, manufacturing, energy, education, retail, and telecommunications) and federal and state government organizations. The Sourcefire 3DŽ System-comprised of multiple Sourcefire hardware and software product offerings-provides a comprehensive, intelligent network defense that unifies intrusion prevention system, or IPS, network behavior analysis, or NBA, network access control, or NAC, and vulnerability assessment, or VA, solutions under a common management framework. This ETM approach equips our customers with an efficient and effective layered security defense-protecting computer network assets before, during and after an attack.
We sell our network security solutions to a diverse customer base that includes 28 of the Fortune 100 and over half of the 30 largest U.S. government agencies. We also manage two of the security industry's leading open source initiatives, Snort and ClamAV.

Key Financial Metrics and Trends
Our financial results are affected by a number of factors, including broad economic conditions, the amount and type of technology spending of our customers, and the financial condition of our customers and the industries and geographic areas that we serve. During the third quarter of 2008, certain of the industries and geographic areas that we serve experienced weakness as macroeconomic conditions, credit market conditions, and levels of business confidence and activity deteriorated. We are continuing to monitor these factors and their potential effect on our customers and on us. A severe or prolonged economic downturn could affect our customers' financial condition and the levels of business activity. This could reduce demand and depress pricing for our products and services, which could have a material adverse effect on our results of operations or financial condition. We evaluate our performance on the basis of several performance indicators, including pricing and discounts, revenue, cost of revenue, gross profit, and operating expenses. We compare these key performance indicators, on a quarterly basis, to both target amounts established by management and to our performance for prior periods. Pricing and Discounts
We maintain a standard price list for all of our products. Additionally, we have a corporate policy that governs the level of discounts our sales organization may offer on our products, based on factors such as transaction size, volume of products, federal or state programs, reseller or distributor involvement and the level of technical support commitment. Our total product revenue and the resulting cost of revenue and gross profit percentage are directly affected by our ability to manage our product pricing policy. Although to date we have not experienced pressure to reduce our prices, competition is increasing and, in the future, we may be forced to reduce our prices to remain competitive.
Revenue
We currently derive revenue from product sales and services. Product revenue is principally derived from the sale of our network security solutions. Our network security solutions include a perpetual software license bundled with a third-party hardware platform. Services revenue is principally derived from technical support and professional services. We typically sell technical support to complement our network security product solutions. Technical support entitles a customer to product updates, new rule releases and both telephone and web-based assistance for using our products. Our professional services revenue includes optional installation, configuration and tuning, which we refer to collectively as network security deployment services. These network security deployment services typically occur on-site after delivery has occurred.
Product sales are typically recognized as revenue at shipment of the product to the customer, whether sold directly or through resellers. For sales made through distributors, we do not recognize revenue until we receive a monthly sales report indicating the product volume sold to end user customers. We recognize revenue from services when the services are performed. For technical support services, we recognize revenue ratably over the term of the support arrangement, which is generally 12 months. Our support agreements generally provide for payment in advance and automatic renewals as evidenced by customer payment.
We sell our network security solutions globally. However, 75% and 77% of our revenue for the nine months ended September 30, 2008 and 2007, respectively, was generated by sales to U.S.-based customers. We expect that our revenue from customers based outside of the United States will increase in amount and as a percentage of total revenue as we strengthen our international presence. We also expect that our revenue from sales through our indirect sales channel will increase in amount and as a percentage of total revenue as we expand our relationships with third-party distributors.
Historically, our product revenue has been seasonal, with a significant portion of our total product revenue in recent fiscal years generated in the fourth quarter. For 2008, we continue to expect a significant portion of our total revenue in the fourth quarter but do not expect that fourth quarter revenue will represent as great a percentage of total revenue as in past years. The timing of our year-end shipments could materially affect our fourth quarter product revenue in any fiscal year and quarterly comparisons. Revenue from our government customers has occasionally been influenced by the September 30th fiscal year-end of the U.S. federal government, which has historically resulted in our revenue from government customers being highest in the third quarter. Notwithstanding these general seasonal patterns, our revenue within a particular quarter is often affected significantly by the unpredictable procurement patterns of our customers. Our prospective customers usually spend a long time evaluating and making purchase decisions for network security solutions. Historically, many of our customers have not finalized their purchasing decisions until the final weeks or days of a quarter. We expect these purchasing patterns to continue in the future.

