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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                                 -------------

                                   FORM 10-K

                                 -------------

(Mark One)

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934

   For the fiscal year ended September 30, 2001

                                      OR

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
    EXCHANGE ACT OF 1934

   For the transition period from     to

                        Commission file number: 0-30863

                                 -------------

                             NETWORK ENGINES, INC.
            (Exact name of registrant as specified in its charter)

<TABLE>
<C>                                            <S>
                   Delaware                                 04-3064173
(State or other jurisdiction of incorporation) (I.R.S. Employer Identification No.)

           25 Dan Road, Canton, MA                            02021
   (Address of principal executive offices)                 (Zip Code)
</TABLE>

       Registrant's telephone number, including area code (781) 332-1000

         Securities registered pursuant to Section 12 (b) of the Act:

                                     None

         Securities registered pursuant to Section 12 (g) of the Act:

                         Common Stock, $0.01 par value

                                 -------------

   Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period than the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]

   Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statement incorporated by reference in part III of this Form 10-K or any
amendment to this Form 10-K. [X]

   The aggregate market value of the voting Common Stock held by non-affiliates
of the registrant on November 30, 2001 was approximately $11,500,000.

   The number of shares outstanding of the registrant's Common Stock as of
November 30, 2001: 33,816,576 shares.

                     Documents incorporated by reference:

   Portions of the registrant's definitive Proxy Statement for its Annual
Meeting of Stockholders for the year ended September 30, 2001, which will be
filed with the Securities and Exchange Commission within 120 days after the end
of the Company's fiscal year, are incorporated by reference into Part III
hereof.

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                             NETWORK ENGINES, INC.
                          ANNUAL REPORT ON FORM 10-K
                 For the Fiscal Year Ended September 30, 2001

                               TABLE OF CONTENTS

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   <C>      <S>                                                         <C>

                                  PART I

   ITEM 1.  BUSINESS...................................................   1

   ITEM 2.  PROPERTIES.................................................   9

   ITEM 3.  LEGAL PROCEEDINGS..........................................  10

   ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS......  11

                                 PART II

   ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
            STOCKHOLDER MATTERS........................................  13

   ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA.......................  15

   ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
            AND RESULTS OF OPERATIONS..................................  16

   ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.  38

   ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................  39

   ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
            AND FINANCIAL DISCLOSURE...................................  67

                                 PART III

   ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.........  67

   ITEM 11. EXECUTIVE COMPENSATION.....................................  67

   ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
            MANAGEMENT.................................................  67

   ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.............  67

                                 PART IV

   ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON
            FORM 8-K...................................................  68

   SIGNATURES..........................................................  69
</TABLE>

<PAGE>

    This Form 10-K contains forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, as amended, that involve
risks and uncertainties. All statements other than statements of historical
information provided herein are forward-looking statements and may contain
projections relating to financial results, economic conditions, trends and
known uncertainties. Our actual results could differ materially from those
discussed in the forward-looking statements as a result of a number of factors,
including the factors discussed in this section and elsewhere in this report
and the risks discussed in our other filings with the Securities and Exchange
Commission. Readers are cautioned not to place undue reliance on these
forward-looking statements, which reflect management's analysis, judgment,
belief or expectation only as of the date hereof. We undertake no obligation to
publicly reissue these forward-looking statements to reflect events or
circumstances that arise after the date hereof.

                                    PART I

ITEM 1. BUSINESS

Description of Business

    Network Engines is a provider of high-density, server appliance hardware
and custom integration services. Server appliances are pre-configured computer
network infrastructure devices designed to deliver specific application
functionality. We are focused on partnering with independent software vendors
("ISVs") and original equipment manufacturers ("OEMs") to provide these
strategic partners with dense server appliance hardware, integration services
and appliance development, deployment and support to allow these strategic
partners to deliver "turn-key" solutions to their end-user customers.

Company Background

    When we first began our focus on the server appliance market, we focused
our business primarily on providing scalable web content servers to
Internet-based organizations, content infrastructure providers and larger
enterprises. It was necessary for us to design most of the hardware components
that went into our servers and, as a result, we invested significant resources
in the development of our products. In June 1999, we introduced the first "1U"
(1.75 inch tall) server, the WebEngine Blazer. Since the introduction of our
WebEngine Blazer product, we experienced significant growth as we invested in
the development of our technology and products, the recruitment and training of
personnel for our engineering, sales and marketing and technical support
departments, and the establishment of an administrative organization. As a
result, our employee base grew from 39 as of June 30, 1999 to 244 as of March
31, 2001, and our operating expenses grew significantly.

    Over time, much of the hardware components of server appliances have become
commoditized and a significant number of companies have entered the server
appliance marketplace. In response to competitive pressures, combined with the
effects of a downturn in the economy, we commenced a restructuring plan in the
quarter ended June 30, 2001 to better align our operating expenses with our
reduced revenues. This restructuring plan resulted in a $2.8 million charge to
operations in April 2001, a 73-employee reduction in our workforce, as well as
the curtailment of planned facility expansion and other cost cutting measures.
We further undertook an extensive review of our business strategy and, in

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July 2001, we implemented a second restructuring of our business, which
de-emphasized much of our customized hardware and software development and
focused our resources on what we believe to be our core competencies of
hardware packaging and software integration. In addition, this restructuring of
our business included a transition from primarily direct sales channels to
partnerships with ISVs and OEMs in order to offer "turn-key" server appliance
solutions to enterprise customers. Our current server appliance hardware
platforms continue to combine creative hardware packaging, cooling and software
integration to provide high-density, scalable appliances in a 1U form factor.
In addition, our implementation of our July 2001 restructuring plan included a
reduction in our workforce from approximately 160 employees to approximately 95
employees. We incurred a charge to operations of approximately $6.9 million in
the fourth quarter ended September 30, 2001 as we executed our July 2001
restructuring plan. At September 30, 2001, we had an accumulated deficit of
approximately $93.4 million.

Industry Background

    Traditionally, organizations built their network infrastructure solutions
with general-purpose servers. This method requires extensive time and technical
resources and capabilities, which increases overall cost of ownership,
including time and cost of implementation. To extend the power and features of
a general-purpose server, organizations must integrate numerous discrete
hardware and software elements, including operating systems, applications,
security systems, load balancers and management tools, which further increases
overall cost of ownership and time-to-revenue. The server appliance was
developed to address these shortcomings of general-purpose servers and because
many organizations seek a well-designed solution to perform a single dedicated
service right out of the box at a low cost of ownership. International Data
Corporation estimates that the worldwide market for server appliances will grow
to $31 billion in 2005 from approximately $3.4 billion in 2000, a compounded
annual growth rate of approximately 156%. As market acceptance of server
appliances continues to grow, we believe that users will increasingly demand
products that meet specific functional requirements and reduce total cost of
ownership and, as a result, server appliance vendors who are able to densely
package and integrate standards-based platforms with various operating,
management and application software will have a broader market opportunity.

The Network Engines Solution

    We provide scalable high-density, standards-based server appliance hardware
platforms, software integration services and supply-chain management services
that enable our strategic partners to deliver "turn-key" solutions that are
easy to use, install and manage. Key elements of our solution include:

    High Performance in a Small Package. Through creative hardware packaging
and cooling, we are able to deliver a significant amount of computing power in
a small package. All of our current products are 1.75 inches in height, also
known as one rack unit ("1U"), which minimizes the space requirements for our
customers without a loss of computing power, thereby helping to reduce cost of
ownership.

    Value-add Integration and Engineering Services. We have significant
software integration skills and specialized technical resources to help our
partners to expand their server appliance product

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offerings while reducing technical resource and support costs by providing one
access point for appliance and system development, deployment and support.

    Supply-chain management. We have extensive manufacturing and inventory
management capabilities, which give us the ability to manage all of the
hardware and manufacturing needs of our partners. We provide our partners with
a "turn-key" solution for the hardware component of their server appliances.

The Network Engines Strategy

    Our objective is to become a leading provider of quality server appliance
hardware platforms and customized services to independent software vendors and
leading OEMs. The key elements of our strategy include:

    Re-focusing Our Product Development. During fiscal 2001, we undertook an
extensive review of our operations, including our product development process.
As a result, we determined that we could both lower the cost of development of
our products and decrease development time through a significant increase in
the usage of "off-the-shelf" or "industry-standard" components in our products.
With our re-focused product development process, we believe that the
integration of new "off-the-shelf" technologies into our products will improve
our products functionality, capacity and reliability and reduce development
time thereby lowering development costs.

    Broadening Our Server Appliance Hardware Platforms. We believe that ISVs
and OEMs have a specific set of requirements for creating "turn-key" appliance
solutions and, as a result, there is a need for a variety of server appliance
hardware platforms and appliance development services. To increase our appeal
to ISVs and OEMs, we are seeking to broaden our current line of server
appliance hardware platforms to expand their technological capabilities while
reducing their cost.

    Creating Exceptional Service and Appliance Development Support Practices.
As a part of our business strategy, we have created the Customer Integration
and Support (CIS) team. This team will assist our ISV partners to develop an
appliance product through the integration of their software and Network
Engines' standards-based hardware platform. The focus of our CIS team is the
development, execution, and completion of a comprehensive project plan,
schedules and deliverables that are focused on the goal of reducing the time to
market of our ISV partners' appliance solutions. Starting with the initial
engagement, our CIS team relationship extends through the product development
process, general release and throughout the entire support lifecycle. Once an
ISV's appliance is released, the CIS team's focus shifts to provide ongoing
technical, logistic and escalation management support.

    Establishing Strong Brand Identity. We seek to develop market recognition
in Network Engines as a leading server appliance hardware vendor. We employ a
public relations campaign aimed at increasing company name recognition and
identification in our targeted market to enhance our sales efforts.

    Investing in Businesses, Products and Technologies. Our primary goal is to
increase shareholder value. We intend to continue to pursue strategic
acquisitions of, or investments in, businesses, products

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<PAGE>

and technologies that will provide us with additional industry expertise,
enhance our range of product offerings, expand our development and production
capacity, broaden our client base, expand our geographical presence and
ultimately enhance shareholder value.

Products and Services

    Network Engines' Appliance Alliance Program is our approach to building
high-performance, high-density server appliance hardware platforms for use by
ISVs and leading OEM technology partners. This program enables us to combine
robust hardware platforms and custom integration and support services with
industry leading software applications to create superior "turnkey" appliance
solutions for end-users. Creating appliance solutions allows ISVs and OEMs to
broaden their product offering to take advantage of greater market
opportunities, faster time to revenue and increased customer satisfaction.

  Products:

    We currently offer ApplianceEngine 1000(TM), WebEngine Sierra(TM) and
Storage Array(TM) server appliance hardware platforms. Each of our server
appliance hardware platforms is in a 1U form and each has significant power,
packing and cooling features, which make them an excellent choice for any
computing environment.

  ApplianceEngine1000:

    The ApplianceEngine 1000 provides reliable, cost-effective performance in a
1U, rack mounted, Intel standards-based platform. The ApplianceEngine 1000 is
built on a solid foundation of Intel-based technologies and industry-standard
hardware components. When combined with application programs, it creates an
optimized, tested and certified appliance ready-to-deploy and use when it
arrives at the end-users' site. The ApplianceEngine 1000 is an easy-to-use,
manage and deploy server appliance hardware platform designed to help our
partners create low-cost and high-performance server appliance solutions. We
are currently offering the ApplianceEngine 1000 at prices beginning at
approximately $1,500 and we began shipments of the ApplianceEngine 1000 in
November 2001.

  WebEngine Sierra:

    The WebEngine Sierra is a 1U, high performance server appliance hardware
platform designed to provide our partners with significant computing power for
the most demanding application requirements. The WebEngine Sierra is ideal for
any application requiring speed and dependability as it combines high-level
processing capabilities with an advanced cooling system and many
"hot-swappable" components. We are currently offering the WebEngine Sierra at
prices beginning at approximately $2,000. We began shipping the WebEngine
Sierra in February 2001.

  Storage Array:

    StorageArray is a highly affordable, 1U disk enclosure designed to provide
additional storage capacity in space-constrained environments. Our modular
design enables our customers to attach the StorageArray to either a WebEngine
Sierra or an ApplianceEngine 1000 for quick and easy capacity

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expansion. The StorageArray packs eight disks of storage, up to 584GB, into a
compact 1U package. We currently offer the StorageArray at prices beginning at
approximately $5,000. We began shipping the StorageArray in February 2001.

  Services:

    Our partners are entitled to take advantage of Network Engines' service
offerings as part of our Appliance Alliance Program. These services include:

  Hardware and Software:

       .   Build-to-order hardware--We build appliances based on each Appliance
           Alliance member's specified configuration. The build process begins
           once an order is received.

       .   Software pre-installation services--Our consulting and engineering
           teams work with our Appliance Alliance members to develop custom
           "images" that contain all of the software needed to create "plug and
           go" appliance solutions.

       .   Software development toolkits--We have designed toolkits to enable
           our partners to take better advantage of our technology. Using our
           Front Panel Software Development Kit (SDK), our partners are able to
           set the appliance name, add custom menus and display status messages
           on the front panel to allow for faster, easier configuration. In
           addition we offer a remote management toolkit, for monitoring system
           health (temperatures, voltages, fan speeds), as well as power and
           reset functions.

  Branding:

       .   Branded bezels--As part of the services provided to Appliance
           Alliance members, the front panel display ("bezel") of each server
           appliance can be privately "branded" to display each individual
           Appliance Alliance member's logo, colors or other identification.

       .   Branded packaging--Appliance Alliance members also have the ability
           to custom brand the packaging for their appliance. We modify
           shipping cartons, packaging and documentation to reflect the
           identity of each of our individual partners to the specifications
           requested.

  Manufacturing:

       .   Testing and qualification--All appliances are tested 100% prior to
           leaving the Network Engines manufacturing facility. We work closely
           with each of our partners to develop clear acceptance and test
           criteria for their appliances.

       .   Inventory management support services--We are equipped to stock any
           custom hardware that our partners require. Arrangement may also be
           made to have appliances pre-built and stocked for immediate shipment.

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  Sales Support:

       .   Joint marketing activities--Appliance Alliance members may
           participate in seminars and tradeshows, as well as joint sales
           trainings. We can also feature our partners' logos, appliance
           description and ordering information on the "Solutions" section of
           our web site. As part of their membership, partners have access to
           white papers, product images, presentations and marketing collateral.

       .   Partner Web pages--Appliance Alliance members have access to a
           secure partner section of our web site, where they will find
           information about their specific configurations and images, the
           Network Engines product roadmap, engineering and marketing documents
           and file transfers and downloads and on-line ordering tools.

Customers

    Prior to July 31, 2001, we sold our products through primarily direct sales
channels to end-users whose businesses were related to the Internet, otherwise
known as "new-economy" businesses. The recent economic slow-down has had a
dramatic effect on these "new-economy" businesses, which resulted in a
significant decline in our net revenues during fiscal 2001. On July 31, 2001,
we began a process of re-focusing our business strategy on selling our server
appliance hardware platforms through indirect sales channels by forming
strategic partnerships with ISVs and OEMs. As a result, our customers now
include ISVs and OEMs that want to build server appliance solutions using our
hardware platforms as a component of their solutions. Because this re-focused
business strategy began so late in our fiscal year, which ended September 30,
2001, we did not begin to realize net revenues from sales to ISV partners
during fiscal 2001. Since the re-focus of our business strategy, we were able
to generate approximately $500,000 of net revenues from sales to one OEM
partner during fiscal 2001. While we expect sales to OEMs to continue, our
current OEM arrangement does not obligate our OEM partner to purchase any
quantity of our products in the future.

Sales

    Our sales organization is focused on developing strategic partnerships with
ISVs who wish to offer their products in an appliance form and OEMs who could
sell Network Engines' hardware under their own label. Our regional sales
managers and systems engineers work in teams to analyze our prospective ISV and
OEM customers' requirements and propose server appliance solutions that meet
their needs and their customers' needs. Our sales teams maintain close
relationships with our customers on an on-going basis to ensure a high degree
of customer satisfaction. Sales managers are compensated with a base salary and
commissions, which are based on their attainment of sales quotas. In addition
to a base salary, our systems engineers receive bonus payments based on the
sales revenues generated by their assigned customers. We have regional sales
managers and systems engineers that are located in and serve strategic
metropolitan areas, including the northeastern United States, the mid-Atlantic
United States, and the west coast of the United States. As of November 30,
2001, we employed 15 people in sales.

Marketing

    Our marketing objectives include building market awareness and acceptance
of Network Engines and our products and services, as well as generating
qualified customer leads. We attend trade shows,

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engage in electronic mail and telemarketing campaigns, and provide information
about our company and our products on our web site. Our executives speak at
industry events and provide briefings to industry analysts and trade press.

    Our marketing goals include the following:

       .   to position us as a leader in providing server appliance hardware
           platforms and custom integration services;

       .   to plan and build an integrated program addressing both internal and
           external audiences, including prospects, customers, business and
           trade press, industry analysts and investors;

       .   to design and implement media and tactical programs that communicate
           effectively with our target audiences; and

       .   to clearly and consistently communicate our positioning in our
           marketing programs.

Support Services

    We believe that our ability to consistently provide high-quality customer
service and support is a key factor in attracting and retaining ISV and OEM
partners. In line with our decision to focus our core business on products for
the ISV and OEM markets, we have engaged a third party services company to
assume the services requirements for all of our discontinued products. As a key
component of our re-focused business strategy, we will provide support to our
ISV and OEM partners through our customer support staff based in our Canton,
Massachusetts facility, as well as through our technical sales engineers, who
are located in key U.S. market areas. We expect that the level of our support
activities will vary depending on each of our partners' needs. Our support
services include on-site service visits provided by our customer support staff
and our technical sales engineers, telephone and e-mail support via our Canton,
Massachusetts facility's help desk and direct support through our web site,
which offers technical information designed to assist in answering frequently
asked questions and in problem diagnosis and resolution. In addition, we
provide a warranty program for all of our products, which ranges from one to
three years in duration for all parts replacement. As of November 30, 2001, we
employed 7 people in support services.

Manufacturing

    We use a combination of in-house production and third-party contract
manufacturing services to produce our server appliance hardware platforms. The
level to which we utilize the services of our contract manufacturer depends on
our production needs in relationship to our production capacity. Our
manufacturing strategy allows us to reduce our capital expenditures, conserve
working capital that would be required to fund inventory, adjust manufacturing
volumes more quickly to meet changes in demand and operate with reduced space
dedicated to manufacturing operations. As of November 30, 2001, we employed 19
people in our manufacturing group.

Research & Development

    We believe that our future success depends on our ability to expand the
features and functionality of our server appliance hardware platforms and
develop additional products that give us technological

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advantages. We have assembled a team of highly skilled engineers with
significant industry experience in high-density packaging, server appliance
design, embedded system and cluster management, networking, software, quality
assurance and technical documentation. As of November 30, 2001, we employed 28
people in this group.

    We will continue to integrate our hardware designs with industry-standard
technology from other vendors in order to meet cost, functionality and
time-to-market objectives. We currently have new server appliance hardware
platforms under development that are intended to reduce the ownership cost of
the server appliance hardware platforms we offer to our customers. Development
work underway is aimed at incorporating the latest microprocessor, main logic
board and memory designs into highly optimized packaging as server appliance
hardware platforms for integration with any application. Our research and
development activities range from feasibility studies to active development
efforts. It is possible that we may choose to abandon any or all of these
activities without bringing them to market.

    Our product development expenses for fiscal 1999, 2000 and 2001 were $2.6
million, $8.2 million and $12.7 million, respectively. We expect our product
development expenses to decrease as a result of our July 2001 restructuring, as
we have discontinued much of the development of proprietary hardware and
software platforms. We will continue however, to invest significant resources
in the development of products that integrate standards-based hardware and
software.

Strategic Relationships

    We have developed, and will continue to seek to develop, relationships with
key technology vendors that enhance our product offerings. We believe the use
of industry-standard technologies can reduce the cost of our development
activities and the cost of our products to our customers. We also believe that
the integration of emerging technologies from new vendors can allow us to bring
products to market more quickly and to reduce the costs that would result from
developing the capability ourselves.

Competition

    Our markets are new, rapidly evolving and highly competitive, and we expect
this competition to persist and intensify in the future. We face competition
primarily from server vendors that provide solutions for ISVs and build servers
for the OEM marketplace.

    Our principal competitors are general-purpose server manufacturers,
including Compaq, Dell, Hewlett-Packard, IBM and Sun Microsystems. These
competitors have expanded their product lines to include several types of
server appliance hardware platforms. In addition, we compete with computer
companies that specialize in building very compact rack-mounted server
products, but who do not typically include software in their offerings.
Examples of these competitors are SteelCloud, Penguin Computing and APPro.

    We believe that we compete favorably on factors that are important to our
target market, including packaging density, ease of installation and
configuration, cooling and power. Our additional service offerings, compared to
traditional hardware-only solutions, give an added value to our customers.

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    We expect competition in the server appliance hardware market to increase
significantly as more companies enter the market and current competitors expand
their product lines. Many of these potential competitors may have significant
competitive advantages, including greater name recognition, more resources to
apply to the development, marketing and sales of their products, and more
established sales channels.

Intellectual Property

    We have invested significantly in the development of proprietary technology
for our products and our operations frequently incorporate proprietary and
confidential information. We rely upon a combination of copyrights, patents,
trademarks and other intellectual property rights in combination with
non-disclosure and contractual arrangements to protect our proprietary rights.
We have patent applications pending but do not currently hold any patents. We
also enter into confidentiality or license agreements with our employees,
consultants and corporate partners, and control access to and distribution of
our software, documentation and other proprietary information.

