MANAGEMENT'S  DISCUSSION  AND  ANALYSIS  OF  FINANCIAL  CONDITION  & RESULTS  OF
OPERATIONS

Results of Operations
The table below summarizes  changes in selected  operating  indicators,  showing
certain income, cost and expense items as a percentage of total revenue for each
of the  past  three  years.  Inflation  has not  been a  significant  factor  in
Datakey's operations to date.

                                 Percentage of Total Revenue
Year Ended December 31,           1997      1996     1995
                                 -------- --------- --------
Revenue........................    100%      100%     100%

Cost and Expenses
Cost of goods sold.............     73%       65%      67%
Research and development.......     53        35       10
Marketing and sales............     29        20       15
General and administrative.....     12        18        9
                                 -------- --------- --------
   Total cost and expenses.....    167       138      101
Interest income................      2         6        5
Income (loss) before income
taxes..........................    (65)      (32)       4
Income taxes (benefit).........      5        (6)       2
                                 -------- --------- --------
Net income (loss)..............    (70)      (26)       2
                                 -------- --------- --------


Comparison of 1997 with 1996

Total  Revenue:  Total  revenue was  $5,977,000 in 1997, a decrease of 9 percent
from  $6,558,000  in 1996.  The revenue  decrease is  primarily  due to customer
requested  delays in major  electronic  products  customer  shipments during the
second half of 1997  resulting  from delays,  cancellation,  or  non-renewal  of
orders from their  customers.  The Company  anticipates that sales of electronic
products  will  continue  to  decrease  in 1998.  Its future  growth will depend
primarily on the market  acceptance of new end-user  products  introduced to the
information security marketplace.

Gross margins:  The gross profit margin  decreased to 27 percent in 1997 from 35
percent in 1996 primarily as a result of lower revenue, product costs associated
with zero charge  evaluation  units to customers,  and increases in reserves for
inventory obsolescence.

Research and development: Research and development expenses increased 41 percent
to $3,186,000 in 1997 from  $2,263,000 in 1996 due to the Company's  significant
increase in product development activities for token-based  information security
systems.

Marketing and sales, General and administrative:  Marketing and sales expense in
1997 increased 31 percent to $1,716,000 from $1,312,000 in 1996 due to a planned
increase in product promotion expense to achieve market  introduction of the new
token-based information security systems.
   General and administrative  expenses decreased 38 percent to $713,000 in 1997
from  $1,156,000  in 1996  primarily due to an accrual in 1996 for severance pay
and benefits due the Company's former chief executive officer.

Interest  income:  Interest income decreased 53 percent to $170,000 in 1997 from
$361,000  in 1996 due to a  decline  in the  Company's  investment  in  interest
bearing investments.

Income tax  expense  (benefit):  The  Company  recorded an income tax expense of
$325,000 in 1997 as compared to an income tax benefit of $388,000 in 1996.  As a
result of the net operating  loss  carryover in excess of $5,000,000 at December
31, 1997, the Company  determined that the realization of the future tax benefit
of the operating  losses for tax purposes was uncertain  and,  accordingly,  the
deferred  tax asset of $325,000  recorded at December  31,  1996,  was  entirely
reserved and charged to expense in 1997.


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Comparison of 1996 with 1995

Total  Revenue:  Total  revenue was  $6,558,000 in 1996, a decrease of 9 percent
from  $7,219,000  in 1995.  The revenue  decrease was  primarily due to customer
requested  delays in commercial OEM product  shipments during the second half of
1996 resulting from delays in shipments to their customers.

Gross margins:  The gross profit margin  increased to 35 percent in 1996 from 33
percent in 1995 in spite of a reduction in revenue  which  normally  reduces the
margin percentage. The improved margin percentage was primarily due to increases
in  product   selling  prices  in  excess  of  the  increases  in  material  and
manufacturing costs.

Research  and  development:  Research and  development  expenses  increased  221
percent  to  $2,263,000  in 1996  from  $704,000  in 1995  due to the  Company's
significant  increase  in  product  development   activities  for  new  end-user
products.