Therefore, a delay in even one large order beyond the end of the quarter could materially reduce our anticipated revenue for a quarter. Because many of our expenses must be incurred before we expect to generate revenue, delayed orders could negatively impact our results of operations for a particular period and could therefore cause us to fail to meet the financial performance expectations of securities industry research analysts or investors. Cost of Revenue
Cost of product revenue includes the cost of the hardware platform bundled into our network security solution, royalties for third-party software included in our network security solution, materials and labor that are incorporated in the quality assurance of our products, logistics, warranty, shipping and handling costs and, in the limited instance where we lease our network security solutions to our customers, depreciation and amortization. Hardware costs, which are our most significant cost item, generally have not fluctuated materially as a percentage of revenue in recent years because competition among hardware platform suppliers has remained strong and, therefore, unit hardware costs have remained consistent. Because of the competition among hardware suppliers and our outsourcing of the manufacture of our products to three separate domestic contract manufacturers, we currently have no reason to expect that our cost of product revenue as a percentage of total product revenue will change significantly in the foreseeable future due to hardware pricing increases. However, hardware or other costs of manufacturing may increase in the future. We incur labor and associated overhead expenses, such as occupancy costs and fringe benefits costs, as part of managing our outsourced manufacturing process. These costs are included as a component of our cost of product revenue.
Cost of services revenue includes the direct labor costs of our employees and outside consultants engaged to furnish those services, as well as their travel and associated direct material costs. Additionally, we include in cost of services revenue an allocation of overhead expenses such as occupancy costs, fringe benefits and supplies, as well as the cost of time and materials to service or repair the hardware component of our products covered under a renewed support arrangement beyond the manufacturer's warranty. As our customer base continues to grow, we anticipate incurring an increasing amount of these service and repair costs, as well as costs for additional personnel to support and service our customers.
Gross Profit
Our gross profit is affected by a variety of factors, including competition, the mix and average selling prices of our products, our pricing policy, technical support and professional services, new product introductions, the cost of hardware platforms, the cost of labor to generate such revenue and the mix of distribution channels through which our products are sold. Although we have not had to reduce the prices of our products or vary our pricing policy in recent years, our gross profit would be adversely affected by price declines if we are unable to reduce costs on existing products and fail to introduce new products with higher margins. Currently, product sales typically have a lower gross profit as a percentage of revenue than our services due to the cost of the hardware platform. Our gross profit for any particular quarter could be adversely affected if we do not complete a sufficient level of sales of higher-margin products by the end of the quarter. As discussed above, many of our customers do not finalize purchasing decisions until the final weeks or days of a quarter, so a delay in even one large order of a higher-margin product could reduce our total gross profit percentage for that quarter. Operating Expenses
Research and Development. Research and development expenses consist primarily of payroll, benefits and related occupancy and other overhead for our engineers, costs for professional services to test our products, and costs associated with data used by us in our product development.
We have expanded our research and development capabilities and expect to continue to expand these capabilities in the future. We are committed to increasing the level of innovative design and development of new products as we strive to enhance our ability to serve our existing commercial and federal government markets as well as new markets for security solutions. To meet the changing requirements of our customers, we will need to fund investments in several development projects in parallel. Accordingly, we anticipate that our research and development expenses will continue to increase in absolute dollars for the foreseeable future, but should decline as a percentage of total revenue as we expect to grow our revenues more rapidly than our research and development expenditures.
Sales and Marketing. Sales and marketing expenses consist primarily of salaries, incentive compensation, benefits and related costs for sales and marketing personnel; trade show, advertising, marketing and other brand-building costs; marketing consultants and other professional services; training, seminars and conferences; travel and related costs; and occupancy and other overhead costs.