    Despite our efforts to protect our proprietary rights, our competitors
might independently develop similar technology or unauthorized parties may
attempt to copy or otherwise obtain and use our products or technology.
Monitoring unauthorized use of our products is difficult, and we cannot be
certain that the steps we have taken will prevent misappropriation of our
technology. This is particularly true in foreign countries where the laws may
not protect our proprietary rights as fully as in the United States. Due to
rapid technological changes in our market, we believe the various legal
protections available for our intellectual property are of limited value. In
addition to such intellectual property, we seek to establish and maintain a
technology leadership position by leveraging technological and creative skills
of our personnel, new product developments and enhancements to existing
products.

Employees

    Our success in training and retaining skilled employees and, if the need
arises, obtaining temporary employees during periods of increased product
demand, is critical to our ability to produce high quality products on a timely
basis. As of November 30, 2001, we had 81 employees. In addition, we may hire
temporary employees during the year depending on market acceptance of our
products. We believe that the demographics surrounding our headquarters, and
our reputation and compensation package, should allow us to retain qualified
employees.

    We are committed to training our employees and we believe that we maintain
good employee relations.

ITEM 2. PROPERTIES

    Our principal business operations are conducted in our corporate
headquarters in Canton, Massachusetts where we lease approximately 75,000
square feet of manufacturing and office space. Included in our leased space is
23,000 square feet of office space that we have sub-leased to a third party for
the remainder of our lease term. We believe that our Canton facility will be
adequate to meet our requirements for the foreseeable future. In addition, we
have a leased development office in Austin, Texas.

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ITEM 3. LEGAL PROCEEDINGS

    On December 29, 1999, a former employee, George Flate, commenced a lawsuit
against us, a current officer and director and a former officer and director in
Suffolk Superior Court, a Massachusetts state court. Mr. Flate alleges that he
was unlawfully terminated as Vice President of OEM Sales in an effort to
deprive him of commission payments. He is seeking undisclosed damages based on
two contractual claims relating to his employment, although we anticipate he
will claim damages in the multi-million dollar range. Specifically, he is
alleging a breach of the implied covenant of good faith and fair dealing
against Network Engines and a claim of intentional interference with
contractual relations against the current and former officers of the company
named in the lawsuit. Both of these claims are based on Mr. Flate's allegations
that he is entitled to commissions from several transactions that were
negotiated after Mr. Flate was no longer with the company. Mr. Flate was
employed by Network Engines for approximately one year. Although we believe
these claims are without merit and we intend to vigorously defend against each
claim asserted in the complaint, an adverse resolution of either of these
claims could require the payment of substantial monetary damages. Moreover, our
defense against these claims might result in the expenditure of significant
financial and managerial resources. The case has proceeded through discovery
and the court has scheduled a pre-trial conference for December 20, 2001, at
which time a trial date will be established. We anticipate that the trial will
be scheduled in the first half of 2002.

    On or about December 3, 2001, Margaret Vojnovich filed in the United States
District Court for the Southern District of New York a lawsuit against Network
Engines, Inc. (the "Company"), Lawrence A. Genovesi, the Company's current
Chairman and former Chief Executive Officer, and Douglas G. Bryant, the
Company's Chief Financial Officer and Vice President of Administration
(collectively, the "Executive Officers"), FleetBoston Robertson Stephens, Inc.,
an underwriter of the Company's initial public offering in July 2000 (the "IPO"
), Credit Suisse First Boston Corp., Goldman Sachs & Co., Lehman Brothers Inc.
and Salomon Smith Barney, Inc. (collectively, the "Underwriter Defendants").
The suit generally alleges that the Underwriter Defendants violated the federal
securities laws by conspiring and agreeing to raise and increase the
compensation received by the Underwriter Defendants by agreeing with some
recipients of an allocation of IPO stock to agree to purchase shares of
manipulated securities in the after-market of the IPO at pre-determined price
levels designed to maintain, distort and/or inflate the price of the Company's
common stock in the aftermarket. The suit also alleges that the Underwriter
Defendants received undisclosed and excessive brokerage commissions and that,
as a consequence, the Underwriter Defendants successfully increased investor
interest in the manipulated IPO securities and increased the Underwriter
Defendants' individual and collective underwritings, compensation and revenues.
The suit further alleges that the defendants violated the federal securities
laws by issuing and selling securities pursuant to the IPO without disclosing
to investors that the Underwriter Defendants in the offering, including the
lead underwriters, had solicited and received excessive and undisclosed
commissions from certain investors. The suit seeks rescission of the purchase
prices paid by purchasers of shares of the Company's common stock and
certification of a plaintiff class consisting of all persons who acquired
shares of the Company's common stock between July 13, 2000 and December 6, 2000.

    The Company is in the process of reviewing this suit and intends to respond
in a timely manner. Additional suits may be filed with similar claims. As of
the date hereof, the Company is unable to

                                      10

<PAGE>

predict the outcome of this suit and any future suits and their ultimate
effect, if any, on the Company's financial condition.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

    No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year ended September 30, 2001.

EXECUTIVE OFFICERS OF THE COMPANY

    Our executive officers, their ages and positions as of November 30, 2001
were as follows:

<TABLE>
<CAPTION>
Name              Age Position
<S>               <C> <C>

John H. Curtis... 59  President and Chief Executive Officer

Douglas G. Bryant 44  Vice President of Administration, Chief Financial
                      Officer, Treasurer and Secretary

Timothy J. Dalton 50  Vice President of Manufacturing

James D. Murray.. 43  Vice President of Sales and Marketing

Ernest V. Labbe.. 54  Vice President of Customer Support
</TABLE>

    John H. Curtis joined Network Engines in March 2001 as president and CEO.
He joined Network Engines from Artel, Inc., where he was vice president of
worldwide sales. Prior to Artel, Mr. Curtis served as senior vice president of
worldwide operations at Banyan and was vice president of worldwide sales at
Intellution Inc. From 1980 to 1992, Mr. Curtis held several senior-level
management positions at Stratus Computer, Inc., including chief operating
officer, vice president of finance and vice president of international sales.

    Douglas G. Bryant has served as our Secretary and Vice President of
Administration since March 2000, our Treasurer since January 1998 and our Chief
Financial Officer since September 1997. Prior to joining Network Engines, Mr.
Bryant served as Chief Financial Officer of CrossComm Corporation, a
manufacturer of internetworking products including routers and switches, from
July 1996 to June 1997, and as Corporate Controller from September 1989 to June
1996.

    Timothy J. Dalton has served as Vice President of Manufacturing since
November 1997. From November 1996 to November 1997, Mr. Dalton served as
Operations Manager of Axil Computer Corporation, a privately-held designer and
manufacturer of eight-way SMP servers. From January 1994 to July 1996, Mr.
Dalton served as Director of Manufacturing Engineering of Concurrent Computer
Corporation, a designer and manufacturer of Real Time Fault Tolerant servers
for the financial and telecommunications industries.

    James D. Murray has served as our Vice President of Sales and Marketing
since September 2001. Prior to assuming this role, Mr. Murray served as our
director of North American sales. From December 1997 to September 1999, Mr.
Murray was with Phillips Speech Processing, formerly Voice Request Corporation,
where he managed sales teams and engineers across the country. Prior to Phillips

                                      11

<PAGE>

Speech Processing, Mr. Murray previously held a variety of management and
senior management sales positions at companies such as Centigram Communications
Corporation, United Technologies and Memorex Telex.

    Ernest V. Labbe has served as our Vice President of Customer Service since
March 2000. Mr. Labbe joined Network Engines from Digital Generation Systems,
Inc., a California-based multi-media network provider for the broadcast market,
where he was vice president of operations. Prior to Digital Generation Systems,
Mr. Labbe was a member of Lucent Technologies' Business Communication Systems
division, where he served as general manager of northeast operations. While at
Lucent, he also served as director of data networking service marketing and
director of multimedia customer service. Mr. Labbe also held customer service
management positions with Proteon, Inc., CrossComm Corporation and Motorola
Corporation.

                                      12

<PAGE>

                                    PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

  (a) Market Information

    Network Engines' common stock began trading on the Nasdaq National Market
on July 13, 2000 under the symbol "NENG". Prior to that time there had been no
market for our common stock. The following table sets forth the high and low
closing sales prices per share for our common stock on the Nasdaq National
Market for the period indicated:

Fiscal Year Ended September 30, 2000:

<TABLE>
<CAPTION>
                                             Fiscal 2001    Fiscal 2000
                                             ------------ ---------------
                                              High   Low   High     Low
<S>                                          <C>    <C>   <C>     <C>
First Quarter............................... $44.00 $1.63    *       *
Second Quarter..............................   3.44  0.97    *       *
Third Quarter...............................   1.40  0.61    *       *
Fourth Quarter..............................   0.87  0.54 $45.375 $24.875
</TABLE>
---------------------
* No public trading of the Company's common stock occurred during these periods.

  (b) Holders of record

    As of November 30, 2001, there were approximately 6,500 holders of record
of our common stock. Because many of such shares are held by brokers and other
institutions on behalf of stockholders, the Company is unable to estimate the
total number of stockholders represented by these record holders.

  (c) Dividends

    Network Engines has never paid or declared any cash dividends on its common
stock. Network Engines currently intends to retain any earnings for future
growth and, therefore, does not expect to pay cash dividends in the foreseeable
future.

  (d) Recent Sales of Unregistered Securities

  Common Stock

    During the fourth quarter of fiscal 2001, the Company did not issue any
unregistered shares of its common stock.

  (e) Use of Proceeds

    Through its initial public offering in July 2000, the Company sold
7,475,000 shares of common stock, inclusive of the underwriters' over
allotment, at an initial public offering price of $17 per share. Net proceeds
received by the Company in its initial public offering were approximately
$116.9 million

                                      13

<PAGE>

reflecting gross proceeds of $127.1 million net of underwriting fees of
approximately $8.9 million and other offering costs of approximately $1.3
million. None of the net proceeds of the initial public offering were paid by
the Company, directly or indirectly, to any director, officer or general
partner of the Company or any of their associates, or to any persons owning ten
percent or more of any class of the Company's equity securities, or any
affiliates of the Company. During the period from the offering to September 30,
2001, we have used the proceeds as follows: approximately $37.5 million was
used to fund the operations of the Company, approximately $4.6 million was used
for capital acquisitions and approximately $198,000 was used to repurchase the
Company's common stock under a stock repurchase plan.

                                      14

<PAGE>

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

    The following selected consolidated financial data are derived from the
financial statements of Network Engines, Inc. The historical results presented
are not necessarily indicative of future results. The selected consolidated
financial data set forth below should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
Network Engines' Consolidated Financial Statements and the Related Notes.

                     Selected Consolidated Financial Data
                     (in thousands, except per share data)

<TABLE>
<CAPTION>
                                                                                       Year ended September 30,
                                                                            ---------------------------------------------
                                                                             1997     1998     1999      2000      2001
<S>                                                                         <C>      <C>      <C>      <C>       <C>
Net product revenues....................................................... $   609  $ 1,102  $ 6,031  $ 38,216  $ 12,850
Net license revenues.......................................................      --       --       --     4,858       665
                                                                            -------  -------  -------  --------  --------
      Total net revenues...................................................     609    1,102    6,031    43,074    13,515
Cost of product revenues...................................................     465    1,591    4,733    26,695    12,344
Cost of license revenues...................................................      --       --       --        34         5
Cost of revenues stock compensation........................................      --       --       16       254       332
Inventory write-down.......................................................      --       --       --        --    20,278
                                                                            -------  -------  -------  --------  --------
      Total cost of revenues...............................................     465    1,591    4,749    26,983    32,959
                                                                            -------  -------  -------  --------  --------
   Gross profit (loss).....................................................     144     (489)   1,282    16,091   (19,444)
Operating expenses:........................................................
   Research and development................................................     395      923    2,564     8,219    12,704
   Selling and marketing...................................................     477    1,593    2,920    15,760    18,118
   General and administrative..............................................     396      620      934     3,963     7,047
   Stock compensation......................................................      --       --      111     2,667     5,800
   Restructuring and other charges.........................................      --       --       --        --    10,886
   Amortization of intangible assets.......................................      --       --       --        --       675
                                                                            -------  -------  -------  --------  --------
      Total operating expenses.............................................   1,268    3,136    6,529    30,609    55,230
                                                                            -------  -------  -------  --------  --------
Income (loss) from operations..............................................  (1,124)  (3,625)  (5,247)  (14,518)  (74,674)
Interest income (expense), net.............................................     (33)    (574)    (897)    2,037     5,151
                                                                            -------  -------  -------  --------  --------
Income (loss) before extraordinary item....................................  (1,157)  (4,199)  (6,144)  (12,481)  (69,523)
Extraordinary gain on extinguishment of debt...............................      --       --      314        --        --
                                                                            -------  -------  -------  --------  --------
Net income (loss)..........................................................  (1,157)  (4,199)  (5,830)  (12,481)  (69,523)
Accretion of redeemable convertible preferred stock........................      --       --     (223)   (8,103)       --
                                                                            -------  -------  -------  --------  --------
Net income (loss) attributable to common stockholders...................... $(1,157) $(4,199) $(6,053) $(20,584) $(69,523)
                                                                            =======  =======  =======  ========  ========
Income (loss) per common share before extraordinary item--basic and diluted $ (0.36) $ (1.31) $ (1.92) $  (1.99) $  (2.03)
Extraordinary item per common share--basic and diluted.....................      --       --     0.09        --        --
                                                                            -------  -------  -------  --------  --------
Net income (loss) per common share--basic and diluted...................... $ (0.36) $ (1.31) $ (1.83) $  (1.99) $  (2.03)
                                                                            =======  =======  =======  ========  ========
Shares used in computing basic and diluted net income (loss)
 per common share..........................................................   3,177    3,200    3,312    10,344    34,241
</TABLE>

<TABLE>
<CAPTION>
                                                         September 30,
                                           ------------------------------------------
                                            1997    1998     1999      2000    2001
<S>                                        <C>     <C>      <C>      <C>      <C>
Balance Sheet Data:
Cash, cash equivalents and restricted cash $   16  $   113  $ 1,535  $112,429 $75,934
Working capital (deficit).................    (97)  (3,937)   1,897   128,332  70,873
Total assets..............................    699    1,730    5,864   146,212  83,004
Long-term debt, less current portion......     58       69      158        90       9
Redeemable convertible preferred stock....  1,000    1,000   12,467        --      --
Total stockholders' equity (deficit)......   (953)   4,554   (9,897)  135,476  74,489
</TABLE>

                                      15

<PAGE>

ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS

Overview

    We are a provider of high-density, server appliance hardware platforms and
custom integration services. Server appliances are pre-configured computer
network infrastructure devices designed to deliver specific application
functionality. We are focused on partnering with independent software vendors
("ISVs") and original equipment manufacturers ("OEMs") to provide these
strategic partners with dense server appliance hardware, integration services
and appliance development, deployment and support to allow these strategic
partners to deliver "turn-key" solutions to their end-user customers. When we
first entered the server appliance market, we focused our business primarily on
providing scalable web content servers to Internet-based organizations, content
infrastructure providers and larger enterprises. It was necessary for us to
design most of the hardware components that went into our servers and, as a
result, we invested significant resources in the development of our products.
In June 1999, we introduced the first "1U" (1.75 inch tall) server, the
WebEngine Blazer. Since the introduction of our WebEngine Blazer product, we
experienced significant growth as we invested in the development of our
technology and products, the recruitment and training of personnel for our
engineering, sales and marketing and technical support departments, and the
establishment of an administrative organization. As a result, our employee base
grew from 39 as of June 30, 1999 to 244 as of March 31, 2001, and our operating
expenses grew significantly.

    Over time, much of the hardware components of server appliances have become
commoditized and a significant number of companies have entered the server
appliance marketplace. In response to competitive pressures combined with the
effects of a downturn in the economy, which had a significant negative impact
on our "new economy" customers, we implemented a restructuring plan in the
quarter ended June 30, 2001, to better align our operating expenses with our
reduced revenues. This restructuring plan resulted in a $2.8 million charge to
operations in April 2001, a 73-employee reduction in our workforce, as well as
the curtailment of planned facility expansion and other cost cutting measures.
We further undertook an extensive review of our business strategy and in July
2001, we implemented a second restructuring of our business, which
de-emphasized much of our customized hardware and software development and
focused our resources on what we believe to be our core competencies of
hardware packaging and software integration. In addition, this restructuring of
our business included a transition from primarily direct sales channels to
partnerships with ISVs and OEMs in order to offer "turn-key" server appliance
hardware platforms to enterprise customers. Our current server appliance
hardware platforms continue to combine creative hardware packaging, cooling and
software integration to provide high-density, scalable appliances in a 1U form
factor. In addition, the implementation of our July 2001 restructuring plan
included a reduction in our workforce from approximately 160 employees to
approximately 95 employees. We incurred a charge to operations of approximately
$6.9 million in the fourth quarter ended September 30, 2001 as we executed our
July 2001 restructuring plan. At September 30, 2001, we had an accumulated
deficit of approximately $93.4 million.

    Our revenues are derived from sales of our server appliance hardware
platforms. We recognize revenues upon shipment, provided evidence of an
arrangement has been received, no obligations

                                      16

<PAGE>

remain outstanding and collectibility is reasonably assured. The majority of
our sales to date have been to customers in the United States.

    In the past, we generated a portion of our net revenues from license
arrangements, which allowed certain customers to sell our WebEngine Blazer
product under their name in exchange for per unit fees. We recognized license
revenues upon the licensee's sale to its customers. During the year ended
September 30, 2001, we recorded approximately $665,000 in license revenues. We
do not anticipate future revenues from existing license revenue arrangements.

    Gross profit (loss) represents net revenues recognized less the cost of
revenues. Cost of revenues includes cost of materials, manufacturing costs,
manufacturing personnel expenses, obsolescence charges, packaging, license fees
and shipping and warranty costs. Our gross profit (loss) is affected by the mix
of our product revenues and our product pricing and the timing, size and
configuration of customer orders.

    Research and development expenses consist primarily of salaries and related
expenses for personnel engaged in research and development, fees paid to
consultants and outside service providers, material costs for prototype and
test units and other expenses related to the design, development, testing and
enhancements of our products. We expense all of our research and development
costs as they are incurred. We believe that a significant level of investment
in product research and development is required to remain competitive. We
expect to continue to devote substantial resources to product development.
However, we expect research and development expenses to decrease in absolute
dollars during fiscal 2002 due to reduced headcount as a result of workforce
reductions implemented during fiscal 2001 and our transition away from the
development of significant proprietary hardware and software. At September 30,
2001, there were 32 employees in research in development.

    Selling and marketing expenses consist primarily of salaries, commissions
and related expenses for personnel engaged in sales, marketing and customer
support functions, as well as costs associated with advertising, trade shows,
public relations and marketing materials. We expect selling and marketing
expenses to decrease in absolute dollars during fiscal 2002 due to reduced
headcount as a result of workforce reductions implemented during fiscal 2001
and our transition to indirect sales channels. At September 30, 2001, there
were 23 employees in sales, marketing and customer support.

    General and administrative expenses consist primarily of salaries and other
related costs for executive, finance, accounting, information technology,
facilities and human resources personnel, as well as accounting, legal, other
professional fees and allowance for doubtful accounts. We expect general and
administrative expenses to decrease in absolute dollars during fiscal 2002 due
to reduced headcount as a result of workforce reductions and other cost
reductions implemented during fiscal 2001. There were 14 general and
administrative employees at September 30, 2001.

    We have recorded deferred stock compensation on our balance sheet of $15.5
million in connection with stock option and restricted stock grants to our
employees and directors that were granted between February 1, 1999 and June 30,
2000. This amount represents the difference between the exercise price and the
deemed fair value of our common stock for financial reporting purposes at

                                      17

<PAGE>

the date of grant. We are amortizing this stock compensation over the vesting
period of the related options. All options granted subsequent to June 30, 2000
have been issued with exercise prices equal to the fair market value of our
common stock and, accordingly, no additional deferred compensation has been
recorded. Through September 30, 2001, we amortized $6.2 million to stock
compensation expense and $5.8 million of deferred stock compensation has been
reversed due to the cancellation of options for terminated employees.

    We recorded $6.4 million of deferred compensation on our balance sheet as a
result of restricted stock issued to the employees of IP Performance, Inc. ("IP
Performance") who were retained as our employees in connection with our
acquisition of IP Performance in November 2000. The restricted stock vests
annually through November 2003 and is contingent upon continued employment.
Through September 30, 2001, we amortized $2.9 million to stock compensation
expense. In accordance with the restricted agreements, if employees who were
retained in connection with our acquisition of IP Performance are terminated
without cause, all of the related restricted stock vests upon termination and
all of the related amortization of deferred stock compensation will be
accelerated.

    During the next twelve months, we expect to amortize stock compensation of:

<TABLE>
<CAPTION>
                           Expected
                       Amortization of
Fiscal Quarter Ending Stock Compensation
                        (in thousands)
<S>                   <C>
 December 31, 2001...       $3,754
 March 31, 2002......          300
 June 30, 2002.......          300
 September 30, 2002..          300
</TABLE>

    We then expect aggregate per quarter stock compensation amortization of
approximately $300,000 during fiscal 2003 and a total of approximately $300,000
during fiscal 2004. The amount of stock compensation expense to be recorded in
future periods could change if restricted stock, or options, for accrued but
unvested compensation is forfeited.

                                      18

<PAGE>

Results of Operations

    The following data summarizes the results of the Company's operations for
each of the past five fiscal years. All percentage amounts were calculated
using the underlying data in thousands.