Marketing and sales, General and administrative:  Marketing and sales expense in
1996  increased  17  percent to  $1,312,000  from  $1,124,000  in 1995 due to an
increase in product  promotion  expense for newly  developed and  in-development
end-user products.
   General and  administrative  expenses  increased 73 percent to  $1,156,000 in
1996 from  $670,000 in 1995  primarily  due to an accrual for  severance pay and
benefits due the Company's former chief executive officer.

Interest  income:  Interest income  decreased 6 percent to $361,000 in 1996 from
$381,000  in 1995 due to a  decline  in the  Company's  investment  in  interest
bearing investments.

Income tax  expense  (benefit):  Income tax  benefit  for 1996 was  $388,000  as
compared to an income tax expense of $106,000 in 1995. The benefit is related to
the 1996 loss  before  taxes of  $2,094,000  for which the  Company  recorded  a
deferred  tax asset of  $325,000,  and 1995  expense is related to the  $282,000
income before taxes.

Liquidity and Capital Resources

   
The  Company  had  a  reduction  of  $4,828,000  in  cash  and  held-to-maturity
marketable  debt securities in 1997 compared to a reduction of $834,000 in 1996.
The 1997 reduction in cash and marketable  debt  securities  resulted  primarily
from significant expenditures,  totaling $4,902,000, in research and development
and  marketing  expenses  principally  related  to  the  Company's  new  product
development activities. Inventory decreased $46,000 to $1,083,000 as of December
31, 1997,  compared to $1,129,000 as of December 31, 1996. Accrued  compensation
expense decreased by $129,000  primarily due to the payment of severance pay and
benefits due the Company's former chief executive officer.  The Company invested
$1,151,000 in the purchase of equipment and  maintenance of licenses and patents
in  1997,  compared  to  $515,000  in  1996.  The  1997  increase  is  primarily
attributable to prepaid  license fees related to licensed  software that will be
bundled  with  the  Company's  information  security  systems  and  purchase  of
automated equipment to improve factory efficiency.  Cash, cash equivalents,  and
investment in  held-to-maturity  marketable  debt  securities as of December 31,
1997,  totaled $1,305,000 as compared to $6,133,000 as of December 31, 1996. See
"Outlook".  Datakey's balance sheet reflects $1,951,000 in working capital and a
current assets to current liabilities ratio of 2.7 to 1 as of December 31, 1997.
    



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Outlook

Certain  statements in the following  Outlook section and in other parts of this
Annual Report are forward looking and are based upon current expectations. These
statements are forward  looking and actual results may differ  materially due to
risks and uncertainties, including those set forth below.

Revenue:  Shipment delays experienced in the second half of 1997 are expected to
continue through the first half of 1998 and likely will result in a reduction in
electronic  products  revenue  for the year as compared  to 1997.  New  end-user
products being introduced to the information  security  marketplace are expected
to result in significant revenue during the second half of 1998. If this revenue
meets  the  Company's  present  expectations,  the  total  revenue  from the new
products could exceed the revenue from the electronic products group.

Gross  margins:  A gradual  improvement  in gross profit  margins during 1998 is
expected through selective price increases,  effective material  purchasing,  an
increase  in revenue  without an  attendant  increase  in factory  overhead  and
improvements in manufacturing efficiency.

Research  and  development:  The  Company  will  continue  to fund  new  product
development activities in 1998 but at about 45 percent less than in 1997.

Marketing and sales,  General and  administrative:  Marketing and sales expenses
are  expected  to  increase  about 40  percent in 1998 to  support  new  product
introductions and the expected  increase in revenue,  but will be about the same
percent of revenue  provided  revenue  from new product  sales  materializes  as
expected.  General and administrative  expenses in 1998 are expected to increase
slightly from the 1997 level.

Interest income (expense):  Interest income is expected to decline materially in
early  1998 as the  Company  intends  to use cash and cash  equivalents  to fund
continuing product development and marketing activities to support the Company's
entry into advanced  information  security products.  Beginning in the second or
third quarter the Company expects to borrow money and begin  incurring  interest
expense under the recently arranged bank line of credit.