As we focus on increasing our market penetration, expanding internationally and continuing to build brand awareness, we anticipate that selling and marketing expenses will continue to increase in absolute dollars, but decrease as a percentage of our revenue, in the future.
General and Administrative. General and administrative expenses consist primarily of salaries, incentive compensation, benefits and related occupancy and other overhead costs for executive, legal, finance, information technology, human resources and administrative personnel; corporate development expenses and professional fees related to legal, audit, tax and regulatory compliance; travel and related costs; information systems, enterprise resource planning ("ERP") system and other infrastructure costs; and corporate insurance.
General and administrative expenses increased during the period of time leading up to our IPO and, as we operate as a public company, we have incurred additional expenses for costs associated with compliance with Section 404 of the Sarbanes-Oxley Act of 2002, directors' and officers' liability insurance, our investor relations function, and an increase in personnel to perform SEC reporting functions.
Stock-Based Compensation. Effective January 1, 2006, we adopted the fair value recognition provisions of the Financial Accounting Standards Board's ("FASB") Statement of Financial Accounting Standard ("SFAS") No. 123(R), Share-Based Payment, using the prospective transition method, which requires us to apply its provisions only to awards granted, modified, repurchased or cancelled after the effective date. Under this transition method, stock-based compensation expense recognized beginning January 1, 2006 is based on the grant date fair value of stock awards granted or modified after January 1, 2006.
Based on the estimated grant date fair value of stock-based awards, we recognized aggregate stock-based compensation expense of $1.6 million and $719,000 for the three months ended September 30, 2008 and 2007, respectively, and $3.4 million and $1.9 million for the nine months ended September 30, 2008 and 2007, respectively. We use the Black-Scholes option pricing and Lattice option pricing models to estimate the fair value of granted stock options. The use of option valuation models requires the input of highly subjective assumptions, including the expected term and the expected stock price volatility.
Results of Operations
Revenue. The following table shows products and technical support and professional services revenue (in thousands):

                       Three Months Ended                                     Nine Months Ended
                         September 30,                 Variance                 September 30,                 Variance
                       2008           2007           $           %           2008           2007           $            %
Products            $   12,661      $  9,403      $ 3,258          35 %    $  28,189      $ 21,103      $  7,086          34 %
Percentage of
total revenue               62 %          64 %                                    56 %          58 %
Technical
support and
professional
services                 7,628         5,403        2,225          41 %       21,769        15,418         6,351          41 %
Percentage of
total revenue               38 %          36 %                                    44 %          42 %

Total revenue       $   20,289      $ 14,806      $ 5,483          37 %    $  49,958      $ 36,521      $ 13,437          37 %

The increase in our product revenue during the three months and nine months ended September 30, 2008, as compared to the three months and nine months ended September 30, 2007, was mostly driven by higher demand for our sensor products, primarily our enterprise class 3D products. For the three months ended September 30, 2008, sensor product revenue increased $2.9 million over the prior-year quarter, which included a $1.1 million increase in our enterprise class 3D products. For the nine months ended September 30, 2008, sensor product revenue increased $6.3 million over the prior year, which included a $3.6 million increase in our enterprise class 3D products. The increase in our services revenue for the three months and nine months ended September 30, 2008 resulted from an increase in our installed customer base due to new product sales in which associated support was purchased, as well as support renewals by our existing customers.

Cost of revenue. The following table shows products and technical support and professional services cost of revenue (in thousands):

                       Three Months Ended                                     Nine Months Ended
                         September 30,                 Variance                 September 30,                Variance
                       2008           2007           $           %            2008          2007           $           %
Products            $    3,585       $ 2,665      $   920          35 %    $    8,061      $ 5,809      $ 2,252          39 %
Percentage of
total revenue               18 %          18 %                                     16 %         16 %
Technical
support and
professional
services                 1,345           800          545          68 %         3,583        2,277        1,306          57 %
Percentage of
total revenue                7 %           5 %                                      7 %          6 %

Total cost of
revenue             $    4,930       $ 3,465      $ 1,465          42 %    $   11,644      $ 8,086      $ 3,558          44 %

Percentage of
total revenue               24 %          23 %                                     23 %         22 %

For the three months and nine months ended September 30, 2008, the increase in product cost of revenue was driven primarily by higher volume demand for our sensor products, for which we must procure and provide the hardware platform to our customers. We did not experience a material increase in our cost per unit of hardware platforms, which is the largest component of our product cost of revenue. The increase in our services cost of revenue for the three months and nine months ended September 30, 2008 was attributable to increased hardware service expense related to support renewal contracts and our hiring of additional personnel to both service our larger installed customer base and to provide training and professional services to our customers.
Gross profit. The following table shows products and technical support and professional services gross profit (in thousands):