<TABLE>
<CAPTION>
                                              1997   1998   1999   2000  2001
 <S>                                          <C>    <C>    <C>    <C>   <C>
 As a Percentage of Net Revenues:
 Net product revenues........................  100%   100%   100%   89%    95%
 Net license revenues........................   --     --     --    11      5
                                              ----   ----   ----   ---   ----
        Total net revenues...................  100    100    100   100    100
 Cost of product revenues....................   76    144     78    62     91
 Cost of license revenues....................   --     --     --    --     --
 Cost of revenues stock compensation.........   --     --     --     1      2
 Inventory write-down........................   --     --     --    --    150
                                              ----   ----   ----   ---   ----
        Total cost of revenues...............   76    144     78    63    243
                                              ----   ----   ----   ---   ----
 Gross profit (loss).........................   24    (44)    22    37   (143)
 Operating expenses:
    Research and development.................   65     84     43    19     94
    Selling and marketing....................   79    145     48    37    134
    General and administrative...............   65     56     15     9     52
    Stock compensation.......................   --     --      2     6     43
    Restructuring and other charges..........   --     --     --    --     81
    Amortization of intangible assets........   --     --     --    --      5
                                              ----   ----   ----   ---   ----
        Total operating expenses.............  209    285    108    71    409
                                              ----   ----   ----   ---   ----
 Income (loss) from operations............... (185)  (329)   (86)  (34)  (552)
 Interest income (expense), net..............   (5)   (52)   (15)    5     38
                                              ----   ----   ----   ---   ----
 Income (loss) before extraordinary item..... (190)  (381)  (101)  (29)  (514)
 Extraordinary gain on extinguishment of debt   --     --      5    --     --
                                              ----   ----   ----   ---   ----
 Net Income (loss)........................... (190%) (381%)  (96%) (29%) (514%)
                                              ====   ====   ====   ===   ====
</TABLE>

  Years ended September 30, 2001 and 2000

  Net Revenues

    Net revenues decreased to $13.5 million in the year ended September 30,
2001 from $43.1 million in the year ended September 30, 2000. The decrease is
due primarily to a decrease in product sales volumes as a result of the general
economic slowdown and its significant negative impact on the information
technology spending of our "new economy" customer base. To a lesser extent, the
decline in net revenues during the year ended September 30, 2001 is the result
of a decrease in license revenues recognized as well as a lower average selling
price of our products due to increased competitive pricing pressure.

  Gross Profit (Loss)

    Gross profit (loss) decreased to a loss of ($19.4) million for the year
ended September 30, 2001 from a profit of $16.1 million in the year ended
September 30, 2000. This decrease is primarily attributable to a net charge of
approximately $20.3 million to write-down excess and obsolete

                                      19

<PAGE>

inventory in the year ended September 30, 2001, for which there was no
comparable charge in the year ended September 30, 2000. The inventory
write-down resulted from an unanticipated decline in sales during the year
ended September 30, 2001, as well as a high level of inventory and firm
inventory commitments compared to the Company's reduced expectations for future
product sales. Excluding the inventory write-down, and stock compensation,
gross profit decreased to $1.2 million, or 8.6% of net revenues, in the year
ended September 30, 2001 from $16.3 million, or 37.9% of net revenues, in the
year ended September 30, 2000. This decrease was primarily due to the decrease
in product sales volumes and a decrease in license revenues recognized during
the year ended September 30, 2001. To a lesser extent, the decrease in gross
profit (loss) is the result of a lower average selling price of our products
due to competitive pricing pressure in the year ended September 30, 2001.

  Operating Expenses

    Research and Development. Research and development expenses increased to
$12.7 million in the year ended September 30, 2001 from $8.2 million in the
year ended September 30, 2001. This increase was due primarily to increased
compensation costs as research and development personnel increased from 68
employees at September 30, 2000 to 85 during fiscal 2001 prior to our April and
July 2001 restructurings. At September 30, 2001 we had 32 employees in research
and development. To a lesser extent, the increase in research and development
expenses was due to expenses related to the development of our WebEngine
Sierra, StorageArray and ApplianceEngine 1000 products, as well as our
StorageEngine Voyager product, which was discontinued in connection with our
July 2001 restructuring.

    Selling and Marketing. Selling and marketing expenses increased to $18.1
million in the year ended September 30, 2001 from $15.8 million in the year
ended September 30, 2000. This increase was due primarily to increased salary
costs as a result of the increase in our sales, marketing and customer support
personnel to a peak of 98 employees during the year ended September 30, 2001
from 80 employees at September 30, 2000. As of September 30, 2001, we had 23
employees in our sales, marketing and customer support organization. In
addition, the increase in selling and marketing expenses is also attributable
to increased travel costs as a result of the changes in sales, marketing and
customer support personnel during fiscal 2001 and facilities related costs as a
result of a full year of expenses associated with the expansion of our Canton
headquarters, which occurred during May 2000. These increases were partially
off-set by decreases in commissions and bonuses as a result of the decrease in
revenue during fiscal 2001, recruiting costs and trade show expenses.

    General and Administrative. General and administrative expenses increased
to $7.0 million in the year ended September 30, 2001 from $4.0 million in the
year ended September 30, 2000. This increase was due primarily to an increase
in bad debt expense as a result of the general economic slowdown over the past
twelve months and the resulting effect that it had on our "new-economy"
customers. In addition, the increase in general and administrative expenses is
due to increased compensation costs as general and administrative personnel
increased from 29 employees at September 30, 2000 to a peak of 34 employees
during the year ended September 30, 2001 and ended at 14 employees as of
September 30, 2001. This increase was also due to increased insurance costs
associated with our operation as a public company and increased consulting and
professional service fees.

                                      20

<PAGE>

    Stock Compensation. We recognized stock compensation expense of $3.2
million and $2.9 million in the years ended September 30, 2001 and 2000,
respectively, related to the grant of options and restricted stock to employees
and directors during fiscal 1999 and prior to our initial public offering in
fiscal 2000. In connection with restricted stock issued to employees as a
result of our acquisition of IP Performance, Inc., we recorded deferred stock
compensation of $6.4 million, of which we recognized $2.9 million as stock
compensation expense during the year ended September 30, 2001.

    Amortization of Goodwill and Intangible Assets. In connection with our
acquisition of IP Performance, Inc. in November 2000, we recorded goodwill and
intangible assets of $2.7 million, of which we amortized $675,000 in the year
ended September 30, 2001. In July 2001, we completed an intensive review of our
business, which resulted in our implementation of a restructuring plan. This
restructuring plan included a discontinuation of much of the customized
hardware and software that had previously been a part of our product
development process. As a result of this restructuring and an assessment of
expected future cash flows, we determined that the recoverability of intangible
assets resulting from our purchase of IP Performance, Inc. was uncertain. We
recognized an impairment charge for the full amount of the unamortized
intangible assets, approximately $2,023,000, during the fourth quarter of
fiscal 2001.

    Restructuring and Other Charges. During the year ended September 30, 2001
we undertook two restructurings of our operations, the first of these
restructurings occurred in April 2001 and the second in July 2001. Our April
2001 restructuring was implemented in order to better align our operating
expenses with reduced revenues and, as a result, we recorded a charge to
operations of $2,812,000. This charge was due to a reduction in our workforce
from 243 employees to 170 employees, the curtailment of a planned expansion
into leased facilities and other items. This charge included approximately
$951,000 for employee related costs including severance payments to terminated
employees and stock option compensation expense related to modifications of
certain stock options held by terminated employees, approximately $1,331,000 to
write off certain assets related to facilities that we will not be occupying
and approximately $530,000 primarily related to non-refundable deposits on
tradeshows we did not attend as well as certain other sales and marketing
commitments. Our July 2001 restructuring was the result of an intensive review
of our business, which resulted in a re-focus of our sales strategy towards
strategic partnerships with ISVs and OEMs and a discontinuation of much of the
customized hardware and software that had previously been included in our
products. As a result of the implementation of our July 2001 restructuring, we
recorded a charge to operations of approximately $6,871,000. This charge
included approximately $1,643,000 of employee related costs, approximately
$2,224,000 as a result of our disposal of certain property and equipment,
approximately $2,023,000 to write off goodwill and intangible assets which were
deemed to be impaired, approximately $618,000 of facility costs associated with
non-cancelable operating leases for space which will not be occupied and
approximately $363,000 of other charges. In addition to the April and July
restructurings, in March 2001, we retired fixed assets related to our WebEngine
Blazer product line. These fixed assets had a total net book value of
approximately $1,203,000 and consisted primarily of computer equipment
previously utilized in the production and sales of the WebEngine Blazer, our
previous generation web content server appliance product. The total of the
restructuring and other charges detailed above was approximately $10,886,000.

                                      21

<PAGE>

  Interest income, interest expense and other

    Interest income increased to $5.2 million in the year ended September 30,
2001 from $2.2 million in the year ended September 30, 2000. This increase was
due to a higher average cash balance as a result of the investment of the net
proceeds of our initial public offering in July 2000.

  Years ended September 30, 2000 and 1999

  Net Revenues

    Net revenues increased to $43.1 million in fiscal 2000 from $6.0 million in
fiscal 1999. The increase is due primarily to increased sales volumes of our
WebEngine Blazer product, which was introduced in June 1999 and, to a lesser
extent, increased license revenues. During fiscal 2000, we earned license
revenues of approximately $4.9 million, primarily from IBM's sales of its
Netfinity 4000R, which incorporates our WebEngine Blazer hardware design,
compared to no license revenues during fiscal 1999.

  Gross Profit (Loss)

    Gross profit increased to $16.1 million in fiscal 2000 from $1.3 million in
fiscal 1999. As a percentage of net revenues, gross profit increased to 37% in
fiscal 2000 from 22% in fiscal 1999. The increase in gross profit was primarily
due to increased sales volumes of our WebEngine Blazer product and, to a lesser
extent, license revenue earned during fiscal 2000, as the cost of license
revenues is considerably less than that of product revenues. The increase in
gross profit as a percentage of net revenues was primarily attributable to the
increase in license revenues and to a lesser extent, the increase in sales
volumes.

  Operating Expenses

    Research and Development. Research and development expenses increased to
$8.2 million in fiscal 2000 from $2.6 million in fiscal 1999. The increase in
research and development expenses was due primarily to increased compensation
and related costs as research and development personnel increased from 15
employees at September 30, 1999 to 68 employees at September 30, 2000. To a
lesser extent, the increase in research and development expenses was due to
increased recruiting costs and increased prototype and test unit costs.

    Selling and Marketing. Selling and marketing expenses increased to $15.8
million in fiscal 2000 from $2.9 million in fiscal 1999. The increase in
selling and marketing expenses was due primarily to increased compensation and
related costs as a result of higher net revenues and as sales, marketing and
customer support personnel increased from 17 employees at September 30, 1999 to
80 employees at September 30, 2000. The increase in selling and marketing
expenses is also attributable to increased advertising costs as a result of our
initial advertising campaign and increased trade show costs. To a lesser
extent, the increase in selling and marketing expenses was due to increased
travel and recruiting costs.

    General and Administrative. General and administrative expenses increased
to $4.0 million in fiscal 2000 from $930,000 in fiscal 1999. The increase in
general and administrative expenses was due

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primarily to increased compensation and related costs as general and
administrative personnel increased from nine employees at September 30, 1999 to
29 employees at September 30, 2000 and to higher consulting costs. To a lesser
extent, the increase in general and administrative expenses was due to
increased corporate recruiting costs.

    Stock Compensation. In fiscal 2000, we recorded deferred stock compensation
of $13.9 million relating to stock options and restricted stock granted to
employees and directors versus $1.6 million recorded in fiscal 1999. These
amounts are being amortized over the vesting period of the related options and
restricted stock. Stock compensation expense increased to $2.9 million in
fiscal 2000 from $131,000 in fiscal 1999.

  Other income (expense), net

    Other income (expense), net increased to $2.0 million of income in fiscal
2000 from ($897,000) of expense in fiscal 1999. The increase was due primarily
to an increase in interest income in fiscal 2000, as a result of the investment
of the net proceeds from our initial public offering in July 2000 and a
decrease in interest expense as a result of our conversion of bridge loans into
redeemable convertible preferred stock in January 1999. Prior to the bridge
loan conversion, we incurred amortization expense associated with the discount
attributable to warrants issued in connection with the bridge loans as well as
interest expense.

  Years ended September 30, 1999 and 1998

  Net Revenues

    Net revenues increased to $6.0 million in fiscal 1999 from $1.1 million in
fiscal 1998. The increase in net revenues from fiscal 1998 to 1999 was
primarily due to the June 1999 introduction of our WebEngine Blazer server
appliance.

  Gross Profit (Loss)

    Gross profit (loss) increased to a $1.3 million gross profit in fiscal 1999
from a ($489,000) gross loss in fiscal 1998. Gross profit (loss) as a
percentage of net revenues increased to 22% in fiscal 1999 from (44%) in fiscal
1998. The increase in gross profit from fiscal 1998 to 1999 was primarily due
to increased sales volume related to the June 1999 introduction of our
WebEngine Blazer that was partially offset by increased obsolescence charges
related to the P6000 product line and increased manufacturing compensation
costs.

  Operating Expenses

    Research and Development. Research and development expenses increased to
$2.6 million in fiscal 1999 from $923,000 in fiscal 1998. The increase in
research and development expenses was primarily due to increased compensation
costs as research and development personnel increased from five at September
30, 1998 to 15 at September 30, 1999 and increased prototype and test unit
costs.

    Selling and Marketing. Selling and marketing expenses increased to $2.9
million in fiscal 1999 from $1.6 million in fiscal 1998. The increase was
primarily due to increased compensation costs as

                                      23

<PAGE>

selling and marketing personnel increased from 13 at September 30, 1998 to 17
at September 30, 1999, higher sales commissions associated with increased net
revenues and increased trade show costs.

    General and Administrative. General and administrative expenses increased
to $930,000 in fiscal 1999 from $620,000 in fiscal 1998. The increase was
primarily due to increased compensation costs as general and administrative
personnel increased from five at September 30, 1998 to nine at September 30,
1999, increased professional fees and increases in our allowance for doubtful
accounts.

    Stock Compensation. During fiscal 1999 we recorded deferred stock-based
compensation of $1.6 million related to stock options granted to employees and
directors. We had no deferred stock-based compensation relating to stock option
grants in fiscal 1998. We recorded $131,000 of stock-based compensation expense
in operating expenses in fiscal 1999. There was no stock-based compensation
expense recorded in operating expenses during fiscal 1998.

  Other income (expense)

    Other income (expense), net increased to ($897,000) of expense in fiscal
1999 from ($574,000) of expense in fiscal 1998. This increase in expense is
primarily due to increased interest expense as a result of the issuance of
additional subordinated promissory notes during fiscal 1999 as well as a full
year of interest expense in fiscal 1999 associated with subordinated promissory
notes issued during fiscal 1998.

  Extraordinary Gain

    The extraordinary gain on extinguishment of debt realized in fiscal 1999
was primarily due to the forgiveness of all interest expense on notes payable
upon the conversion of that debt into series B and series C redeemable
convertible preferred stock.

Liquidity and Capital Resources

    Since fiscal 1997, we have financed our operations primarily through the
sale of equity securities, borrowings and the sale of our products. On July 18,
2000, we completed our initial public offering by selling 7,475,000 shares of
our common stock, including the exercise of the underwriters' over-allotment
option of 975,000 shares, at $17 per share and raised approximately $116.9
million, net of offering costs and underwriting fees totaling approximately
$10.2 million. Prior to our initial public offering, we raised approximately
$37.3 million, net of offering costs, from the issuance of preferred stock. As
of September 30, 2001, we had $74.8 million in cash and cash equivalents,
excluding restricted cash of $1.1 million.

    Cash used in operating activities was $5.1 million, $23.7 million and $32.9
million in the years ended September 30, 1999, 2000 and 2001, respectively.
Cash used in operating activities in fiscal 1999 was primarily due to a net
loss of $5.8 million and increases in accounts receivable and inventories,
offset in part by increases in accounts payable and accrued expenses and
adjusted for non-cash charges for depreciation, inventory reserves and
amortization of discount on notes payable. Cash used in operating activities in
fiscal 2000 was primarily due to a net loss of $12.5 million and increases

                                      24

<PAGE>

in accounts receivable, the amount due from our contract manufacturer and
inventories offset in part by increases in accounts payable, accrued expenses
and deferred revenue and adjusted for non-cash charges for stock compensation,
depreciation and inventory reserves. Cash used in operating activities in
fiscal 2001 was primarily due to a net loss of $69.5 million, an increase in
inventories and prepaid expenses and other current assets and decreases in
accounts payable and deferred revenue. These uses of cash were offset in part
by a decrease in accounts receivable and a net increase in the amount due to
our contract manufacturer and adjustments for non-cash charges for inventory
reserves, restructuring and other charges, stock compensation and depreciation
and amortization.

    Cash used in investing activities was $723,000, $7.8 million and $4.2
million in fiscal 1999, 2000 and 2001 respectively. Cash used in investing
activities was primarily for purchases of property and equipment and, in fiscal
2000, leasehold improvements to our facility in Canton, Massachusetts. Cash
used in investing activities during the year ended September 30, 2001 also
included deposits of restricted cash for an executive loan guarantee and an
increase in other assets.

    Cash provided by (used in) financing activities was $7.2 million, $142.4
million and ($383,000) in fiscal 1999, 2000 and 2001, respectively. Cash
provided by financing activities in fiscal 1999, was primarily the result of
the sale of preferred stock and through bridge loans from stockholders, which
provided net proceeds of approximately $6.2 million and $1.0 million,
respectively. All bridge loans were converted into preferred stock in fiscal
1999. In fiscal 2000, cash provided by financing activities was primarily
generated through our initial public offering of common stock and from the sale
of preferred stock through which we raised net proceeds of approximately $116.9
million and $25.2 million, respectively. Cash used in financing activities in
the year ended September 30, 2001 was primarily through the issuance of notes
to stockholders and the acquisition of treasury stock, offset in part by cash
provided by the issuance of common stock from the exercise of stock options and
through our employee stock purchase plan.

    In August 2001, our board of directors authorized the repurchase of up to
$5,000,000 of our common stock from time to time on the open market or in
non-solicited privately negotiated transactions. Through November 30, 2001, we
have repurchased approximately 1,412,000 shares of our common stock for
approximately $1,136,000.

    In connection with our April 2001 and July 2001 restructurings, we are
obligated to make additional cash payments of approximately $1,100,000 over the
next twelve months. We anticipate that funds required to make all restructuring
payments will be available from our current working capital. We believe that
the restructuring actions undertaken during fiscal 2001 will result in cost
savings to the Company of approximately $17,000,000 during fiscal 2002.

    Our future liquidity and capital requirements will depend upon numerous
factors, including:

       .   our ability to form an adequate number of strategic partnerships
           with ISVs and OEMs;

       .   the level of success of our strategic ISV and OEM partners in
           selling server appliance solutions that include our server appliance
           hardware platforms;

       .   the costs and timing of product engineering efforts and the success
           of these efforts;

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<PAGE>

       .   the costs involved in obtaining maintaining and enforcing
           intellectual property rights; and

       .   market developments.

    We believe that our available cash resources, including cash and cash
equivalents, together with cash we expect to generate from sales of our
products will be sufficient to meet our debt service, operating and capital
requirements through at least the next 12 months. After that, we may need to
raise additional funds. We may seek to raise additional funds through
borrowings, public or private equity financings or from other sources. There
can be no assurance that additional financing will be available at all or, if
available, will be on terms acceptable to us. If additional financing is needed
and is not available on acceptable terms, we may need to reduce our operating
expenses.

Recent Accounting Pronouncements

    In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 141 ("SFAS 141"), "Business Combinations" and SFAS No. 142 ("SFAS 142"),
"Goodwill and Other Intangible Assets." SFAS 141 requires that all business
combinations be accounted for under the purchase method only and that certain
acquired intangible assets in a business combination be recognized as assets
apart from goodwill. SFAS 142 requires, among other things, the cessation of
the amortization of goodwill. In addition, the standard includes provisions for
the reclassification of certain existing recognized intangibles as goodwill,
reassessment of the useful lives of existing recognized intangibles,
reclassification of certain intangibles out of previously reported goodwill and
the identification of reporting units for purposes of assessing potential
future impairments of goodwill. SFAS 142 also requires the completion of a
transitional goodwill impairment test six months from the date of adoption.
SFAS 141 is effective for all business combinations initiated after June 30,
2001. SFAS 142 is effective for the Company's fiscal quarters beginning on
October 1, 2002; early adoption is not permitted. The Company is currently
assessing the impact of adopting SFAS 142 on its financial position and results
of operations.

    In October 2001, the FASB issued Statement of Financial Accounting
Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets" ("SFAS 144"). The objectives of SFAS 144 are to address significant
issues relating to the implementation of FASB Statement No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be
Disposed Of" ("SFAS 121"), and to develop a single accounting model, based on
the framework established in SFAS 121, for long-lived assets to be disposed of
by sale, whether previously held and used or newly acquired. SFAS 144
supersedes SFAS 121; however, it retains the fundamental provisions of SFAS 121
for (1) the recognition and measurement of the impairment of long-lived assets
to be held and used and (2) the measurement of long-lived assets to be disposed
of by sale. SFAS 144 supersedes the accounting and reporting provisions of
Accounting Principles Board No. 30, "Reporting the Results of
Operations--Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions"
("APB 30"), for segments of a business to be disposed of. However, SFAS 144
retains APB 30's requirement that entities report discontinued operations
separately from continuing operations and extends that reporting requirement to
"a component of an entity" that either has been disposed of or is classified as
"held for sale." SFAS 144

                                      26

<PAGE>

also amends the guidance of Accounting Research Bulletin No. 51, "Consolidated
Financial Statements," to eliminate the exception to consolidation for a
temporarily controlled subsidiary. SFAS 144 is effective for financial
statements issued for fiscal years beginning after December 15, 2001, including
interim periods, and, generally, its provisions are to be applied
prospectively. The Company does not expect the application of SFAS 144 to have
a material impact on the Company's financial position or results of operations.

               FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

    The risks and uncertainties described below are not the only ones we are
faced with. Additional risks and uncertainties not presently known to us, or
that are currently deemed immaterial, may also impair our business operations.
If any of the following risks actually occur, our financial condition and
operating results could be materially adversely affected.