Income tax expense (benefit): As a result of a net operating loss carry-forward,
the Company  does not expect to record an income tax  benefit or expense  during
1998.

Expected first half loss: The Company expects to report a loss in the first half
of 1998 but may return to  profitability  by the end of 1998 if revenue from the
new product line materializes as expected.

Liquidity  and  capital  resources:  The Company  plans to continue  new product
development in 1998 at a lower level than in 1997 and marketing  activities will
continue  at an  increased  level  during  1998.  The  Company  expects to spend
$4,000,000 to $4,500,000 on these  activities.  Inventory levels are expected to
increase slightly in 1998 to support advanced  information  security products as
well as electronic  products.  1998  investments in equipment and maintenance of
licenses  and patents are expected to return to a level of $500,000 to $550,000.
The  Company  believes  its  working  capital  and cash  equivalent  investments
together  with  its bank  line of  credit  are  sufficient  to fund its  planned
operations and continued  development  and promotional  activities  during 1998,
provided that the revenue from new products  materialize  as expected.  The bank
line is scheduled to expire in May 1998,  but the Company  expects to be able to
renew it for another year. The Board of Directors believes the prudent course of
action is for the Company to seek additional debt or equity  financing,  and the
Company  is  currently   discussing   financing   options  with  several   local
broker-dealers.


<PAGE>

Risks and Uncertainties

   Rapid technological change:  Datakey's information security end-user products
such as SignaSURE  CIP and  SignaSURE ESS will  integrate  hardware  tokens with
software   that   provides  a  much  higher  level  of  security  than  software
implementations  alone. There is a possibility that software-only  solutions may
overcome this deficiency in the future.
   Customer acceptance:  While Datakey performs market research and beta testing
to determine  the  viability of its new products,  actual user  acceptance  will
ultimately  dictate  the  success  of the  marketing  and sales  efforts  of new
products such as SignaSURE CIP and ESS.  Although the Company  believes that the
decision to fund these new  products is correct,  there are no  assurances  that
investments already made and additional investments planned for 1998 will result
in a financial return.
   Product delivery schedules:  Delays in the release of new products will cause
operational inefficiencies, increased development costs and reduced revenues.
   Price  competition:  While  Datakey  believes  that its strategy of providing
token-based  product solutions at a price that is competitive with software-only
products is attainable,  there are no assurances that competitive pressures will
not force the Company to accept reduced margins to compete in the future.  Large
companies with  significantly  greater  resources  have  recognized the need for
information  security  and could  enter  this  market as  competitors  with much
greater  financial  resources.  A portion  of the new  end-user  products'  cost
consists of royalties and license fees which would need to be  re-negotiated  in
order to maintain acceptable profit margins.
   Integrated information security products: Although the Company's new products
will operate  seamlessly  with popular  application  programs,  new  application
programs that integrate  information security into their product could erode the
future market for these Datakey products.
   Marketing  and sales:  The future  revenue  of  Datakey  end-user  systems is
dependent  on the  success of a new and  untested  marketing  and  direct  sales
organization.
   Need for  information  security:  Corporate  utilization  of the Internet and
internal  intranets  dictate a need for information  security,  but there are no
assurances that other, more secure information transmission media may not become
available in the future that would preclude the need for the type of information
security provided by the Company's products.
   Financing: There is no assurance that the Company's current negotiations with
broker-dealers  will lead to a financing on acceptable terms.  Should there be a
delay in new orders or if new product revenue does not materialize to the extent
currently  projected,   the  inability  to  obtain  acceptable  financing  could
jeopardize the Company's ability to maintain its current business operations.

Other Matters

The Company has begun its analysis of the impact, if any, from the changeover of
various computer systems during the year 2000. Based upon its internal  analysis
and results of  questions  posed to major  software and service  suppliers,  the
Company feels that year 2000 will have no  significant  financial or operational
impact.