##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q



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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2001

OR



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

COMMISSION FILE NUMBER 0-26825

N2H2, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

WASHINGTON
(STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION)

91-1686754
(I.R.S. EMPLOYER IDENTIFICATION NO.)

900 FOURTH AVENUE, SUITE 3600, SEATTLE, WA 98164
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)

REGISTRANTS TELEPHONE NUMBER, INCLUDING AREA CODE: (206) 336-1501

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

As of August 6, 2001, the registrant had outstanding 22,036,779 shares of
common stock, no par value.





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TABLE OF CONTENTS



|                              |                                                                                                |                                                                        |  |  |  |  |  | 
|----------------------------- | ---------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------- |  |  |  |  |  | 
|PART I FINANCIAL INFORMATION
|                              | ITEM 1. FINANCIAL STATEMENTS                                                                  
|                              |                                                                                                | CONDENSED CONSOLIDATED BALANCE SHEETS                                 
|                              |                                                                                                | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
|                              |                                                                                                | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS                       
|                              |                                                                                                | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                  
|                              | ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
|                              | ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            
|PART II OTHER INFORMATION   
|                              | ITEM 1. LEGAL PROCEEDINGS                                                                     
|                              | ITEM 2(d). CHANGES IN SECURITIES AND USE OF PROCEEDS                                          
|                              | ITEM 3. DEFAULTS UPON SENIOR SECURITIES                                                       
|                              | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                   
|                              | ITEM 5. OTHER INFORMATION                                                                     
|                              | ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K                                                      
|SIGNATURES                   
|EXHIBIT 10.1                 
|EXHIBIT 10.2                 
|EXHIBIT 10.3                 
|EXHIBIT 10.4                 

N2H2, INC.

TABLE OF CONTENTS

|                              |                                                                                               |                                                                        |    |    |   | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------- | -- | -- | - | 
|PART I FINANCIAL INFORMATION |                                                                                               |                                                                        | 3  |   
|                             
|                             
|                             
|                             
|                              | Item 1. Financial Statements                                                                  |                                                                        |    | 3  |  
|                             
|                             
|                             
|                             
|                              |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS                                  |    |    | 3 | 
|                             
|                             
|                             
|                             
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS |    |    | 4 | 
|                             
|                             
|                             
|                             
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS                        |    |    | 5 | 
|                             
|                             
|                             
|                             
|                              |                                                                                               | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                   |    |    | 6 | 
|                             
|                             
|                             
|                             
|                              | Item 2. Managements Discussion And Analysis Of Financial Condition And Results Of Operations |                                                                        |    | 9  |  
|                             
|                             
|                             
|                             
|                              | Item 3. Quantitative And Qualitative Disclosures About Market Risk                            |                                                                        |    | 14 |  
|                             
|                             
|                             
|                             
|PART II OTHER INFORMATION    |                                                                                               |                                                                        | 15 |   
|                             
|                             
|                             
|                             
|                              | Item 1. Legal Proceedings                                                                     |                                                                        |    | 15 |  
|                             
|                             
|                             
|                             
|                              | Item 2. Changes In Securities And Use Of Proceeds                                             |                                                                        |    | 15 |  
|                             
|                             
|                             
|                             
|                              | Item 3. Defaults Upon Senior Securities                                                       |                                                                        |    | 15 |  
|                             
|                             
|                             
|                             
|                              | Item 4. Submission Of Matters To A Vote Of Security Holders                                   |                                                                        |    | 15 |  
|                             
|                             
|                             
|                             
|                              | Item 5. Other Information                                                                     |                                                                        |    | 15 |  
|                             
|                             
|                             
|                             
|                              | Item 6. Exhibits And Reports On Form 8-K                                                      |                                                                        |    | 15 |  
|                             
|                             
|                             
|                             
|SIGNATURES                    |                                                                                               |                                                                        | 16 |   

2



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##### Table of Contents






PART I FINANCIAL INFORMATION




ITEM 1. FINANCIAL STATEMENTS




N2H2, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands)