                        Risks Related to Restructuring

We have recently restructured our business. There can be no assurance that our
restructuring will have the intended effect on our business.

    During the year ended September 30, 2001, we restructured our business. Our
restructuring included a considerable reduction in our workforce and our future
operating expenses and an adjustment to our business strategy to concentrate
our resources on our core competencies, which we believe to be hardware
platform packaging and the ability to integrate our hardware platforms with
various operating systems, management systems and application software systems.
Our restructuring also includes a transition from primarily direct sales
channels to partnerships with independent software vendors and original
equipment manufacturers in order to offer "turn-key" solutions for enterprise
customers. In addition, our restructuring includes the termination of sales of
our WebEngine Blazer, WebEngine Roadster, WebEngine Viper, AdminEngine and
StorageEngine Voyager products. There can be no assurance that our
restructuring, even if fully implemented, will have a positive effect on our
financial results, our operations, our market share, the market price of our
common stock or public perception of us in the server appliance marketplace, or
that we will ever achieve substantial revenues, any one of which could cause
further decline in the market price of our common stock.

If we fail to generate significant revenues from strategic partnerships with
independent software vendors and original equipment manufacturers, our
operations could be materially adversely affected and as a result, we may
choose to discontinue one or more of the components of our new business
strategy.

    To date, our revenues have been principally derived from direct sales to
companies in the Internet marketplace, otherwise known as "new economy"
customers. A major component of our restructuring is a business strategy change
to focus our sales and marketing efforts on indirect sales through strategic
partnerships with ISVs and OEMs. To date, we have not entered into a
significant number of definitive agreements with ISVs and OEMs. We may not be
able to develop a significant number of strategic partnerships with ISVs and
OEMs and, even if we are successful in developing strategic partnerships

                                      27

<PAGE>

with ISVs and OEMs, this strategy may fail to generate sufficient revenues to
offset the demands that this strategy will place on our business. A failure to
generate significant revenues from strategic partnerships could materially
adversely affect our operations and, as a result, we may choose to discontinue
one or more of the components of our new business strategy.

               Risks Related to Competition Within Our Industry

If we are not able to effectively compete against providers of general-purpose
servers, specific-purpose servers or other server appliance providers, our
revenues will not increase and may decrease further.

    In the market for server appliance hardware platforms, we face significant
competition from larger companies who market general-purpose servers,
specific-purpose servers and server appliances and have greater financial
resources and name recognition than we do. Many of these companies have larger
and more established service organizations to support these products. These and
other large competitors may be able to leverage their existing resources,
including their service organizations, and provide a wider offering of products
and higher levels of support on a more cost-effective basis than we can. In
addition, competing companies may be able to undertake more extensive
promotional activities, adopt more aggressive pricing policies and offer more
attractive terms to their customers than we can. If these large competitors
provide lower cost server appliance hardware platforms with greater
functionality or support than our products, or if some of their products are
comparable to ours and are offered as part of a range of products that is
broader than ours, our products could become undesirable. Even if the
functionality of competing products is equivalent to ours, we face a
substantial risk that a significant number of customers would elect to pay a
premium for similar functionality rather than purchase products from a
less-established vendor. Increased competition may continue to negatively
affect our business and future operating results by leading to price
reductions, higher selling expenses or a reduction in our market share.

If server appliances are not increasingly adopted as a solution to meet
companies' computer application needs, the market for our products may not grow
and the market price of our common stock could decline as a result of lower
revenues or reduced investor expectations.

    We expect that substantially all of our revenues will come from sales of
our newest and future server appliance hardware platforms. As a result, we
depend on the growing use of server appliances to meet businesses' computer
application needs. The market for server appliance products has only recently
begun to develop and it is evolving rapidly. Because this market is new, we
cannot predict its potential size or future growth rate with a high degree of
certainty. Our revenues may not grow and the market price of our common stock
could decline if the server appliance market does not grow rapidly.

    We believe that our expectations for the growth of the server appliance
market may not be fulfilled if customers continue to use general-purpose
servers. The role of our products could, for example, be limited if
general-purpose servers become better at performing functions currently being
performed by server appliances or are offered at a lower cost. This could force
us to further lower the prices of our products or result in fewer sales of our
products.

                                      28

<PAGE>

Our revenues could be reduced further if our larger competitors make
acquisitions in order to join their extensive distribution capabilities with
our smaller competitors' products.

    Large server manufacturers may not only develop their own server appliance
solutions, but they may also acquire or establish cooperative relationships
with our smaller competitors, including smaller private companies. Because
large server manufacturers have significant financial and organizational
resources available, they may be able to quickly penetrate the server appliance
market by leveraging the technology and expertise of smaller companies and
utilizing their own extensive distribution channels. We expect that the server
industry will experience further consolidation. It is possible that new
competitors or alliances among competitors may emerge and rapidly acquire
significant market share through consolidation. Consolidation within the server
marketplace could adversely affect our revenues.

We may sell fewer products if other vendors' products are no longer compatible
with ours or other vendors bundle their products with those of our competitors
and sell them at lower prices.

    Our ability to sell our products depends in part on the compatibility of
our products with other vendors' software and hardware products. Developers of
these products may change their products so that they will no longer be
compatible with our products. These other vendors may also decide to bundle
their products with other server appliances for promotional purposes and
discount the sales price of the bundle. If that were to happen, our business
and future operating results could suffer if we were no longer able to offer
commercially viable products.

Server appliance products are subject to rapid technological change due to
changing operating system software and network hardware and software
configurations, and our sales will suffer if our products are rendered obsolete
by new technologies.

    The server appliance market is characterized by rapid technological change,
frequent new product introductions and enhancements, potentially short product
life cycles, changes in customer demands and evolving industry standards. Our
products could be rendered obsolete if products based on new technologies are
introduced or new industry standards emerge.

    New products and product enhancements can require long development and
testing periods, which require us to retain, and may require us to hire
additional, technically competent personnel. Significant delays in new product
releases or significant problems in installing or implementing new products
could seriously damage our business. We have on occasion experienced delays in
the scheduled introduction of new and enhanced products and cannot be certain
that we will avoid similar delays in the future.

    Our future success depends upon our ability to utilize our creative
packaging and hardware and software integration skills to combine
industry-standard hardware and software to produce low-cost, high-performance
products that satisfy our strategic partners' requirements and achieve market
acceptance. We cannot be certain that we will successfully identify new product
opportunities and develop and bring new products to market in a timely and
cost-effective manner.

                                      29

<PAGE>

                    Risks Related to Our Financial Results

We are an early-stage company in the evolving market for server appliances and
have recently released key new products, which have not yet obtained
significant market acceptance.

    Because of our limited operating history in the server appliance market, it
is difficult to discern trends that may emerge and affect our business. We may
experience negative trends associated with seasonality that, due to our limited
operating history, we have not experienced in the past. In February 2001 we
began shipping our WebEngine Sierra, our next generation server appliance,
designed to replace our recently discontinued WebEngine Blazer product. To
date, this product has not obtained significant market acceptance and we cannot
be sure whether this, our recently introduced ApplianceEngine 1000 product, or
additional new product offerings, will obtain market acceptance, whether they
will capture adequate market share or whether we will be able to recognize
significant revenue from them. Our limited historical financial performance may
make it difficult for you to evaluate the success of our business to date and
to assess its future viability.

    If our new and enhanced products do not gain market acceptance, we may not
be able to attract and engage strategic ISV and OEM partners. If we are unable
to attract and engage ISV and OEM partners, our revenues and operating results
will be adversely affected. Factors that may affect the market acceptance of
our products, some of which are beyond our control, include the following:

       .   the growth and changing requirements of the server appliance market;

       .   the performance, quality, price and total cost of ownership of our
           products; and

       .   the availability, price, quality and performance of competing
           products and technologies.

We have a history of losses and expect to experience losses in the future,
which could result in the market price of our common stock declining.

    Since our inception, we have incurred significant net losses, including net
losses of $5.8 million, $12.5 million and $69.5 million in fiscal 1999, 2000
and 2001, respectively. We expect to continue to have net losses in the future.
In addition, we had an accumulated deficit of $93.4 million as of September 30,
2001. We believe that our future growth depends upon the success of our new
product development and selling and marketing efforts, which will require us to
incur significant product development, selling and marketing and administrative
expenses. As a result, we will need to generate significant revenues to achieve
profitability. We cannot be certain that we will achieve profitability in the
future or, if we achieve profitability, that we will be able to sustain it. If
we do not achieve and maintain profitability, the market price for our common
stock may continue to decline.

    During the year ended September 30, 2001, we implemented restructuring
plans to curtail discretionary selling, general and administrative expenses,
consolidate our international operations, implement new business strategies to
efficiently maximize our resources and utilize other cost saving methods. If
these, or other cost control measures that we may employ, are unsuccessful, our
expenses could increase and our losses could be greater than expected, which
could negatively impact the market price for our common stock.

                                      30

<PAGE>

Our revenues fell sharply in fiscal 2001 and we may not be able to return to
our historical revenue growth rates, which could cause our stock price to
decline even further.

    Our revenues grew rapidly in fiscal 1999 and fiscal 2000 and fell sharply
in fiscal 2001. We are unable to predict whether or not we will be able to
return to the rate of revenue growth achieved in fiscal 1999 and fiscal 2000
because of uncertain economic conditions, competition and our inexperience in
identifying and engaging ISV and OEM partners. If we are unable to return to
the rate of revenue growth we experienced in fiscal 2000, our stock price could
experience further declines.

If the commodification of products and competition in the server appliance
market increases, then the average unit price of our products may decrease and
our operating results may suffer.

    Products in the appliance server market may be subject to further
commodification as the industry matures and other businesses introduce more
competing products. The average unit price of our products has already
decreased, and may continue to decrease, in response to changes in our product
mix, competitive pricing pressures, or new product introductions into the
server appliance marketplace. If we are unable to offset decreases in our
average selling prices by increasing our sales volumes, our revenues will
decline. Changes in the mix of sales of our products, including the mix of
higher margin sales of products sold in smaller quantities and somewhat lower
margin sales of products sold in larger quantities, could adversely affect our
operating results for future quarters. To maintain our gross margins, we also
must continue to reduce the manufacturing cost of our products. Our efforts to
produce higher margin products, continue to improve our products and produce
new products may make it difficult to reduce our manufacturing cost per
product. Further, our utilization of a contract manufacturer, Sanmina-SCI
Systems, may not allow us to reduce our cost per product.

Our quarterly revenues and operating results may fluctuate due to a lack of
growth of the server appliance market in general or failure of our products to
achieve market acceptance.

    Our quarterly revenues and operating results are difficult to predict and
may fluctuate significantly from quarter to quarter because server appliances
generally, and our current products in particular, are relatively new and the
future growth of the market for our products is uncertain. In addition, we
expect to rely on additional new products for growth in our net revenues in the
future. If the server appliance market in general fails to grow as expected or
our products fail to achieve market acceptance, our quarterly net revenues and
operating results may fall below the expectations of investors and public
market research analysts. In this event, the price of our common stock could
decline further.

We have historically derived a substantial portion of our revenues from a small
number of customers, and our revenues may decline significantly if any major
customer cancels or delays a purchase of our products.

    A relatively small number of customers have historically accounted for a
significant portion of our net revenues. In fiscal 1999, sales to three
customers accounted for 46%, 28% and 14% of net revenues. In fiscal 2000, sales
to two customers accounted for 16% and 12% of net revenues. In fiscal 2001,
none of our customers accounted for greater than 10% of our net revenues.
However, we anticipate a reliance on large customers for a significant portion
of our future net revenues. None of our

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<PAGE>

customers is obligated to purchase any quantity of our products in the future.
If any of our current large customers stop purchasing from us, delay future
purchases or discontinue use of our technology, our revenues and profitability
may be adversely affected, our reputation in the industry may suffer and our
ability to predict cash flow accurately may decrease. Accordingly, unless and
until we expand and diversify our customer base, our future success will depend
upon the timing and size of future purchase orders, if any, from our largest
customers.

               Risks Related to Our Marketing and Sales Efforts

We need to effectively manage our sales and marketing operations to increase
market awareness and sales of our products. If we fail to do so, our growth, if
any, will be limited.

    Through our recent restructuring plans, we significantly reduced our
selling and marketing personnel in an attempt to reduce operating expenses and
to conserve cash. Although we have fewer selling and marketing personnel, we
must continue to increase market awareness and sales of our products. If we
fail in this endeavor, our growth, if any, will be limited.

Our efforts to promote our brand may not result in the desired brand
recognition by customers or in increased sales.

    In the fast growing market for server appliance hardware platforms, we
believe we need a strong brand to compete successfully. In order to attract and
retain customers, we believe that our brand must be recognized and viewed
favorably by our customers. As part of our recent restructuring plans, we
reduced our marketing programs. If we are unable to design and implement
effective marketing campaigns or otherwise fail to promote and maintain our
brand, our sales may not increase and our business may be adversely affected.
Our business may also suffer if we incur excessive expenses promoting and
maintaining our brand but fail to achieve the expected or desired increase in
revenues.

If we are unable to effectively manage our customer service and support
activities, we may not be able to retain our existing customers and attract new
customers.

    We have a small customer service and support organization. We need to
effectively manage our customer support operations to ensure that we maintain
good relationships with our customers. If our customer support organization is
unsuccessful in maintaining good customer relationships, we may lose customers
to our competitors and our reputation in the market could be damaged. As a
result, we may lose revenue and incur losses greater than expected.

                  Risks Related to Our Product Manufacturing

We rely on a single contract manufacturer to produce our products at high
volumes, which could have an adverse effect on our operations.

    Our agreement with Sanmina-SCI does not guarantee production levels,
manufacturing line space or manufacturing prices. In addition, our agreement
with Sanmina-SCI renews annually and allows

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<PAGE>

either party to elect not to renew the agreement. If we are required to, or if
we choose to, change outside manufacturers, we may experience transitional
difficulties and we may lose sales and customer relationships may suffer. In
addition, in the event that we require additional manufacturing capacity,
Sanmina-SCI may not have additional facilities available when we need them.
Commencing volume production or expanding production to another facility owned
by Sanmina-SCI may be expensive and time-consuming. In addition, commencement
of the manufacturing of our products at additional Sanmina-SCI manufacturing
sites we may need in the future may cause transitional problems, including
delays and quality control issues, which could cause us to lose sales and
impair our ability to achieve profitability. We may need to find new outside
manufacturers to manufacture our products in higher volume and at lower costs
to meet increased demand and competition.

    Because the Sanmina Corporation and SCI Systems merger occurred very
recently, there can be no assurance as to the effect, positive or negative,
that this merger will have on the operation of Sanmina-SCI as it relates to our
agreement with them.

If we do not accurately forecast our component requirements, our business and
operating results could be adversely affected.

    We use rolling forecasts based on anticipated product orders to determine
our component requirements. Lead times for materials and components that we
order vary significantly and depend on factors including specific supplier
requirements, contract terms and current market demand for those components. In
addition, a variety of factors, including the timing of product releases,
potential delays or cancellations of orders and the timing of large orders,
make it difficult to predict product orders. As a result, our component
requirement forecasts may not be accurate. If we overestimate our component
requirements, we may have excess inventory, which would increase our costs and
negatively impact our cash position. If we underestimate our component
requirements, we may have inadequate inventory, which could interrupt our
manufacturing and delay delivery of our products to our customers. Any of these
occurrences would negatively impact our business and operating results.

Our dependence on sole source and limited source suppliers for key components
makes us susceptible to supply shortages that could prevent us from shipping
customer orders on time, if at all, and could result in lost sales or customers.

    We depend upon single source and limited source suppliers for our
industry-standard processors, main logic boards and power supplies and our
heat-pipe, chassis and sheet metal parts. We also depend on limited sources to
supply several other industry-standard components. We have in the past
experienced, and may in the future experience, shortages of, or difficulties in
acquiring, components needed to produce our products. Shortages have been of
limited duration and have not yet caused delays in production of our products.
However, shortages in supply of these key components for an extended time would
cause delays in the production of our products, prevent us from satisfying our
contractual obligations and meeting customer expectations, and result in lost
sales or customers. If we are unable to buy components we need or if we are
unable to buy components at acceptable prices, we will not be able to
manufacture and deliver our products on a timely or cost-effective basis to our
customers.

                                      33

<PAGE>

Risks Related to Our Products' Dependence on Intellectual Property and Our Use
                                 of Our Brand

Our reliance upon contractual provisions, domestic copyright and trademark laws
and our applied-for patents to protect our proprietary rights may not be
sufficient to protect our intellectual property from others who may sell
similar products.

    Our products are differentiated from those of our competitors by our
internally developed software and hardware and the manner in which they are
integrated into our products. If we fail to protect our intellectual property,
other vendors could sell products with features similar to ours, and this could
reduce demand for our products. We believe that the steps we have taken to
safeguard our intellectual property afford only limited protection. Others may
develop technologies that are similar or superior to our technology or design
around the copyrights and trade secrets we own. Despite the precautions we have
taken, laws and contractual restrictions may not be sufficient to prevent
misappropriation of our technology or deter others from developing similar
technologies. In addition, there can be no guarantee that any of our patent
applications will result in patents, or that any such patents would provide
effective protection of our technology.

    In addition, the laws of the countries in which we decide to market our
services and solutions may offer little or no effective protection of our
proprietary technology. Reverse engineering, unauthorized copying or other
misappropriation of our proprietary technology could enable third-parties to
benefit from our technology without paying us for it, which would significantly
harm our business.

We have invested substantial resources in developing our products and our
brand, and our operating results would suffer if we were subject to a
protracted infringement claim or one with a significant damages award.

    Substantial litigation regarding intellectual property rights and brand
names exists in our industry. We expect that server appliance products may be
increasingly subject to third party infringement claims as the number of
competitors in our industry segment grows and the functionality of products in
different industry segments overlaps. We are not aware that our products employ
technology that infringes any proprietary rights of third parties. However,
third parties may claim that we infringe their intellectual property rights.
Any claims, with or without merit, could:

       .   be time-consuming to defend;

       .   result in costly litigation;

       .   divert our management's attention and resources;

       .   cause product shipment delays; or

       .   require us to enter into royalty or licensing agreements.

    Royalty or licensing agreements may not be available on terms acceptable to
us, if at all. A successful claim of product infringement against us or our
failure or inability to license the infringed or similar technology could
adversely affect our business because we would not be able to sell the impacted
product without redeveloping it or incurring significant additional expenses.

                                      34

<PAGE>

                      Other Risks Related to Our Business

A class action lawsuit has been filed against us, our chairman and one of our
executive officers.

    On or about December 3, 2001, a class action lawsuit was filed against us,
our chairman, one of our executive officers and the underwriters of our initial
public offering. We are unable to predict the outcome of this suit, or other
similar suits, on our financial condition and while we maintain certain
insurance coverage, there can be no assurance that this claim will not result
in substantial monetary damages in excess of our insurance coverage. In
addition, we may expend significant resources to defend this case. This class
action lawsuit, or other similar suits, could negatively impact both our
financial condition and the market price for our common stock.

If the market price of our common stock is not quoted on a national exchange,
our ability to raise future capital may be hindered and the market price of our
common stock may be negatively impacted.

    The market price for our common stock has significantly declined during the
past year and our common stock failed to achieve a closing bid price of one
dollar for a period of thirty days. As a result, we received notification from
the NASDAQ stock market that, if our common stock failed to maintain a closing
bid price of one dollar or greater for a period of ten trading days prior to
and including October 29, 2001, then there is the potential that our common
stock could be de-listed from the NASDAQ National Market. However, on September
27, 2001, NASDAQ announced that it had suspended its minimum bid and market
value of public float requirements for continued listing until January 2, 2002.
NASDAQ adopted this measure to help companies remain listed in view of the
extraordinary market conditions following the tragedy of September 11, 2001.
Under the temporary relief provided by the new rules, companies will not be
cited for bid price or market value of public float deficiencies and companies,
such as Network Engines, currently under review for deficiencies or in the
hearings process will be taken out of the process with respect to the bid price
or market value of public float requirements and no deficiencies will accrue
during the proposed suspension process. Nevertheless, when the minimum bid
price requirement for continued listing on NASDAQ is reinstated on January 2,
2002, new de-listing proceedings may be initiated against out common stock. If
we are unable to regain compliance with these requirements, our common stock
may be de-listed from trading on the NASDAQ. If our common stock were de-listed
from NASDAQ, among other things, this could result in a number of negative
implications, including reduced liquidity in our common stock as a result of
the loss of market efficiencies associated with NASDAQ and the loss of federal
preemption of state securities laws as well as the potential loss of confidence
by suppliers, customers and employees, the loss of analyst coverage and
institutional investor interest, fewer business development opportunities and
greater difficulty in obtaining financing.

If we do not retain our senior management, we may not be able to successfully
execute our business plan.

    As a result of our recent restructurings we have lost members of our
management team. The loss of key members of our current management team could
harm us. Our success is substantially dependent on the ability, experience and
performance of these members of our senior management

                                      35

<PAGE>

team. Because of their ability and experience, we may not be able to implement
successfully our business strategy, if we lose one or more of these members.

If we fail to retain appropriate levels of qualified technical personnel, we
may not be able to develop and introduce our products on a timely basis.

    We require the services of qualified technical personnel. We have
experienced the negative effects of an economic slowdown. Our revenues have
declined significantly during the past year and the market price of our common
stock has decreased significantly. As a result, we have implemented plans to
substantially reduce our operating expenditures, including a reduction in the
number of personnel in our organization. This reduction in personnel places
added pressure on the remaining employees and management of the Company. These
and other factors may make it difficult for us to retain the qualified
employees and management that we need to effectively manage our business
operations, including key research and development activities. If we are unable
to retain a sufficient number of technical personnel we may not be able to
complete development of, or upgrade or enhance, our products in a timely
manner, which could negatively impact our business and could hinder any future
growth.