                       Three Months Ended                                     Nine Months Ended
                         September 30,                 Variance                 September 30,                Variance
                       2008           2007           $           %           2008           2007           $           %
Products            $    9,076      $  6,738      $ 2,338          35 %    $  20,128      $ 15,294      $ 4,834          32 %
Percentage of
total revenue               45 %          46 %                                    40 %          42 %
Technical
support and
professional
services                 6,283         4,603        1,680          36 %       18,186        13,141        5,045          38 %
Percentage of
total revenue               31 %          31 %                                    36 %          36 %

Total gross
profit              $   15,359      $ 11,341      $ 4,018          35 %    $  38,314      $ 28,435      $ 9,879          35 %

Percentage of
total revenue               76 %          77 %                                    77 %          78 %

Gross profit as a percentage of total revenue for the three months and nine months ended September 30, 2008, as compared to the prior-year periods, remained relatively flat for services revenue. Gross profit as a percentage of total revenue for products for the three months and nine months ended September 30, 2008 decreased slightly, primarily due to the product mix sold being weighted more toward lower margin products and increased write-offs of our evaluation units.
Operating expenses. The following table highlights our operating expenses (in thousands):

                        Three Months Ended                                       Nine Months Ended
                          September 30,                  Variance                  September 30,                 Variance
                        2008           2007           $            %            2008           2007           $            %
Research and
development          $    3,267      $  2,895      $    372          13 %     $   9,525      $  8,076      $  1,449          18 %
Percentage of
total revenue                16 %          20 %                                      19 %          22 %
Sales and
marketing                 8,655         6,746         1,909          28 %        23,834        18,563         5,271          28 %
Percentage of
total revenue                43 %          46 %                                      48 %          51 %
General and
administrative            4,984         2,540         2,444          96 %        13,929         7,288         6,641          91 %
Percentage of
total revenue                24 %          16 %                                      28 %          20 %
Depreciation and
amortization                775           427           348          81 %         1,852         1,177           675          57 %
Percentage of
total revenue                 4 %           3 %                                       4 %           3 %
In-process
research and
development                   -         2,947        (2,947 )      (100 )%            -         2,947        (2,947 )      (100 )%
Percentage of
total revenue                 - %          20 %                                       - %           8 %

Total operating
expenses             $   17,681      $ 15,555      $  2,126          14 %     $  49,140      $ 38,051      $ 11,089          29 %

Percentage of
total revenue                87 %         105 %                                      99 %         104 %

Research and development expenses for the three months ended September 30, 2008 increased over the prior-year quarter, primarily due to an increase in salaries, incentive compensation, benefits and occupancy overhead expenses of $298,000 and an increase in stock-based compensation expense of $114,000, partially offset by a decrease of $82,000 in consulting fees. For the nine months ended September 30, 2008, research and development expenses increased over the prior year, primarily due to an increase in salaries, incentive compensation, benefits and occupancy overhead expenses of $1.3 million and an increase in stock-based compensation expense of $286,000, partially offset by a decrease of $168,000 in consulting fees. These increased expenses resulted from the hiring of additional personnel in our research and development department to support the release of updates and enhancements to our 3D products.
Sales and marketing expenses for the three months ended September 30, 2008 increased over the prior-year quarter, primarily due to an increase of $1.8 million in salary, commissions and incentive compensation and benefit expenses as a result of additional sales and marketing personnel and increased revenue, an increase of $178,000 in travel and travel-related expenses and an increase of $75,000 in stock-based compensation expense. For the nine months ended September 30, 2008, sales and marketing expenses increased over the prior-year period, primarily due to an increase of $4.1 million in salary, commissions and incentive compensation and benefit expenses as a result of additional sales and marketing personnel and increased revenue, an increase of $537,000 in travel and travel-related expenses, an increase of $298,000 in advertising, promotion, partner-marketing programs and trade show expenses in support of our network security solutions and an increase of $262,000 in stock-based compensation expense.
General and administrative expenses for the three months ended September 30, 2008 increased over the prior-year quarter, primarily due to an increase of $867,000 in professional fees related to legal, audit, tax and regulatory compliance, an increase of $699,000 in salaries, incentive compensation and benefit expenses for personnel hired in our accounting, information technology, human resources and legal departments, stock-based compensation expense of $449,000 for the acceleration of vesting of equity awards for our former CEO and . . .