If our products fail to perform properly and conform to our specifications, our
customers may demand refunds or assert claims for damages and our reputation
and operating results may suffer.

    Because our server appliance hardware platforms are complex, they could
contain errors that can be detected at any point in a product's life cycle. In
the past we have discovered errors in some of our products and have experienced
delays in the shipment of our products during the period required to correct
these errors or we have had to replace defective products that were already
shipped. These delays and replacements have principally related to new product
releases. Errors in our products may be found in the future and any of these
errors could be significant. Detection of any significant errors may result in:

       .   the loss of or delay in market acceptance and sales of our products;

       .   diversion of development resources;

       .   injury to our reputation; or

       .   increased maintenance and warranty costs.

    These problems could harm our business and future operating results.
Product errors or delays could be material, including any product errors or
delays associated with the introduction of new products or the versions of our
products that support Windows or UNIX-based operating systems. While we attempt
to limit our risk contractually, if our products fail to conform to warranted
specifications, customers could demand a refund for the purchase price or
assert claims for damages.

    Moreover, because our products may be used in connection with critical
distributed computing systems services, we may receive significant liability
claims if our products do not work properly. Our agreements with customers
typically contain provisions intended to limit our exposure to liability
claims. However, these limitations may not preclude all potential claims.
Liability claims could exceed

                                      36

<PAGE>

our insurance coverage and require us to spend significant time and money in
litigation or to pay significant damages. Any claims for damages, even if
unsuccessful, could seriously damage our reputation and our business.

Our stock may be subject to substantial price and volume fluctuations due to a
number of factors, many of which will be beyond our control that may prevent
our stockholders from reselling our common stock at a profit.

    The securities markets have experienced significant price and volume
fluctuations in the past and the market prices of the securities of technology
companies have been especially volatile. This market volatility, as well as
general economic, market or political conditions, could reduce the market price
of our common stock in spite of our operating performance. In addition, our
operating results could be below the expectations of public market analysts and
investors, and in response the market price of our common stock could decrease
significantly. Investors may be unable to resell their shares of our common
stock for a profit. In the past, companies that have experienced volatility in
the market price of their stock have been the object of securities class action
litigation. If we were the object of securities class action litigation, it
could result in substantial costs and a diversion of management's attention and
resources. The recent decline in the market price of our common stock and
market conditions generally could adversely affect our ability to raise
additional capital, to complete future acquisitions of or investments in other
businesses and to attract and retain qualified technical and sales and
marketing personnel.

We have anti-takeover defenses that could delay or prevent an acquisition and
could adversely affect the price of our common stock.

    Our board of directors has the authority to issue up to 5,000,000 shares of
preferred stock and, without any further vote or action on the part of the
stockholders, will have the authority to determine the price, rights,
preferences, privileges and restrictions of the preferred stock. This preferred
stock, if issued, might have preference over the rights of the holders of
common stock and could adversely affect the price of our common stock. The
issuance of this preferred stock may make it more difficult for a third party
to acquire us or to acquire a majority of our outstanding voting stock. We
currently have no plans to issue preferred stock.

    In addition, provisions of our second amended and restated certificate of
incorporation, second amended and restated by-laws and equity compensation
plans may deter an unsolicited offer to purchase Network Engines. These
provisions, coupled with the provisions of the Delaware General Corporation
Law, may delay or impede a merger, tender offer or proxy contest involving
Network Engines. For example, our board of directors will be divided into three
classes, only one of which will be elected at each annual meeting. These
factors may further delay or prevent a change of control of our business.

Future sales by existing stockholders could depress the market price of our
common stock.

    Sales of a substantial number of shares of our common stock by existing
stockholders could depress the market price of our common stock and impair our
ability to raise capital through the sale of additional equity securities.

                                      37

<PAGE>

We have recently begun a stock repurchase plan. This plan may not have a
positive impact on the market price of our common stock.

    In August 2001, we announced and implemented a plan to repurchase up to $5
million of our common stock over time in the open market and through
non-solicited private transactions. There can be no assurance that this stock
repurchase plan will have a positive effect on the market price of our common
stock.

We may need additional capital that may not be available to us and, if raised,
may dilute our existing investors' ownership interest in us.

    We may need to raise additional funds to develop or enhance our services
and solutions, to fund expansion, to respond to competitive pressures or to
acquire complementary products, businesses or technologies. Additional
financing may not be available on terms that are acceptable to us. If we raise
additional funds through the issuance of equity or convertible debt securities,
the percentage ownership of our stockholders would be reduced and these
securities might have rights, preferences and privileges senior to those of our
current stockholders. If adequate funds are not available on acceptable terms,
our ability to fund our expansion, take advantage of unanticipated
opportunities, develop or enhance products or services, or otherwise respond to
competitive pressures would be significantly limited.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

    We do not engage in any foreign currency hedging transactions and
therefore, do not believe we are subject to exchange rate risk. We are exposed
to market risk related to changes in interest rates. We invest excess cash
balances in cash equivalents. We believe that the effect, if any, of reasonably
possible near-term changes in interest rates on our financial position, results
of operations and cash flows will not be material.

                                      38

<PAGE>

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                 Page
<S>                                                              <C>
REPORT OF INDEPENDENT ACCOUNTANTS...............................  40

CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 30, 2000 AND 2001...  41

CONSOLIDATED STATEMENT OF OPERATIONS FOR THE YEARS ENDED
  SEPTEMBER 30, 1999, 2000 AND 2001.............................  42

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT) FOR THE
  YEARS ENDED SEPTEMBER 30, 1999, 2000 AND 2001.................  43

CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED
  SEPTEMBER 30, 1999, 2000 AND 2001.............................  44

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS......................  45
</TABLE>

                                      39

<PAGE>

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders
of Network Engines, Inc.:

    In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, of stockholders' equity
(deficit) and of cash flows present fairly, in all material respects, the
financial position of Network Engines, Inc. and its subsidiaries at September
30, 2001 and 2000, and the results of their operations and their cash flows for
each of the three years in the period ended September 30, 2001 in conformity
with accounting principles generally accepted in the United States of America.
These financial statements are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements based
on our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States of America, which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

/s/ PRICEWATERHOUSECOOPERS LLP

Boston, Massachusetts
November 5, 2001, except for footnote 18
  for which the date is December 3, 2001

                                      40

<PAGE>

                             NETWORK ENGINES, INC.

                          CONSOLIDATED BALANCE SHEETS

                (in thousands except share and per share data)

<TABLE>
<CAPTION>
                                                                                                                 September 30,
                                                                                                              ------------------
                                                                                                                2000      2001
<S>                                                                                                           <C>       <C>
                                                  ASSETS
Current assets:
   Cash and cash equivalents................................................................................. $112,382  $ 74,805
   Restricted cash...........................................................................................       47     1,129
   Accounts receivable, net of allowance for doubtful accounts of $370 and $1,014 at September 30, 2000 and
    2001, respectively.......................................................................................   11,805     1,601
   Inventories...............................................................................................    6,600       607
   Prepaid expenses and other current assets.................................................................    1,031       857
   Due from contract manufacturer............................................................................    7,113       380
                                                                                                              --------  --------
      Total current assets...................................................................................  138,978    79,379
   Property and equipment, net...............................................................................    7,098     3,454
   Other assets..............................................................................................      136       171
                                                                                                              --------  --------
      Total assets........................................................................................... $146,212  $ 83,004
                                                                                                              ========  ========
                                   LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Accounts payable.......................................................................................... $  6,906  $  2,023
   Due to contract manufacturer..............................................................................       --     3,117
   Accrued compensation and other related benefits...........................................................    1,773       883
   Other accrued expenses....................................................................................    1,077       962
   Accrued restructuring and other charges...................................................................       --     1,368
   Deferred revenue..........................................................................................      827        93
   Current portion of capital lease obligations and notes payable............................................       63        60
                                                                                                              --------  --------
      Total current liabilities..............................................................................   10,646     8,506
Capital lease obligations and notes payable, net of current portion..........................................       90         9
Commitments and contingencies (Note 10)......................................................................

Stockholders' equity:
   Preferred stock, $.01 par value, 5,000,000 authorized and no shares issued and outstanding................       --        --
   Common stock, $.01 par value, 100,000,000 shares authorized; 34,218,585 and 35,188,095 shares issued;
    34,218,585 and 34,887,195 shares outstanding at September 30, 2000 and 2001, respectively................      342       352
   Additional paid-in capital................................................................................  171,314   175,288
   Accumulated deficit.......................................................................................  (23,915)  (93,438)
   Notes receivable from stockholders........................................................................      (94)     (702)
   Deferred stock compensation...............................................................................  (12,171)   (6,813)
   Treasury stock, at cost, 300,900 shares at September 30, 2001.............................................       --      (198)
                                                                                                              --------  --------
      Total stockholders' equity.............................................................................  135,476    74,489
                                                                                                              --------  --------
         Total liabilities and stockholders' equity.......................................................... $146,212  $ 83,004
                                                                                                              ========  ========
</TABLE>

The accompanying notes are an integral part of the consolidated financial
                                  statements.

                                      41

<PAGE>

                             NETWORK ENGINES, INC.

                     CONSOLIDATED STATEMENT OF OPERATIONS

                     (in thousands, except per share data)

<TABLE>
<CAPTION>
                                                                Year ended September 30,
                                                              ---------------------------
                                                               1999      2000      2001
<S>                                                           <C>      <C>       <C>
Net product revenues......................................... $ 6,031  $ 38,216  $ 12,850
Net license revenues.........................................      --     4,858       665
                                                              -------  --------  --------
     Total net revenues......................................   6,031    43,074    13,515
Cost of product revenues (excluding stock compensation)......   4,733    26,695    12,344
Cost of license revenues.....................................      --        34         5
Cost of revenues stock compensation..........................      16       254       332
Inventory write-down.........................................      --        --    20,278
                                                              -------  --------  --------
     Total cost of revenues..................................   4,749    26,983    32,959
                                                              -------  --------  --------
   Gross profit (loss).......................................   1,282    16,091   (19,444)
Operating expenses:..........................................
   Research and development (excluding stock compensation
    of $37, $430 and $3,392 for the years ended September
    30, 1999, 2000 and 2001, respectively)...................   2,564     8,219    12,704
   Selling and marketing (excluding stock compensation of
    $53, $1,217 and $1,244 for the years ended September
    30, 1999, 2000 and 2001, respectively)...................   2,920    15,760    18,118
   General and administrative (excluding stock compensation
    of $21, $1,020 and $1,164 for the years ended September
    30, 1999, 2000 and 2001, respectively)...................     934     3,963     7,047
   Stock compensation........................................     111     2,667     5,800
   Restructuring and other charges...........................      --        --    10,886
   Amortization of intangible assets.........................      --        --       675
                                                              -------  --------  --------
     Total operating expenses................................   6,529    30,609    55,230
                                                              -------  --------  --------
Loss from operations.........................................  (5,247)  (14,518)  (74,674)
Interest income..............................................      52     2,197     5,175
Interest expense and other...................................    (949)     (160)      (24)
                                                              -------  --------  --------
Loss before extraordinary item...............................  (6,144)  (12,481)  (69,523)
Extraordinary gain on extinguishment of debt.................     314        --        --
                                                              -------  --------  --------
Net loss.....................................................  (5,830)  (12,481)  (69,523)
Accretion of redeemable convertible preferred stock..........    (223)   (8,103)       --
                                                              -------  --------  --------
Net loss attributable to common stockholders................. $(6,053) $(20,584) $(69,523)
                                                              =======  ========  ========
Loss per common share before extraordinary item--basic and
 diluted..................................................... $ (1.92) $  (1.99) $  (2.03)
Extraordinary item per common share--basic and diluted.......    0.09        --        --
                                                              -------  --------  --------
Net loss per common share--basic and diluted................. $ (1.83) $  (1.99) $  (2.03)
                                                              =======  ========  ========
Shares used in computing basic and diluted net loss per
 common share................................................   3,312    10,344    34,241
</TABLE>

The accompanying notes are an integral part of the consolidated financial
                                  statements.

                                      42

<PAGE>

                             NETWORK ENGINES, INC.

           CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)

                       (in thousands, except share data)

<TABLE>
<CAPTION>

                                                                                                         Notes
                                                 Shares of Common Stock Common Additional              Receivable    Deferred
                                                 ---------------------  Stock   Paid-in   Accumulated     from        Stock
                                                   Issued   In Treasury Issued  Capital     Deficit   Stockholders Compensation
<S>                                              <C>        <C>         <C>    <C>        <C>         <C>          <C>
Balance, September 30, 1998.....................  3,407,250              $ 34   $  1,016   $ (5,604)     $  --       $     --
Issuance costs associated with Series C
 redeemable convertible preferred stock.........                                    (188)
Issuance of common stock upon stock option
 exercise.......................................     22,612                --          2
Issuance of common stock warrants in connection
 with bridge loans..............................                                     608
Issuance of common stock warrants in connection
 with Series C redeemable convertible preferred
 stock..........................................                                     157
Issuance of common stock options to consultants
 and compensation expense for stock option
 modifications..................................                                       4
Deferred stock compensation related to grants of
 stock options..................................                                   1,566                               (1,566)
Amortization of deferred stock compensation to
 expense........................................                                                                          127
Accretion of redeemable convertible preferred
 stock to redemption value......................                                    (223)
Net loss........................................                                             (5,830)
                                                 ----------  --------    ----   --------   --------      -----       --------
Balance, September 30, 1999.....................  3,429,862        --      34      2,942    (11,434)        --         (1,439)
Issuance of restricted common stock.............    650,000                 6        221                   (90)
Issuance costs associated with Series D
 redeemable convertible preferred stock.........                                     (82)
Issuance of common stock upon initial public
 offering, net of issuance costs................  7,475,000                75    116,809
Conversion of redeemable convertible preferred
 stock to common stock in connection with the
 initial public offering........................ 21,448,442               214     45,606
Issuance of common stock upon stock option
 exercises......................................    650,577                 7         66
Issuance of common stock upon warrant exercises.    564,704                 6        202
Interest on note receivable from stockholder....                                                            (4)
Deferred stock compensation related to grants of
 stock options..................................                                  13,916                              (13,916)
Amortization of deferred stock compensation to
 expense........................................                                                                        2,921
Deferred compensation related to cancellation of
 stock options for terminated employees.........                                    (263)                                 263
Accretion of redeemable convertible preferred
 stock to redemption value......................                                  (8,103)
Net loss........................................                                            (12,481)
                                                 ----------  --------    ----   --------   --------      -----       --------
Balance, September 30, 2000..................... 34,218,585        --     342    171,314    (23,915)       (94)       (12,171)
Issuance of common stock upon stock option
 exercises......................................    243,624                 2         59
Issuance of common stock upon warrant exercises.    159,065                 2         23
Issuance of common stock under employee stock
 purchase plan..................................    116,372                 1        396
Issuance of common stock under merger
 agreement......................................    450,449                 5      8,887                               (6,351)
Purchase of treasury stock......................             (300,900)
Issuance of stockholder notes receivable........                                                          (584)
Interest on notes receivable from stockholders..                                                           (24)
Amortization of deferred stock compensation to
 expense........................................                                                                        6,132
Stock compensation related to common stock
 option modifications...........................                                     186
Deferred compensation related to cancellation of
 stock options for terminated employees.........                                  (5,577)                               5,577
Net loss........................................                                            (69,523)
                                                 ----------  --------    ----   --------   --------      -----       --------
Balance, September 30, 2001..................... 35,188,095  (300,900)   $352   $175,288   $(93,438)     $(702)      $ (6,813)
                                                 ==========  ========    ====   ========   ========      =====       ========
</TABLE>
<TABLE>
<CAPTION>

                                                              Total
                                                          Stockholders'
                                                 Treasury    Equity
                                                  Stock     (Deficit)
<S>                                              <C>      <C>
Balance, September 30, 1998.....................  $  --     $ (4,554)
Issuance costs associated with Series C
 redeemable convertible preferred stock.........                (188)
Issuance of common stock upon stock option
 exercise.......................................                   2
Issuance of common stock warrants in connection
 with bridge loans..............................                 608
Issuance of common stock warrants in connection
 with Series C redeemable convertible preferred
 stock..........................................                 157
Issuance of common stock options to consultants
 and compensation expense for stock option
 modifications..................................                   4
Deferred stock compensation related to grants of
 stock options..................................                  --
Amortization of deferred stock compensation to
 expense........................................                 127
Accretion of redeemable convertible preferred
 stock to redemption value......................                (223)
Net loss........................................              (5,830)
                                                  -----     --------
Balance, September 30, 1999.....................     --       (9,897)
Issuance of restricted common stock.............                 137
Issuance costs associated with Series D
 redeemable convertible preferred stock.........                 (82)
Issuance of common stock upon initial public
 offering, net of issuance costs................             116,884
Conversion of redeemable convertible preferred
 stock to common stock in connection with the
 initial public offering........................              45,820
Issuance of common stock upon stock option
 exercises......................................                  73
Issuance of common stock upon warrant exercises.                 208
Interest on note receivable from stockholder....                  (4)
Deferred stock compensation related to grants of
 stock options..................................                  --
Amortization of deferred stock compensation to
 expense........................................               2,921
Deferred compensation related to cancellation of
 stock options for terminated employees.........                  --
Accretion of redeemable convertible preferred
 stock to redemption value......................              (8,103)
Net loss........................................             (12,481)
                                                  -----     --------
Balance, September 30, 2000.....................     --      135,476
Issuance of common stock upon stock option
 exercises......................................                  61
Issuance of common stock upon warrant exercises.                  25
Issuance of common stock under employee stock
 purchase plan..................................                 397
Issuance of common stock under merger
 agreement......................................               2,541
Purchase of treasury stock......................   (198)        (198)
Issuance of stockholder notes receivable........                (584)
Interest on notes receivable from stockholders..                 (24)
Amortization of deferred stock compensation to
 expense........................................               6,132
Stock compensation related to common stock
 option modifications...........................                 186
Deferred compensation related to cancellation of
 stock options for terminated employees.........                  --
Net loss........................................             (69,523)
                                                  -----     --------
Balance, September 30, 2001.....................  $(198)    $ 74,489
                                                  =====     ========
</TABLE>

The accompanying notes are an integral part of the consolidated financial
                                  statements.

                                      43

<PAGE>

                             NETWORK ENGINES, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

                                (in thousands)

<TABLE>
<CAPTION>
                                              Year Ended September 30,
                                            ---------------------------
                                             1999      2000      2001
<S>                                         <C>      <C>       <C>
Cash flows from operating
 activities:
   Net loss................................ $(5,830) $(12,481) $(69,523)
   Adjustments to reconcile net
    loss to net cash used in
    operating activities:
     Depreciation and amortization.........     361     1,353     3,722
     Provision for inventory
       reserve, net........................     663     1,036    20,278
     Amortization of discount on
       notes payable.......................     841        --        --
     Provision for doubtful
       accounts............................     120       176       755
     Gain on extinguishment of debt........    (314)       --        --
     Stock compensation....................     127     2,921     6,132
     Interest on notes receivable
       from stockholders...................      --        (4)      (24)
     Non-cash portion of
       restructuring and other
       charges.............................      --       100     7,088
     Changes in operating assets
       and liabilities, net of
       effects of acquisition and
       restructuring:
        Accounts receivable................  (1,653)   (9,956)    9,449
        Inventories........................  (1,327)   (6,385)  (14,285)
        Prepaid expenses and other
          current assets...................    (136)     (809)     (923)
        Due from contract
          manufacturer.....................      --    (7,113)    6,733
        Accounts payable...................   1,602     4,552    (5,087)
        Due to contract
          manufacturer.....................      --        --     3,117
        Accrued expenses...................     329     2,236       357
        Deferred revenue...................      76       722      (734)
                                            -------  --------  --------
           Net cash used in
             operating activities..........  (5,141)  (23,652)  (32,945)
Cash flows from investing
 activities:
   Purchases of property and
    equipment..............................    (623)   (7,720)   (3,102)
   Changes in restricted cash..............      --        53    (1,082)
   Purchase of other assets................    (100)     (136)      (35)
   Acquisition of business
    including acquisition expenses.........      --        --       (30)
                                            -------  --------  --------
           Net cash used in
             investing activities..........    (723)   (7,803)   (4,249)
Cash flows from financing
 activities:
   Proceeds from bridge loans and
    notes payable..........................   1,156     2,205        --
   Payments on capital lease
    obligations and notes payable..........    (128)   (2,273)      (84)
   Issuance of notes receivable
    from stockholders......................      --        --      (584)
   Proceeds from issuance of
    common stock...........................       2   117,302       483
   Acquisition of treasury stock...........      --        --      (198)
   Proceeds from issuance of
    redeemable convertible
    preferred stock, net of
    issuance costs.........................   6,156    25,168        --
                                            -------  --------  --------
           Net cash provided by
             (used in) financing
             activities....................   7,186   142,402      (383)
                                            -------  --------  --------
Net increase (decrease) in cash
 and cash equivalents......................   1,322   110,947   (37,577)
Cash and cash equivalents,
 beginning of period.......................     113     1,435   112,382
                                            -------  --------  --------
Cash and cash equivalents, end of
 period.................................... $ 1,435  $112,382  $ 74,805
                                            =======  ========  ========
Supplemental cash flow information:
   Interest paid........................... $    36  $     55  $     24
Non-cash transactions:
   Acquisition of property and
    equipment under capital leases......... $   117  $     --  $     --
   Bridge loans and accrued
    interest converted to Series B
    and C redeemable convertible
    preferred stock........................ $ 5,057  $     --  $     --
   Restricted common stock issued
    in exchange for note
    receivable from stockholder............ $    --  $     90  $     --
   Redeemable convertible
    preferred stock converted to
    common stock........................... $    --  $ 45,820  $     --
</TABLE>

The accompanying notes are an integral part of the consolidated financial
                                  statements.

                                      44

<PAGE>

                             NETWORK ENGINES, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. NATURE OF BUSINESS

  Business

    Network Engines, Inc. ("Network Engines" or "the Company") is a provider of
high-density, scalable server appliance hardware platforms. Server appliances
are pre-configured computer network infrastructure devices designed to deliver
specific application functionality. As a result of the Company's July 2001
restructuring, the Company is focused on partnering with independent software
vendors ("ISVs") and original equipment manufacturers ("OEMs") to provide these
strategic partners with dense server appliance hardware, integration services
and appliance development, deployment, installation and support to allow these
strategic partners to deliver "turn-key" solutions to their end-user customers.
To date, the Company's customers have been primarily located in the United
States and Europe. The Company operates in one reportable segment.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

  Basis of Presentation

    The accompanying consolidated financial statements include the accounts of
the Company and its wholly-owned subsidiaries. All significant intercompany
transactions and balances have been eliminated. Certain amounts in the prior
years' financial statement have been reclassified to conform to current year
presentation. The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of financial
statements and the reported amounts of revenue and expenses during the period.
The most significant estimates reflected in these financial statements include
accounts receivable and sales allowances and inventory valuation. Actual
results could differ from those estimates.

  Cash, Cash Equivalents and Restricted Cash

    The Company considers all highly liquid investments purchased with original
maturities of three months or less to be cash equivalents. At September 30,
2000, the Company's cash equivalents consisted of approximately $74,149,000 of
municipal bonds, $30,520,000 of commercial paper and $7,713,000 of money market
funds. At September 30, 2001, the Company's cash equivalents consisted of
approximately $69,240,000 of municipal bonds and $4,843,000 of money market
funds. These investments are stated at amortized cost, including accrued
interest, which approximates fair value. At September 30, 2000 and 2001,
$47,000 and $77,000 of cash was restricted and pledged as collateral on the
Company's facilities, respectively. Additionally, at September 30, 2001,
approximately $1,052,000 was restricted and deposited with a financial
institution as a guarantee for a personal loan of the Company's Chairman (see
Note 17).

    All investments are classified as available-for-sale with any associated
unrealized gains or losses included in other comprehensive income or loss,
which is a separate component of stockholders'

                                      45

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

equity, until realized. As of and for the years ended September 30, 1999, 2000
and 2001, realized and unrealized gains or losses were immaterial.

  Concentrations of Risk

    Credit. Financial instruments, which potentially subject the Company to
concentrations of credit risk, consist principally of cash, cash equivalents,
restricted cash and trade receivables. The Company invests primarily in
commercial paper and money market funds of major financial institutions. The
Company provides credit to customers in the normal course of business and does
not require collateral from its customers but routinely assesses their
financial strength. The Company maintains reserves for potential credit losses
and such losses have been within management's expectations.

    Customers. Revenue of approximately $2,774,000 (46%), $1,689,000 (28%) and
$844,000 (14%) was attributable to three customers during the year ended
September 30, 1999. Revenue of approximately $6,819,000 (16%) and $4,968,000
(12%) was attributable to two customers during the year ended September 30,
2000. The Company had no customers who accounted for greater than 10% of the
Company's revenue for the year ended September 30, 2001.

    Two customers accounted for approximately $2,818,000 (23%) of accounts
receivable at September 30, 2000 and one customer accounted for approximately
$543,000 (21%) of accounts receivable at September 30, 2001.

  Fair Value of Financial Instruments

    Financial instruments, including cash, cash equivalents, restricted cash,
accounts receivable, notes receivable and accounts payable, are carried in the
financial statements at amounts that approximate their fair value as of
September 30, 2000 and 2001.

  Inventories

    Inventories are valued at the lower of cost or market, with cost determined
using the first-in, first-out method.

  Due from Contract Manufacturer

    During the normal course of operations, the Company sells certain inventory
components to its contract manufacturer. The Company does not record revenue
from these transactions and accordingly trade receivables are not recorded for
balances due from the Company's contract manufacturer.

  Property and Equipment

    Property and equipment are recorded at cost and depreciated using the
straight-line method over their estimated useful lives. Leasehold improvements
are amortized over the shorter of the useful life of the improvement or the
remaining term of the lease. Property and equipment held under capital leases
is stated at the present value of the minimum lease payments at the inception
of the lease and is amortized using the straight-line method over the lesser of
the life of the related asset or the term of the

                                      46

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

lease. Upon retirement or sale, the cost of the assets disposed of and the
related accumulated depreciation are removed from the accounts and any
resulting gain or loss is included in the determination of net income or loss.
Repairs and maintenance are charged to expense as incurred.

  Intangible Assets

    Acquisition-related intangible assets resulted from the Company's
acquisition of IP Performance, Inc., which was accounted for under the purchase
method, and consisted of intangible assets and goodwill. Intangible assets are
reported at cost, net of accumulated amortization. Intangible assets are
amortized on a straight-line basis over their estimated useful lives of three
years. The Company periodically evaluates the existence of intangible asset
impairments. Recoverability of these assets is assessed at each reporting
period based on undiscounted expected cash flows, considering a number of
factors including past operating results, budgets and economic projections,
market trends and product development cycles.

  Revenue Recognition

    The Company recognizes product revenue upon shipment, provided evidence of
an arrangement has been received, no obligations remain outstanding and
collectibility is reasonably assured. The Company recognizes license revenue
upon sell through to the licensees' end users. The Company accrues for
anticipated returns and warranty costs upon product delivery. Revenue from
support contracts is recognized ratably over the term of the agreement.

    During the fourth quarter of 2001, the Company adopted EITF 00-10,
"Accounting for Shipping and Handling Fees and Costs." EITF 00-10 requires that
shipping and handling costs associated with amounts billed to customers be
included in revenues and cost of revenues and not offset against each other.
Upon adoption of EITF 00-10, shipping and handling costs should be
retroactively reclassified for all periods presented in the statement of
operations. Due to the immateriality of shipping and handling costs in all
reported periods, the Company has not reclassified these amounts within the
consolidated statement of operations.

  Advertising Costs

    Advertising costs are charged to expense as incurred. Advertising expenses
for the years ended September 30, 2000 and 2001 were approximately $1,271,000
and $1,480,000, respectively. Prior to the year ended September 30, 2000,
advertising expenses were not material.

  Research and Development

    Research and development costs, except for certain software development
costs, are expensed as incurred. Software development costs incurred after
technological feasibility has been achieved and until the products are
available for general release are capitalized and amortized as the greater of
the

                                      47

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

ratio of current revenues to total expected revenues from the product or the
straight-line method over the remaining estimated economic life of the product.
Costs of internally developed software, qualifying for capitalization have not
been material to date.

  Accounting for Stock-Based Compensation

    Stock options and restricted stock issued to employees and members of the
Company's Board of Directors are accounted for in accordance with Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees,"
and related interpretations ("APB 25"); accordingly, compensation expense is
recorded for options and restricted stock awarded to employees and directors to
the extent that the exercise or purchase prices are less than the common
stock's fair market value on the date of grant, where the number of shares and
exercise or purchase price are fixed. The difference between the fair value of
the Company's common stock and the exercise or purchase price of the stock
option or restricted stock award is recorded as deferred stock compensation.
Deferred stock compensation is amortized to compensation expense over the
vesting period of the underlying stock option or restricted stock. Upon
cancellation of options with residual deferred compensation balances at the
date of cancellation, the remaining amount of unrecognized deferred
compensation is reversed as an adjustment to additional paid-in capital. The
Company follows the disclosure requirements of Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS
123") (see Note 8). Stock-based awards to non-employees are accounted for under
provisions of SFAS 123.

  Income Taxes

    Deferred tax assets and liabilities are determined based on the difference
between the financial statement and the tax bases of assets and liabilities
using enacted tax rates in effect in the years in which the differences are
expected to reverse. A valuation reserve against deferred tax assets is
recorded if, based upon the weight of available evidence, it is more likely
than not that some or all of the deferred tax assets will not be realized.

  Comprehensive Income (Loss)

    Comprehensive income (loss) is comprised of two components, net income
(loss) and other comprehensive income (loss). During the years ended September
30, 1999, 2000 and 2001, the Company had no items qualifying as other
comprehensive income (loss); accordingly, comprehensive loss equaled net loss.

  Net Loss Per Common Share

    Basic net loss per share is computed by dividing the net loss attributable
to common stockholders for the period by the weighted average number of shares
of common stock outstanding during the period, excluding shares of common stock
subject to repurchase by the Company ("restricted shares"). Diluted net loss
per share is computed by dividing the net loss attributable to common
stockholders for the period by the weighted average number of shares of common
stock and potential common stock

                                      48

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

outstanding during the period, if dilutive. Potential common stock includes
restricted shares and incremental shares of common stock issuable upon the
exercise of stock options and warrants and upon conversion of redeemable
convertible preferred stock. Because the inclusion of potential common stock
would be anti-dilutive for all periods presented, diluted net loss per share is
the same as basic net loss per share.

    The following table sets forth the potential common stock excluded from the
calculation of net loss per common share because their inclusion would be
anti-dilutive (in thousands):

<TABLE>
<CAPTION>
                                       As of September 30,
                                       -------------------
                                        1999   2000  2001
<S>                                    <C>     <C>   <C>
Options to purchase common stock......  1,937  4,381 6,045
Warrants to purchase common stock.....  2,350  1,786 1,625
Unvested restricted common stock......     57    556   396
Redeemable convertible preferred stock 12,495     --    --
                                       ------  ----- -----
                                       16,839  6,723 8,066
                                       ======  ===== =====
</TABLE>

  Recent Accounting Pronouncements

    In June 2001, the Financial Accounting Standards Board issued SFAS No. 141
("SFAS 141"), "Business Combinations" and SFAS No. 142 ("SFAS 142"), "Goodwill
and Other Intangible Assets." SFAS 141 requires that all business combinations
be accounted for under the purchase method of accounting only and that certain
acquired intangible assets in a business combination be recognized as assets
apart from goodwill. SFAS 142 requires, among other things, the cessation of
the amortization of goodwill. In addition, the standard includes provisions for
the reclassification of certain existing recognized intangibles as goodwill,
reassessment of the useful lives of existing recognized intangibles,
reclassification of certain intangibles out of previously reported goodwill and
the identification of reporting units for purposes of assessing potential
future impairments of goodwill. SFAS 142 also requires the completion of a
transitional goodwill impairment test six months from the date of adoption.
SFAS 141 is effective for all business combinations initiated after June 30,
2001. SFAS 142 is effective for the Company's fiscal quarters beginning on
October 1, 2002; early adoption is not permitted. The Company currently does
not expect SFAS 142 to have a material impact on its financial position and
results of operations.

    In October 2001, the FASB issued Statement of Financial Accounting
Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets" ("SFAS 144"). The objectives of SFAS 144 are to address significant
issues relating to the implementation of FASB Statement No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be
Disposed Of" ("SFAS 121"), and to develop a single accounting model, based on
the framework established in SFAS 121, for long-lived assets to be disposed of
by sale, whether previously held and used or newly acquired. SFAS 144
supersedes SFAS 121; however, it retains the fundamental provisions of SFAS 121
for (1) the recognition and measurement of the impairment of long-lived assets
to be held and used

                                      49

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

and (2) the measurement of long-lived assets to be disposed of by sale. SFAS
144 supersedes the accounting and reporting provisions of Accounting Principles
Board No. 30, "Reporting the Results of Operations--Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions" ("APB 30"), for segments of a
business to be disposed of. However, SFAS 144 retains APB 30's requirement that
entities report discontinued operations separately from continuing operations
and extends that reporting requirement to "a component of an entity" that
either has been disposed of or is classified as "held for sale." SFAS 144 also
amends the guidance of Accounting Research Bulletin No. 51, "Consolidated
Financial Statements," to eliminate the exception to consolidation for a
temporarily controlled subsidiary. SFAS 144 is effective for financial
statements issued for fiscal years beginning after December 15, 2001, including
interim periods, and, generally, its provisions are to be applied
prospectively. The Company does not expect the application of SFAS 144 to have
a material impact on the Company's financial position or results of operations.

3. INVENTORIES

    Inventories consisted of the following (in thousands):

<TABLE>
<CAPTION>
                September 30,
                -------------
                 2000   2001
<S>             <C>     <C>
Raw materials.. $3,524  $226
Work in process    847   235
Finished goods.  2,229   146
                ------  ----
                $6,600  $607
                ======  ====
</TABLE>

4. PROPERTY AND EQUIPMENT

    Property and equipment consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                               September 30,
                                                               -------------
                                         Useful Life            2000   2001
<S>                            <C>                             <C>    <C>
Office furniture and equipment             5 years             $1,465 $  906
Engineering and production
  equipment                                3 years              1,755    641
Computer equipment and
  software                                 3 years              2,879  2,992
Leasehold improvements         Lesser of 3 years or lease term  2,118  1,630
Demonstration equipment                 1.5--3 years              978     --
                                                               ------ ------
                                                                9,195  6,169
Less: accumulated depreciation
  and amortization                                              2,097  2,715
                                                               ------ ------
                                                               $7,098 $3,454
                                                               ====== ======
</TABLE>

                                      50

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


    As of September 30, 2000 and 2001, the Company had approximately $153,000
and $69,000 (net of approximately $123,000 and $207,000 of accumulated
amortization) of office furniture, computer software and equipment under
capital leases, respectively.

    Depreciation and amortization expense was approximately $361,000,
$1,353,000 and $3,047,000 for the years ended September 30, 1999, 2000 and
2001, respectively.

5. CAPITAL LEASE OBLIGATIONS, NOTES PAYABLE AND BRIDGE LOANS

    The Company leases certain furniture, equipment and software under
non-cancelable capital leases. The lease terms range from 36 to 60 months and
have interest rates of 12% to 15.5%. As of September 30, 2001, the required
monthly installment of principal and interest for all capital leases was
approximately $6,000.

    Future minimum lease payments under all noncancelable capital leases as of
September 30, 2001 were as follows (in thousands):

<TABLE>
<S>                                      <C>
Year ended September 30,
2002.................................... $63
2003....................................  14
                                         ---
Total payments..........................  77
Less amounts representing interest......  10
                                         ---
Present value of future minimum payments  67
Less amount due within one year.........  60
                                         ---
Long-term portion....................... $ 7
                                         ===
</TABLE>

  Notes Payable

    At September 30, 1998, the Company had an un-collateralized interest
bearing notes payable of approximately $25,000 with two stockholders. During
the year ended September 30, 1999, the Company entered into an agreement with
the holders of the related party notes whereby the interest rate on each note
was halved, no further interest accrued after January 13, 1999 and all late
fees were waived. In total, approximately $51,000 of interest and late fees
were forgiven during the year ended September 30, 1999. Both notes and the
remaining accrued interest were paid in full in August 1999. The interest
forgiveness and waiver of late fees were recorded as an extraordinary gain on
extinguishment of debt during the year ended September 30, 1999.

    In November 1998, the Company entered into a line of credit for the
purchase of equipment with a maximum limit of $60,000. The interest rate on the
line is determined on the average daily balance of prime plus 1.0% (6.0% at
September 30, 2001). Under the terms of the agreement, any equipment advances
that were outstanding on November 30, 1998 (approximately $56,000) were payable
in 34 equal monthly installments of principal, plus accrued interest,
commencing December 31, 1998. Equipment advances, once repaid, may not be
re-borrowed. The line of credit is collateralized by substantially all of the
assets of the Company. At September 30, 2000 and 2001, the Company had
approximately $21,000 and $2,000 outstanding under the equipment line,
respectively.

                                      51

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Bridge Loans

    At September 30, 1998, the Company had un-collateralized subordinated
promissory notes totaling $3,950,000 outstanding that were payable on demand
with an interest rate of 10% per annum. In connection with these promissory
notes, the Company granted warrants to purchase 1,645,732 shares of common
stock at an exercise price of $0.37 per share. These warrants were immediately
exercisable on the date of issue and expire after ten years. The fair value of
the warrants on the date of issue of approximately $581,000 was recorded in
stockholders' equity (deficit) and as a discount on the related notes payable.
The discount was amortized as interest expense over the estimated life of the
notes and resulted in additional interest expense of $348,000 and $233,000
during the years ended September 30, 1998 and 1999, respectively.

    During the year ended September 30, 1999, the Company issued a series of
uncollateralized subordinated promissory notes totaling $1,100,000 that were
payable on demand with interest rates of 10% and 15%. In connection with these
notes, the Company granted warrants to purchase 798,562 shares of the Company's
common stock at an exercise price of $0.37 per share. The fair value of the
warrants on the date of issue of approximately $608,000 was recorded in
stockholders' equity (deficit) and as a discount on the related notes payable.
The discount was amortized as interest expense during the year ended September
30, 1999.

    On January 13, 1999, the Company converted approximately $2,750,000 of the
subordinated promissory notes into 357,142 shares of Series B redeemable
convertible preferred stock ("Series B Preferred") and approximately $2,300,000
of the subordinated promissory notes plus approximately $7,000 of accrued
interest into 299,631 shares of Series C redeemable convertible preferred stock
("Series C Preferred"). The note holders forgave $263,245 of accrued interest
upon the conversion of the subordinated promissory notes. The interest
forgiveness was recorded as an extraordinary gain on extinguishment of debt in
the year ended September 30, 1999.

7. STOCKHOLDERS' EQUITY AND REDEEMABLE CONVERTIBLE PREFERRED STOCK

  Preferred Stock

    The Company has authorized up to 5,000,000 shares of preferred stock, $0.01
par value per share for issuance. The preferred stock will have such rights,
preferences, privileges and restrictions, including voting rights, dividend
rights, conversion rights, redemption privileges, and liquidation preferences,
as shall be determined by the Board of Directors.

  Common Stock

    On November 12, 1999, the Company completed a three-for-one split of the
Company's common stock, which was effected through a stock dividend (the "1999
Stock Split"). On May 17, 2000, the

                                      52

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Company completed a 2.5-for-one split of the Company's common stock, which was
effected through a stock dividend (the "2000 Stock Split"). All common stock
share and per share amounts that appear in the financial statements and the
notes thereto have been restated to reflect both the 1999 Stock Split and the
2000 Stock Split.

    In November 1999, the Company issued 262,500 shares of restricted common
stock at $0.24 per share to certain directors of the Company. Of these shares,
75,000 shares vested 50% on November 18, 2000 and will vest 12.5% per quarter
thereafter and 187,500 shares vested 25% on November 18, 2000 and will vest
6.25% per quarter thereafter. As of September 30, 2001, 147,656 shares had
vested. Unvested restricted shares are subject to forfeiture in the event that
a director ceases to be a director of the Company. The Company recorded
deferred stock compensation of approximately $522,000, which represents the
excess of the fair value of the restricted shares at the date of issue over the
purchase price. Compensation expense will be recognized ratably over the
vesting period of the restricted stock. For the years ended September 30, 2000
and 2001, the Company recognized approximately $145,000 and $172,000,
respectively, of related stock compensation expense.

    In November 1999, the Company issued 375,000 shares of restricted common to
Lawrence A. Genovesi, the Company's former Chief Executive Officer and current
Chairman of the Board of Directors. These shares vested quarterly upon the
achievement of certain financial targets or in December 2004, whichever was
earlier. As of September 30, 2001, 93,750 shares had vested. Unvested
restricted shares are subject to forfeiture in the event that Mr. Genovesi
ceased to be employed by the Company. The Company recorded deferred stock
compensation of approximately $684,000, which represented the excess of the
fair value of the restricted shares at the date of issue over the purchase
price. Compensation expense will be recognized ratably over the vesting period
of the restricted stock. In connection with these restricted stock grants, the
Company accepted a recourse note payable from Mr. Genovesi in the amount of
$90,000. This note has an interest rate of 6.08% and is payable on the earlier
of demand by the Company or November 18, 2004. For the years ended September
30, 2000 and 2001, the Company recognized approximately $124,000 and $136,000,
respectively, of related stock compensation expense. In connection with a
severance agreement effective September 30, 2001, the Company agreed to amend
this restricted stock agreement and, in November 2001, the Company repurchased
93,750 of these shares of restricted common stock at $0.24 per share, which
represented the original issue price, through forgiveness of an equal amount
due under the note receivable from Mr. Genovesi. Additionally, for the
remaining unvested restricted common stock of 187,500 shares, the Company
amended the agreement to provide for quarterly vesting of that amount through
September 30, 2004, contingent upon Mr. Genovesi remaining to be a director of
the Company.

    In March 2000, the Company issued 12,500 shares of restricted stock at
$6.00 per share to a director of the Company. These shares vested on March 14,
2001.

    On July 12, 2000, the Company completed its initial public offering of
common stock. The Company sold 7,475,000 shares of its common stock, par value
$.01 per share (the "Common Stock") at $17 per share including the
underwriters' over-allotment option. The Company received proceeds of

                                      53

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

approximately $116,900,000, net of offering costs and underwriting fees
totaling approximately $10,175,000, from its initial public offering.

    On August 14, 2001, the Company announced that its Board of Directors had
approved the repurchase of up to $5 million of the Company's common stock in
the open market or in non-solicited privately negotiated transactions. The
Company plans to use any repurchased shares for its employee stock plans.
During the year ended September 30, 2001, the Company repurchased 300,900
shares of common stock at a cost of approximately $198,000.

  Redeemable Convertible Preferred Stock

    The following table summarizes redeemable convertible preferred stock
activity (in thousands, except share data):

<TABLE>
<CAPTION>
                                                          Redeemable Convertible
                                                             Preferred Stock
                                                          ---------------------
                                                            Shares      Amount
<S>                                                       <C>          <C>
Balance, September 30, 1998..............................    185,250   $  1,000
January 1999 issuance of Series B redeemable convertible
  preferred stock upon conversion of bridge loans........    357,142      2,750
January 1999 issuance of Series C redeemable convertible
  preferred stock upon conversion of bridge loans........    299,631      2,307
January 1999 issuance of Series C redeemable convertible
  preferred stock for cash...............................    422,102      3,093
June 1999 issuance of Series C redeemable convertible
  preferred stock for cash...............................    401,816      3,094
Accretion of redeemable convertible preferred stock to
  redemption value.......................................         --        223
                                                          ----------   --------
Balance, September 30, 1999..............................  1,665,941     12,467
December 1999 issuance of Series D redeemable convertible
  preferred stock for cash...............................  3,581,554     25,250
Accretion of redeemable convertible preferred stock to
  redemption value.......................................         --      8,103
Conversion of Series A, B, C and D redeemable convertible
  preferred stock into common stock upon initial public
  offering............................................... (5,247,495)   (45,820)
                                                          ----------   --------
Balance, September 30, 2000 and 2001.....................         --   $     --
                                                          ==========   ========
</TABLE>

    In connection with the Company's initial public offering in July 2000, all
outstanding shares of preferred stock converted into 21,448,442 shares of
common stock, in accordance with the Company's certificate of incorporation.
Prior to the conversion, the Company had four series of redeemable convertible
preferred stock: Series A preferred stock, Series B preferred stock, Series C
preferred stock and Series D preferred stock.

                                      54

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


8. STOCK INCENTIVE PLANS

    Options and awards to purchase shares of the Company's common stock have
been granted to employees and directors under the Company's 1997 Stock
Incentive Plan (the "1997 Plan"), which was adopted by the Board of Directors
in November 1997. On October 21, 1999, the 1997 Plan was terminated and all
outstanding options became options under the 1999 Stock Incentive Plan.

    In October 1999, the Company's shareholders approved the 1999 Stock
Incentive Plan (the "1999 Plan"). Under the 1999 Plan, stock option and
restricted stock or other stock-based awards for up to 4,747,902 shares of
common stock may be issued to employees, officers, directors, consultants and
advisors of the Company. Options are granted for terms of up to ten years and
vest over varying periods. New employee option grants generally vest 25% on the
first anniversary of the grant date and thereafter in equal quarterly
installments over the next three years. Subsequent grants to existing employees
generally vest in equal quarterly installments over four years. The option
price per share is determined by the Board of Directors.

    In May 2000, the Company's shareholders approved an increase of 3,300,000
in the number of shares authorized under the 1999 Plan and an automatic annual
increase in the number of shares authorized under the 1999 Plan. The automatic
annual increase is equal to the lesser of: 5% of the outstanding shares on the
first day of each fiscal year; 4,000,000 shares or an amount determined by the
Board of Directors, which is subject to a maximum of 20,047,902 authorized
shares under the plan. During the year ended September 30, 2001, the Company
increased the number of shares available under the plan by approximately
1,710,000 shares.

    Stock option activity for the 1997 Plan and 1999 Plan (the "Plans"), since
October 1, 1998 was as follows:

<TABLE>
<CAPTION>
                                            Weighted
                                            Average
                                Number of   Exercise
                                 Options     Price
<S>                             <C>         <C>
Outstanding, September 30, 1998    608,400   $0.07
   Granted.....................  1,593,975    0.14
   Exercised...................    (22,612)   0.07
   Cancelled...................   (242,610)   0.08
                                ----------
Outstanding, September 30, 1999  1,937,153    0.13
   Granted.....................  3,323,299    6.20
   Exercised...................   (650,577)   0.11
   Cancelled...................   (229,287)   2.28
                                ----------
Outstanding, September 30, 2000  4,380,588    4.62
   Granted.....................  4,681,751    2.57
   Exercised...................   (243,624)   0.25
   Cancelled................... (2,773,841)   5.66
                                ----------
Outstanding, September 30, 2001  6,044,874    2.73
                                ==========
</TABLE>

                                      55

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


    As of September 30, 1999, 2000 and 2001, options to purchase 199,915,
107,057 and 1,340,117 shares of common stock, respectively, were exercisable
with a weighted-average exercise price per share of $0.08, $0.14 and $2.95,
respectively. For financial reporting purposes, the weighted average fair
values of options granted during the year ended September 30, 1999 and 2000
with exercise prices equal to the fair market value and with exercise prices at
below fair market value were $0.02 (31,875 options) and $1.05 (1,562,100
options) per share and $16.01 (781,925 options) and $7.40 (2,541,374 options),
respectively. All options granted during the year ended September 30, 2001 were
granted with exercise prices equal to the fair market value of the Company's
common stock on the grant date and had a weighted average fair value of $2.47
per share. As of September 30, 2001, 2,677,255 shares were available for future
grants under the Plans and the Company had reserved 6,044,874 shares of common
stock for the exercise of outstanding stock options.

    The following table summarizes the stock options outstanding at September
30, 2001:

<TABLE>
<CAPTION>
                             Options Outstanding         Options Exercisable
                     ----------------------------------- -------------------
                               Weighted Weighted Average            Weighted
                               Average     Remaining                Average
                     Number of Exercise Contractual Life Number of  Exercise
Exercise Price Range  Options   Price      (in years)     Options    Price
<S>                  <C>       <C>      <C>              <C>        <C>
   $0.07--$0.24..... 1,163,285  $ 0.18        7.73         630,575   $ 0.17
   $0.58--$0.79..... 1,664,253  $ 0.68        9.79          53,144   $ 0.79
   $1.07--$1.63..... 1,599,253  $ 1.33        9.30          76,889   $ 1.22
   $1.68--$2.53.....   498,202  $ 2.01        8.37         259,842   $ 2.00
   $4.00--$6.00.....   138,421  $ 5.22        8.48          91,310   $ 5.31
   $6.50--$8.00.....   453,194  $ 7.63        8.74         112,147   $ 8.00
   $12.88--$14.50...   502,766  $13.80        8.92         110,302   $14.50
   $27.63--$45.38...    25,500  $35.38        8.92           5,908   $34.98
                     ---------                           ---------
                     6,044,874  $ 2.73        8.96       1,340,117   $ 2.95
                     =========                           =========
</TABLE>

    During the years ended September 30, 1999, 2000 and 2001, the Company
recorded deferred compensation for restricted stock and stock options granted
at prices deemed to be below fair market value for financial reporting purposes
of approximately $1,566,000, $13,916,000 and $6,351,000, respectively. The
deferred stock compensation recorded in 2001 was associated with the Company's
acquisition of IP Performance, Inc. (see Note 13). The Company is recognizing
the compensation expense over the vesting periods of the restricted stock. The
Company recognized compensation expense relating deferred compensation of
approximately $131,000, $2,921,000 and $6,132,000 for the years ended September
30, 1999, 2000 and 2001, respectively. During the year ended September 30,
2001, the Company reversed approximately $5,577,000 of deferred stock
compensation due to the cancellation of options for terminated employees

                                      56

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


    Had compensation expense for the Company's Plans been determined based on
the fair value at the date of grant for awards made since the Plans' adoption,
consistent with the provisions of SFAS 123, the Company's net loss attributable
to common stockholders and net loss per common share for the years ended
September 30, 1999, 2000 and 2001 would have increased to the pro forma amounts
indicated below:

<TABLE>
<CAPTION>
                    1999                  2000                  2001
            --------------------  --------------------  --------------------
              Net loss   Net loss   Net loss   Net loss   Net loss   Net loss
            attributable   per    attributable   per    attributable   per
             to common    common   to common    common   to common    common
            stockholders  share   stockholders  share   stockholders  share
                          (in thousands, except per share data)
<S>         <C>          <C>      <C>          <C>      <C>          <C>
As reported   $(6,053)    $(1.83)   $(20,584)   $(1.99)   $(69,523)   $(2.03)
Pro forma..   $(6,066)    $(1.83)   $(21,990)   $(2.13)   $(73,131)   $(2.14)
</TABLE>

    For this purpose, the fair value of options at the date of grant were
estimated using the Black Scholes option pricing model with the following
assumptions: risk-free interest rates of 5.5%, 6.2% and 4.85% for 1999, 2000
and 2001, respectively; no dividend yield for each of the years presented; no
volatility factor for 1999 and a volatility factor of 150% for 2000 and 183%
for 2001; and a weighted-average expected life of the options of five years for
each of the years presented.

    In May 2000, the Company's shareholders approved the 2000 Director Option
Plan. Under the 2000 Director Option Plan, the Company may make formula grants
of stock options to non-employee directors of up to 500,000 shares of common
stock. Through September 30, 2001, 75,000 options were granted under the 2000
Director Option Plan.

    In May 2000, the Company's shareholders approved the 2000 Employee Stock
Purchase Plan (the "Purchase Plan"). Under the Purchase Plan, the Company may
issue up to an aggregate of 750,000 shares of common stock to eligible
employees. Eligible employees must be employed by the Company for more than 20
hours per week and more than five months in a fiscal year. Under the Purchase
Plan, the Company makes two offerings each fiscal year, at the end of which
employees may purchase shares of common stock through payroll deductions made
over the term of each offering. The per-share purchase price at the end of each
offering is equal to lesser of 85% of the closing price of the common stock at
the beginning or end of the offering period. Offering periods begin on the 15th
day of November and May each year. During the year ended September 30, 2001,
116,372 shares were issued under the Purchase Plan.

                                      57

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


9. STOCK WARRANTS

    The following table summarizes stock warrant activity during each of the
three years ended September 30, 2001:

<TABLE>
<CAPTION>
                                                            Common Stock Warrants
                                            ------------------------------------------------------
                                             Shares    Exercise Price       Expiration Date
<S>                                         <C>        <C>            <C>
Outstanding, September 30, 1998............ 1,895,219   $0.07--$0.53    August 2002--August 2008
   Issuance of warrants in connection with
     issuance of bridge loans..............   798,562      $0.37      November 2008--December 2008
   Cancellation of warrants in connection
     with conversion of bridge loans into
     preferred stock.......................  (549,607)     $0.37
   Issuance of warrants in connection with
     issuance of Series C redeemable
     convertible preferred stock...........   206,250      $0.37              January 2009
                                            ---------
Outstanding, September 30, 1999............ 2,350,424   $0.07--$0.53   August 2002--January 2009
   Exercise of warrants....................  (564,704)     $0.37
                                            ---------
Outstanding, September 30, 2000............ 1,785,720   $0.07--$0.53   August 2002--January 2009
   Exercise of warrants....................  (160,312)     $0.37
                                            ---------
Outstanding, September 30, 2001............ 1,625,408   $0.07--$0.53   August 2002--January 2009
                                            =========
</TABLE>

    Warrants issued during the years ended September 30, 1998 and 1999, with
fair values of approximately $588,000 and $608,000, respectively, were issued
in connection with bridge loans. The fair value of these warrants was recorded
in additional paid-in capital and interest expense over the life of the related
bridge loans.

    During the year ended September 30, 1999, the Company entered into
agreements with the holders of the 1998 Bridge Loans whereby 549,607 of the
warrants granted in conjunction with the 1998 Bridge Loans were cancelled in
connection with the conversion of the 1998 Bridge Loans into redeemable
convertible preferred stock. Also during the year ended September 30, 1999, the
Company issued warrants to some of the holders of Series C preferred stock, in
connection with that financing. The fair value of those warrants of
approximately $157,000 was recorded as a discount on the Series C Preferred
stock and in additional paid-in capital.

    During the year ended September 30, 2001, 102,815 shares of common stock
were issued upon the exercise of 104,062 warrants in a cashless transaction in
accordance with the terms of the warrant agreements.

    As of September 30, 2001, the Company had reserved 1,625,408 shares of
common stock for the exercise of all of the Company's outstanding warrants.

                                      58

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


10. COMMITMENTS AND CONTINGENCIES

  Operating Leases

    The Company leases its office space under non-cancelable operating leases.
As of September 30, 2001, the future minimum lease payments under these
non-cancelable operating leases were as follows (in thousands):

<TABLE>
            <S>                                               <C>
            Year Ending September 30,
            2002............................................. $  848
            2003.............................................    892
            2004.............................................    916
            2005.............................................    356
                                                              ------
            Total............................................ $3,012
                                                              ======
</TABLE>

    The total of future minimum rentals to be received by the Company under
non-cancelable sub-leases related to the above leases is $1,036,000. Such
amounts are not reflected in the schedule of lease payments above.

    Rent expense, net of sub-lease income of approximately $36,000, was
approximately $50,000, $614,000 and $1,086,000 for the years ended September
30, 1999, 2000 and 2001, respectively.

  Contingencies

    On December 29, 1999, a former employee, George Flate, commenced a lawsuit
against the Company, a current officer and director and a former officer and
director in Suffolk Superior Court, a Massachusetts state court. Mr. Flate
alleges that he was unlawfully terminated as Vice President of OEM Sales by the
Company in an effort to deprive him of commission payments. He is seeking
undisclosed damages based on two contractual claims relating to his employment,
although the Company anticipates he will claim damages in the multi-million
dollar range. Specifically, he is alleging a breach of the implied covenant of
good faith and fair dealing against the Company and a claim of intentional
interference with contractual relations against the current and former officers
of the company named in the lawsuit. Both of these claims are based on Mr.
Flate's allegations that he is entitled to commissions from several
transactions that were negotiated after Mr. Flate was no longer with the
Company. Mr. Flate was employed by the Company for approximately one year.
Although the Company believes that these claims are without merit and intends
to vigorously defend against each claim asserted in the complaint, an adverse
resolution of either of these claims could require the payment of substantial
monetary damages. Moreover, the Company's defense against these claims might
result in the expenditure of significant financial and managerial resources.
The case has proceeded through discovery and the court has scheduled a
pre-trial conference for December 20, 2001, at which time a trial date will be
established. The Company anticipates that the trial will be scheduled in the
first half of 2002.

                                      59

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


    We may be, from time to time, a party to other litigation arising in the
normal course of our business. Management believes that none of these other
actions, individually or in the aggregate, will have a material adverse effect
on our financial position or results of operations (see Note 18).

11. INCOME TAXES

    Due to the loss incurred during fiscal years 1999, 2000 and 2001, the
Company did not record a provision for any federal or state income taxes in
those years. The following is a reconciliation between the amount of the
Company's income taxes utilizing the U.S. federal statutory rate and the
Company's actual provision for income taxes for the years ended September 30,
1999, 2000 and 2001 (in thousands):

<TABLE>
<CAPTION>
                                                 1999     2000      2001
<S>                                             <C>      <C>      <C>
At U.S. federal statutory rate................. $(1,781) $(4,243) $(23,638)
State taxes, net of federal effect.............    (381)    (673)   (3,879)
Research and development credits...............     (92)    (220)     (515)
Non-deductible stock option compensation charge      43      948     2,085
Non-deductible intangible asset amortization...      --       --       916
Non-deductible expenses and other items........    (103)     (56)       71
Effect of change in valuation allowance........   2,314    4,244    24,960
                                                -------  -------  --------
Provision for income taxes..................... $    --  $    --  $     --
                                                =======  =======  ========
</TABLE>

    Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. As of September 30, 2000
and 2001, net deferred tax assets consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                      2000      2001
<S>                                  <C>      <C>
Net operating losses................ $ 5,110  $ 18,372
Tax credit carryforwards............     570     1,345
Capitalized research and engineering   1,129     5,265
Temporary differences...............   1,929     8,716
                                     -------  --------
Total deferred tax asset............   8,738    33,698
Valuation allowance.................  (8,738)  (33,698)
                                     -------  --------
Net deferred tax asset.............. $    --  $     --
                                     =======  ========
</TABLE>

    A valuation allowance is established if it is more likely than not that all
or a portion of the deferred tax asset will not be realized. Accordingly, as of
September 30, 2000 and 2001, a valuation allowance was recorded for the full
amount of the deferred tax asset due to the uncertainty of their realization.

    As of September 30, 2001, the Company had net operating loss carry-forwards
for both federal and state income tax purposes of approximately $46.0 million,
which expire at various dates through

                                      60

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

2020 and 2005, respectively. The Company also has available research and
development credits for federal and state income tax purposes of approximately
$876,000 and $675,000, respectively, which expire at various dates through 2020.

    An ownership change, as defined in the Internal Revenue Code, resulting
form the issuance of additional stock may limit the amount of net operating
loss and tax credit carryforwards that can be utilized annually to offset
future taxable income and tax liabilities. The amount of the annual limitation
is determined based upon the Company's value immediately prior to the ownership
change. Subsequent significant changes in ownership could further affect the
limitations in future years.

12. EMPLOYEE SAVINGS PLAN

    The Company sponsors a savings plan for its employees, who meet certain
eligibility requirements, which is designed to be a qualified plan under
section 401(k) of the Internal Revenue Code. Eligible employees are permitted
to contribute to the 401(k) plan through payroll deductions within statutory
and plan limits. The Company does not contribute to the plan.

13. ACQUISITION OF IP PERFORMANCE

    On November 8, 2000, the Company completed its acquisition of IP
Performance, Inc. ("IP Performance"), a developer of network acceleration
technology, through the exchange of 128,693 shares of Network Engines common
stock for all outstanding shares of IP Performance capital stock. The
acquisition was accounted for using the purchase method of accounting.
Accordingly, the fair market value of the acquired assets and assumed
liabilities have been included in the Company's financial statements as of the
acquisition date and the results of IP Performance operations have been
included in the Company's financial statements thereafter. The purchase price
of approximately $2,540,000, plus assumed net liabilities of approximately
$95,000 and acquisition expenses of approximately $63,000, resulted in goodwill
and intangible assets of approximately $2,698,000. The Company's pro forma
statements of operations prior to the acquisition would not differ materially
from reported results.

    In July 2001, the Company completed an intensive review of its business,
which resulted in its implementation of a restructuring plan. This
restructuring plan included a discontinuation of much of the customized
hardware and software that had previously been a part of the Company's product
development process. As a result of this restructuring and an assessment of
expected future cash flows, the Company determined that the recoverability of
the IP Performance-related intangible assets was unlikely. Accordingly, the
Company recognized an impairment charge for the full amount of the unamortized
intangible assets, approximately $2,023,000, during the fourth quarter of
fiscal 2001. Prior to the impairment, the Company had been amortizing the
goodwill and intangible assets over a three-year period resulting in
approximately $675,000 of amortization expense during the year ended September
30, 2001.

                                      61

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


    In connection with the acquisition, the Company also issued 321,756 shares
of restricted common stock to key employee shareholders of IP Performance.
These shares are restricted as to sale and such restrictions lapse in three
equal annual installments beginning on November 8, 2001, contingent upon
continued employment of the holder. In connection with the issuance of these
restricted shares, the Company recorded approximately $6,351,000 of deferred
compensation, which is being recognized as stock compensation expense ratably
over the vesting periods. Through September 30, 2001, the Company recognized
approximately $2,889,000 of stock compensation expense. The amount of stock
compensation expense to be recorded in future periods could decrease if holders
of unvested restricted stock cease to be employees of the Company prior to the
lapse of the vesting period. In addition, if employees who were retained in
connection with the Company's acquisition of IP Performance are terminated
without cause, all of the related restricted stock vests upon termination and
all of the related amortization of deferred stock compensation will be
accelerated.

14. INVENTORY WRITE-DOWN

    During the year ended September 30, 2001, the Company recorded an inventory
write-down of approximately $23,657,000 for excess and obsolete inventory
related to the Company's WebEngine Blazer, WebEngine Sierra and StorageEngine
Voyager products. This excess and obsolete inventory was due to an
unanticipated shortfall in sales of these products and the resulting reduction
in expected future sales of these products as well as the discontinuation of
the Company's WebEngine Blazer and StorageEngine Voyager products. The net
write-down included inventory held at the Company's contract manufacturer,
inventory on-hand and firm purchase commitments. The Company recorded a
recovery of the gross charge of approximately $3,379,000 as a result of the
Company's better-than-expected sales of products and components as well as
favorable negotiations with vendors on inventory commitments, which had been
included in the gross inventory write-down.

15. RESTRUCTURING AND OTHER CHARGES

    During the year ended September 30, 2001, the Company undertook two
restructurings of its operations, the first of these restructurings occurred in
April 2001 and the second in July 2001. The Company's April 2001 restructuring
was to better align the Company's operating expenses with reduced revenues, and
as a result of its implementation, the Company recorded a charge to operations
of $2,812,000. This charge was due to a reduction in workforce from 243
employees to 170 employees, the curtailment of a planned expansion into leased
facilities and other items. This charge included approximately $951,000 for
employee related costs including severance payments to terminated employees and
stock option compensation expense of $186,000 related to modifications of
certain stock options held by terminated employees, approximately $1,331,000 to
write off certain assets related to facilities that the Company will not be
occupying and approximately $530,000 primarily related to non-refundable
deposits on tradeshows that the Company will not be attending as well as
certain other sales and marketing commitments. The Company's July 2001
restructuring was the result of an intensive review of its business, which
resulted in a re-focus of the Company's sales strategy towards strategic
partnerships with ISVs and OEMs and a discontinuation of much of the customized
hardware and software that had previously been included in the Company's
products. As a result of the

                                      62

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

implementation of the July 2001 restructuring, the Company recorded a charge to
operations of approximately $6,871,000. This charge included approximately
$1,643,000 of employee related costs as the Company reduced its workforce by 70
employees, approximately $2,224,000 as a result of the Company's disposal of
certain property and equipment, approximately $2,023,000 to write off goodwill
and intangible assets which were deemed to be impaired, approximately $618,000
of facility costs associated with non-cancelable operating leases for space
which will not be occupied and approximately $363,000 of other charges. In
addition to the April and July restructurings, in March 2001, the Company
recorded a charge due to the retirement of fixed assets related to its
WebEngine Blazer product line. These fixed assets had a total net book value of
approximately $1,203,000 and consisted primarily of computer equipment
previously utilized in the production and sales of the WebEngine Blazer, the
Company's previous generation web content server appliance product. The total
of the restructuring and other charges detailed above was approximately
$10,886,000. The reduction in the Company's workforce implemented during the
year ended September 30, 2001, impacted employees in all of the Company's
groups, including manufacturing, research and development, selling and
marketing and general and administrative.

    The following table sets forth restructuring accrual activity during the
year ended September 30, 2001:

<TABLE>
<CAPTION>
                                                    Employee Facility Impaired
                                                    Related  Related   Assets  Other   Total
<S>                                                 <C>      <C>      <C>      <C>    <C>
Restructuring and other charges.................... $ 2,594  $ 1,949  $ 5,450  $ 893  $10,886
Cash payments......................................  (1,917)    (196)      --   (317)  (2,430)
Non-cash utilization...............................    (186)  (1,194)  (5,450)  (258)  (7,088)
                                                    -------  -------  -------  -----  -------
Restructuring accrual balance at September 30, 2001 $   491  $   559  $    --  $ 318  $ 1,368
                                                    =======  =======  =======  =====  =======
</TABLE>

    The Company expects the remaining restructuring accrual balance to be fully
utilized by September 30, 2002, including cash payments of approximately
$1,100,000.

16. SEGMENT AND GEOGRAPHIC DATA

    The Company organizes itself as one segment and through September 30, 2001
conducted its operations primarily in the United States. Revenues were
generated from the following geographic regions (in thousands):

<TABLE>
<CAPTION>
                Year ended September 30,
                ------------------------
                 1999     2000    2001
<S>             <C>     <C>      <C>
United States.. $6,031  $41,803  $12,095
Other countries     --    1,271    1,420
                ------  -------  -------
                $6,031  $43,074  $13,515
                ======  =======  =======
</TABLE>

    All of the Company's long-lived assets were located in the United States as
of September 30, 1999, 2000 and 2001.

                                      63

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


17. RELATED PARTY TRANSACTIONS

    In January 2001, the Company entered into a series of related agreements
with Lawrence A. Genovesi, the Company's current Chairman and former President,
Chief Executive Officer and Chief Technology Officer. These agreements were
entered into to avoid significant sales of the Company's stock by Mr. Genovesi
as a result of a margin call on a personal loan collateralized by Mr.
Genovesi's holdings of the Company's common stock. The Company agreed to
guarantee a personal loan obtained by Mr. Genovesi from a financial institution
(the "Bank") through a deposit of $1,051,850 of the Company's cash with the
Bank (the "Guarantee"). The Guarantee period ends on January 9, 2002 and the
balance of the amount deposited with the Bank will be returned to the Company,
however, the Company may renew this guarantee upon its initial expiration. Mr.
Genovesi and the Company also entered into an agreement whereby Mr. Genovesi
has agreed to reimburse the Company for any obligations incurred by the Company
under the Guarantee (the "Reimbursement Agreement"). Any unpaid balances under
the Reimbursement Agreement bear interest at a rate of 10% per annum. In the
event of a default of the Reimbursement Agreement by Mr. Genovesi, the Company
has the right to apply any and all compensation due to Mr. Genovesi against all
of Mr. Genovesi's obligations outstanding under the Reimbursement Agreement. In
addition, the Company and Mr. Genovesi entered into a revolving promissory note
of up to $210,000 (the "Note"). The Note bears interest at a rate of 5.9% per
annum and is due and payable in full upon the earlier of January 9, 2002 or 30
days following the date Mr. Genovesi ceased to be an employee of the Company.

    In conjunction with the Guarantee, the Reimbursement Agreement and the
Note, the Company and Mr. Genovesi entered into a pledge agreement whereby Mr.
Genovesi pledged to the Company all shares of the Company's common stock owned
by Mr. Genovesi as of the date of the agreement or subsequently acquired, and
all options and other rights to acquire shares of the Company's common stock
owned by Mr. Genovesi as of the date of the agreement or subsequently acquired
(collectively the "Pledged Securities"). Additionally, Mr. Genovesi pledged to
the Company all additional securities or other consideration from time to time
acquired by Mr. Genovesi in substitution for, or in respect of, the Pledged
Securities. If Mr. Genovesi elects to sell any of the Pledged Securities during
the term of the agreement, all proceeds of such sale will be applied first to
any outstanding obligations related to the Note and then to any amounts payable
under the Reimbursement Agreement. In addition to the Pledged Securities, the
Note is collateralized by a second mortgage on certain real property owned by
Mr. Genovesi. As of September 30, 2001, approximately $76,000 was outstanding
under the Note (included in the balance sheet as notes receivable from
stockholders) and no amounts were required to be reimbursed to the Company
under the Reimbursement Agreement.

    In April 2001, the Company entered into full recourse loan agreements with
certain current and former employees and certain current and former executive
officers of the Company (the "Loan Agreements"). These loan agreements were
entered into to avoid substantial sales of the Company's common stock by these
employees and executive officers as a result of alternative minimum tax
obligations incurred by these employees and executive officers. The net amount
loaned to the employees and executive officers under the Loan Agreements was
approximately $508,000.

                                      64

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Outstanding amounts under the Loan Agreements accrue interest at a rate of
4.63% per annum and are due and payable in full upon the earlier of one year
from the date of each individual agreement or thirty days after termination of
employment with the Company, unless termination is involuntary and without
cause. In conjunction with the Loan Agreements, each employee and executive
officer pledged all shares of capital stock of the Company now owned, or
acquired in the future, (the "Pledged Stock"), and any distributions on the
Pledged Stock or proceeds from their sale. Amounts due under these Loan
Agreements have been included in the balance sheet as notes receivable from
stockholders.

18. SUBSEQUENT EVENTS

    In November 2001, the Company entered into an agreement to engage a third
party to provide long-term product support for the Company's discontinued
product lines. Under the terms of this agreement, the Company has agreed to
provide training, documentation, access to qualified employees of the Company
and certain fully reserved inventory on hand as of September 30, 2001 to this
third party in exchange for the third party's agreement to assume all warranty
support services to previous purchasers of the Company's discontinued products.

    In November 2001, the Company repurchased 234,822 shares of the Company's
common stock from Lawrence A. Genovesi, the Company's current Chairman and
former President, Chief Executive Officer and Chief Technology Officer for
$225,195 in a private transaction. The purchase price was determined based on
the average closing price of the Company's common stock over the ten trading
days prior to the purchase date. Mr. Genovesi used the proceeds to pay off all
amounts outstanding under a revolving promissory note owed to the Company (see
Note 17), to pay down a recourse note payable to the Company (see Note 7) and
to pay taxes incurred in connection with the Company's repurchase of its common
stock from Mr. Genovesi.

    On or about December 3, 2001, Margaret Vojnovich filed in the United States
District Court for the Southern District of New York a lawsuit against Network
Engines, Inc., Lawrence A. Genovesi, the Company's current Chairman and former
Chief Executive Officer, and Douglas G. Bryant, the Company's Chief Financial
Officer and Vice President of Administration (collectively, the "Executive
Officers"), FleetBoston Robertson Stephens, Inc., an underwriter of the
Company's initial public offering in July 2000 (the "IPO" ), Credit Suisse
First Boston Corp., Goldman Sachs & Co., Lehman Brothers Inc. and Salomon Smith
Barney, Inc. (collectively, the "Underwriter Defendants"). The suit generally
alleges that the Underwriter Defendants violated the federal securities laws by
conspiring and agreeing to raise and increase the compensation received by the
Underwriter Defendants by agreeing with some recipients of an allocation of IPO
stock to agree to purchase shares of manipulated securities in the after-market
of the IPO at pre-determined price levels designed to maintain, distort and/or
inflate the price of the Company's common stock in the aftermarket. The suit
also alleges that the Underwriter Defendants received undisclosed and excessive
brokerage commissions and that, as a consequence, the Underwriter Defendants
successfully increased investor interest in the manipulated IPO securities and
increased the Underwriter Defendants' individual and collective underwritings,
compensation and revenues. The suit further alleges that the defendants
violated the federal securities laws by issuing and

                                      65

<PAGE>

                             NETWORK ENGINES, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

selling securities pursuant to the IPO without disclosing to investors that the
Underwriter Defendants in the offering, including the lead underwriters, had
solicited and received excessive and undisclosed commissions from certain
investors. The suit seeks rescission of the purchase prices paid by purchasers
of shares of the Company's common stock and certification of a plaintiff class
consisting of all persons who acquired shares of the Company's common stock
between July 13, 2000 and December 6, 2000.

    The Company is in the process of reviewing this suit and intends to respond
in a timely manner. Additional suits may be filed with similar claims. As of
the date hereof, the Company is unable to predict the outcome of this suit and
any future suits and their ultimate effect, if any, on the Company's financial
condition.

19. QUARTERLY FINANCIAL DATA (UNAUDITED)

    The following information has been derived from unaudited consolidated
financial statements that, in the opinion of management, include all recurring
adjustments necessary for a fair presentation of such information.

<TABLE>
<CAPTION>
                                                          Three Months Ended
                                             --------------------------------------------
                                             December 31, March 31, June 30, September 30,
                                                 2000       2001      2001       2001
                                                 (in thousands, except per share data)
<S>                                          <C>          <C>       <C>      <C>
Revenues....................................   $  6,894   $  2,516  $ 2,380    $  1,725
Gross profit (loss).........................    (13,358)    (9,708)   2,977         645
Net loss attributable to common stockholders    (25,862)   (22,802)  (9,640)    (11,219)
Basic and diluted net loss per common share.   $  (0.76)  $  (0.67) $ (0.28)   $  (0.32)
Basic and diluted weighted average shares
  outstanding...............................     33,862     34,219   34,436      34,522
</TABLE>

<TABLE>
<CAPTION>
                                                          Three Months Ended
                                             --------------------------------------------
                                             December 31, March 31, June 30, September 30,
                                                 1999       2000      2000       2000
                                                 (in thousands, except per share data)
<S>                                          <C>          <C>       <C>      <C>
Revenues....................................   $ 4,415     $ 6,051  $14,519     $18,089
Gross profit (loss).........................     1,792       1,807    5,502       6,990
Net loss attributable to common stockholders    (1,586)     (4,221)  (3,916)     (2,758)
Basic and diluted net loss per common share.   $ (0.70)    $ (2.11) $ (1.66)    $ (0.11)
Basic and diluted weighted average shares
  outstanding...............................     3,417       3,633    4,413      30,100
</TABLE>

    During the fourth quarter of 2001, the Company recorded a recovery of
approximately $542,000 as a result of the Company's better-than-expected sales
of products and components as well as favorable negotiations with vendors on
inventory commitments, which had been included in the write-down of inventory
earlier in 2001. The Company also recorded restructuring and other charges of
approximately $6,871,000 during the fourth quarter of 2001.

                                      66

<PAGE>

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE

    NONE

                                   PART III

    Certain information required by Part III of this Form 10-K is omitted
because we will file a definitive proxy statement pursuant to Regulation 14A
(the "Proxy Statement") not later than 120 days after the end of the fiscal
year covered by this Form 10-K, and certain information to be included therein
is incorporated herein by reference.

ITEM 10.  DIRECTORS AND OFFICERS OF THE REGISTRANT

    The information regarding directors and compliance with Section 16 (a) of
the Securities and Exchange Act of 1934, as amended, required by Item 10 of
Form 10-K is incorporated herein by reference to the Proxy Statement. The
information regarding executive officers is included in Part I of this Form
10-K under the section captioned "Executive Officers of the Company."

ITEM 11.  EXECUTIVE COMPENSATION

    The information required by Item 11 of Form 10-K is incorporated herein by
reference to the Proxy Statement, under the section captioned "Executive
Compensation and Other Information." The information specified in Item 402 (k)
and (l) of Regulation S-K and set forth in the Proxy Statement is not
incorporated by reference.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

    The information required by Item 12 of Form 10-K is incorporated by
reference from the Proxy Statement under the section captioned "Security
Ownership of Certain Beneficial Owners and Management."

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

    The information required by Item 13 of Form 10-K is incorporated by
reference from the Proxy Statement under the section captioned "Certain
Relationships and Related Transactions."

                                      67

<PAGE>

                                    PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

    (a) (1) Financial Statements

    The following consolidated financial statements are filed as part of this
report under "Item 8--Financial Statements and Supplementary Data":

<TABLE>
<CAPTION>
                                                                                                      Page
<S>                                                                                                   <C>
Report of Independent Accountants....................................................................  40
Consolidated Balance Sheets as of September 30, 2000 and 2001........................................  41
Consolidated Statement of Operations for the years ended September 30, 1999, 2000 and 2001...........  42
Consolidated Statement of Stockholders' Equity (Deficit) for the years ended September 30, 1999, 2000
  and 2001...........................................................................................  43
Consolidated Statement of Cash Flows for the years ended September 30, 1999, 2000 and 2001...........  44
Notes to Consolidated Financial Statements...........................................................  45
</TABLE>

    (a) (2) List of Schedules

    Schedule II--Valuation and Qualifying Accounts for the three fiscal years
ended September 30, 2001.

    All other schedules to the consolidated financial statements are omitted as
the required information is either inapplicable or presented in the
consolidated financial statements.

    (a) (3) List of Exhibits

    The exhibits which are filed with this report or which are incorporated by
reference are set forth in the Exhibit Index hereto.

    (b) Reports on Form 8-K

    We did not file any reports on Form 8-K during the last quarter of the
period covered by this report.

                                      68

<PAGE>

                                  SIGNATURES

    Pursuant to the requirements of Section 13 or 15(d) 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, on December 21,
2001.

                                          NETWORK ENGINES, INC

                                                     /s/ JOHN H. CURTIS
                                          By: _________________________________
                                                       John H. Curtis
                                             President and Chief Executive
                                                          Officer

    Pursuant to the requirements of the Securities Exchange Act of 1934, the
Report has been signed as of December 21, 2001 below by the following person on
behalf of the Registrant and in the capacities indicated.

          Name                             Title

   /s/ JOHN H. CURTIS    President, Chief Executive Officer
------------------------ (Principal Executive Officer) and Director
     John H. Curtis

 /s/ DOUGLAS G. BRYANT   Vice President of Administration, Chief
------------------------ Financial Officer, Treasurer and Secretary
   Douglas G. Bryant     (Principal Financial Officer and Principal
                         Accounting Officer)

/s/ LAWRENCE A. GENOVESI Chairman of the Board of Directors
------------------------
  Lawrence A. Genovesi

  /s/ JOHN A. BLAESER    Director
------------------------
    John A. Blaeser

  /s/ LAWRENCE KERNAN    Director
------------------------
    Lawrence Kernan

  /s/ DENNIS A. KIRSHY   Director
------------------------
    Dennis A. Kirshy

 /s/ FRANK M. POLESTRA   Director
------------------------
   Frank M. Polestra

/s/ ROBERT M. WADSWORTH  Director
------------------------
  Robert M. Wadsworth

                                      69

<PAGE>

                REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL
                              STATEMENT SCHEDULE

To the Board of Directors and Stockholders
of Network Engines, Inc.:

    Our audits of the consolidated financial statements referred to in our
report dated November 5, 2001, except for footnote 18 for which the date is
December 3, 2001, appearing in this Annual Report on Form 10-K of Network
Engines, Inc. also included an audit of the financial statement schedule listed
in Item 14(a)(2) of this Form 10-K. In our opinion, the financial statement
schedule presents fairly, in all material respects, the information set forth
therein when read in conjunction with the related consolidated financial
statements.

/s/ PRICEWATERHOUSECOOPERS LLP

Boston, Massachusetts
November 5, 2001

                                      70

<PAGE>

                                  SCHEDULE II

                             NETWORK ENGINES, INC.
                       VALUATION AND QUALIFYING ACCOUNTS
                                (in thousands)

<TABLE>
<CAPTION>
                                             Balance at                       Balance at
                                            Beginning of                        End of
Fiscal Year           Description              Period    Additions Deductions   Period
<S>         <C>                             <C>          <C>       <C>        <C>
   1999:    ALLOWANCE FOR DOUBTFUL ACCOUNTS     $107       $120       $ --      $  227
   2000:    ALLOWANCE FOR DOUBTFUL ACCOUNTS     $227       $176       $ 33      $  370
   2001:    ALLOWANCE FOR DOUBTFUL ACCOUNTS     $370       $755       $111      $1,014
</TABLE>

                                      71

<PAGE>

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
Exhibit
  No.                                                   Exhibit
<C>       <S>
   3.1**  Second Amended and Restated Certificate of Incorporation of the Registrant.
   3.2**  Second Amended and Restated By-laws of the Registrant
   4.1*   Specimen common stock certificate
   4.2**  Agreement and Plan of Merger dated November 7, 2000, among Network Engines, Inc., IPP
          Acquisition Co. and IP Performance, Inc.
  10.1*   Lease dated October 19, 1999 with New Boston Batterymarch, LP for 25 Dan Road, Canton,
          Massachusetts
  10.2*   The Registrant's 1999 Stock Incentive Plan
  10.3*   Form of Incentive Stock Option Agreement under the Registrant's 1999 Stock Incentive Plan
  10.4*   The Registrant's 2000 Employee Stock Purchase Plan
  10.5*   The Registrant's 2000 Director Stock Option Plan
  10.6*   Investor Rights Agreement Investor Rights Agreement, dated December 20, 1999, among the
          Registrant and certain investors in our preferred stock and warrants.
  10.7*   Restricted Stock Agreement with Lawrence Genovesi, dated November 18, 1999, under the 1999
          Stock Incentive Plan.
  10.8+** Manufacturing and Purchase Agreement dated, August 4, 2000, between the Registrant and SCI
          Systems, Inc.
  10.9*   Restricted Stock Agreement with Dennis Kirshy, dated January 7, 1998, under the 1997 Stock
          Incentive Plan
 10.10*   Restricted Stock Agreement with Dennis Kirshy, dated November 18, 1999, under the 1999 Stock
          Incentive Plan
 10.11*   Restricted Stock Agreement with John Blaeser, dated November 18, 1999, under the 1999 Stock
          Incentive Plan
 10.12*   P6000 Asset Purchase Agreement between the Registrant and Copernicus Systems, Inc. dated April
          13, 2000
 10.13*   Loan Modification Agreement, dated as of April 5, 2000, between the Registrant and Silicon Valley
          Bank
 10.14*   Restricted Stock Agreement with Michael H. Shanahan, dated April 3, 2000, under the 1999 Stock
          Incentive Plan
 10.15*   Form of option granted to each of Frank M. Polestra, Robert M. Wadsworth and Lawrence Kernan
          on March 16, 2000
 10.16*   Form of First Amendment to the Registrant's 1999 Stock Incentive Plan
 10.17*   License Agreement between the Registrant and International Business Machines Corporation, dated
          July 19, 1999
 10.18*   First Amendment dated February 1, 2000 and Second Amendment dated June 1, 2000 to Lease for
          25 Dan Road, Canton, Massachusetts
 10.19*** Reimbursement Agreement, dated January 9, 2001, between the Registrant and Lawrence A. Genovesi
 10.20*** Secured Revolving Promissory Note, dated January 9, 2001, between the Registrant and
          Lawrence A. Genovesi
 10.21*** Pledge Agreement, dated January 9, 2001, between the Registrant and Lawrence A. Genovesi
 10.22#   Employment Agreement, dated March 21, 2001, between the Registrant and John H. Curtis
 10.23#   Incentive Stock Option Agreement, dated March 21, 2001, between the Registrant and John H. Curtis
 10.24#   Nonstatutory Stock Option Agreement, dated March 21, 2001, between the Registrant and John H. Curtis
 10.25#   Secured Promissory Note, dated April 9, 2001, between the Registrant and Rene E. Thibault
 10.26#   Secured Promissory Note, dated April 6, 2001, between the Registrant and Douglas G. Bryant
 10.27#   Secured Promissory Note, dated April 6, 2001, between the Registrant and Timothy J. Dalton
 10.28#   Pledge Agreement, dated April 9, 2001, between the Registrant and Rene E. Thibault
 10.29#   Pledge Agreement, dated April 6, 2001, between the Registrant and Douglas G. Bryant
 10.30#   Pledge Agreement, dated April 6, 2001, between the Registrant and Timothy J. Dalton
</TABLE>

<PAGE>

<TABLE>
<CAPTION>
Exhibit
  No.                                              Exhibit
<C>      <S>
 10.31## Sub-lease agreement dated June 21, 2001, with Techmar Communications, Inc. for 45 Dan Road,
         Canton, Massachusetts.
 10.32## Consent to Sub-lease from Dan Road Buildings, LLC regarding sub-lease agreement for 45 Dan
         Road, Canton, Massachusetts.
 10.33   Severance Agreement, dated November 13, 2001, between the Registrant and Lawrence A.
         Genovesi.
 10.34   Amendment No. 1 to Restricted Stock Agreement, dated November 14, 2001, with Lawrence A.
         Genovesi.
  21.1   Subsidiaries of the Registrant
  23.1   Consent of PricewaterhouseCoopers LLP
</TABLE>
---------------------
*  Incorporated by reference from exhibits filed with the Company's
   registration statement (File No. 333-34286) on Form S-1, as amended, filed
   under the Securities Act of 1933, as amended.
+  Confidential treatment requested as to certain portions, which portions were
   omitted and filed separately with the Securities and Exchange Commission
   pursuant to a Confidential Treatment Request.
** Incorporated by reference from exhibits filed with the Company's Annual
   Report on Form 10-K for the period ended September 30, 2000.
*** Incorporated by reference from exhibits filed with the Company's Quarterly
    Report on Form 10-Q for the period ended December 31, 1999.
#  Incorporated by reference from exhibits filed with the Company's Quarterly
   Report on Form 10-Q for the period ended March 31, 2001.
## Incorporated by reference from exhibits filed with the Company's Quarterly
   Report on Form 10-Q for the period ended June 30, 2001.