|                                                  |                                                                                                                                  |                            |                                            |         |          |        |               |         |        |        | 
|------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------------------------------------------ | ------- | -------- | ------ | ------------- | ------- | ------ | ------ | 
|                                                  |                                                                                                                                  |                            |                                            |         | JUNE 30, |        | SEPTEMBER 30,
|                                                  |                                                                                                                                  |                            |                                            |         | 2001     |        | 2000         
|                                                  |                                                                                                                                  |                            |                                            |         |          |        |              
|ASSETS:                                           |                                                                                                                                  |                            |                                            |         |          |        |               |        
|                                                 
|                                                 
|                                                 
|                                                 
|Current assets:                                   |                                                                                                                                  |                            |                                            |         |          |        |               |        
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Cash and cash equivalents                                                                                                        |                            | $                                          | 3,117   |          |        | $             | 7,993   |       
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Restricted cash and cash equivalents                                                                                             |                            |                                            | 675     |          |        |               |        |       
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Investments                                                                                                                      |                            |                                            | 2,500   |          |        |               | 17,292  |       
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Accounts receivable, net of allowances                                                                                           |                            |                                            | 537     |          |        |               | 2,069   |       
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Prepaid expenses and other current assets                                                                                        |                            |                                            | 298     |          |        |               | 1,161   |       
|                                                  |                                                                                                                                  |                            |                                            |         |          |        |               |        
|                                                  |                                                                                                                                  | Total current assets       |                                            |         | 7,127    |        |               |         | 28,515 |       
|                                                 
|                                                 
|                                                 
|                                                 
|Long-term investments                             |                                                                                                                                  |                            |                                           |         |          |        | 3,000         |        
|                                                 
|                                                 
|                                                 
|                                                 
|Acquired intangible assets, net                   |                                                                                                                                  |                            |                                           |         |          |        | 1,490         |        
|                                                 
|                                                 
|                                                 
|                                                 
|Property and equipment, net                       |                                                                                                                                  |                            | 7,761                                      |         |          |        | 10,192        |        
|                                                 
|                                                 
|                                                 
|                                                 
|Other assets, net                                 |                                                                                                                                  |                            | 271                                        |         |          |        | 914           |        
|                                                  |                                                                                                                                  |                            |                                            |         |          |        |               |        
|                                                  |                                                                                                                                  |                            | Total assets                               |         | $        | 15,159 |               |         | $      | 44,111 | 
|                                                  |                                                                                                                                  |                            |                                            |         |          |        |               |        
|LIABILITIES AND SHAREHOLDERS EQUITY:             |                                                                                                                                  |                            |                                            |         |          |        |               |        
|                                                 
|                                                 
|                                                 
|                                                 
|Current liabilities:                              |                                                                                                                                  |                            |                                            |         |          |        |               |        
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Accounts payable                                                                                                                 |                            | $                                          | 370     |          |        | $             | 1,982   |       
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Royalties payable                                                                                                                |                            |                                            |        |          |        |               | 198     |       
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Accrued liabilities                                                                                                              |                            |                                            | 1,198   |          |        |               | 1,277   |       
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Deferred revenue                                                                                                                 |                            |                                            | 1,773   |          |        |               | 762     |       
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Current portion of capital lease obligations                                                                                     |                            |                                            | 217     |          |        |               | 205     |       
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Current portion of long-term debt                                                                                                |                            |                                            |        |          |        |               | 1,646   |       
|                                                  |                                                                                                                                  |                            |                                            |         |          |        |               |        
|                                                  |                                                                                                                                  | Total current liabilities  |                                            |         | 3,558    |        |               |         | 6,070  |       
|                                                 
|                                                 
|                                                 
|                                                 
|Deferred revenue                                  |                                                                                                                                  |                            | 2,138                                      |         |          |        | 184           |        
|                                                 
|                                                 
|                                                 
|                                                 
|Capital lease obligations, net of current portion |                                                                                                                                  |                            | 69                                         |         |          |        | 222           |        
|                                                 
|                                                 
|                                                 
|                                                 
|Long-term debt, net of current portion            |                                                                                                                                  |                            |                                           |         |          |        | 3,076         |        
|                                                  |                                                                                                                                  |                            |                                            |         |          |        |               |        
|                                                  |                                                                                                                                  | Total liabilities          |                                            |         | 5,765    |        |               |         | 9,552  |       
|                                                  |                                                                                                                                  |                            |                                            |         |          |        |               |        
|Shareholders equity:                             |                                                                                                                                  |                            |                                            |         |          |        |               |        
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Common stock, no par value; 250,000,000 shares
authorized, 22,036,779 and 22,582,509 shares issued
and outstanding, respectively |                            |                                            | 92,190  |          |        |               | 93,085  |       
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Notes receivable from shareholders, net of allowances                                                                            |                            |                                            | (44     | )        |        |               | (1,073  | )     
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Deferred stock compensation                                                                                                      |                            |                                            | (2,676  | )        |        |               | (6,069  | )     
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Accumulated other comprehensive loss                                                                                             |                            |                                            | (139    | )        |        |               | (61     | )     
|                                                 
|                                                 
|                                                 
|                                                 
|                                                  | Accumulated deficit                                                                                                              |                            |                                            | (79,937 | )        |        |               | (51,323 | )     
|                                                  |                                                                                                                                  |                            |                                            |         |          |        |               |        
|                                                  |                                                                                                                                  | Total shareholders equity |                                            |         | 9,394    |        |               |         | 34,559 |       
|                                                  |                                                                                                                                  |                            |                                            |         |          |        |               |        
|                                                  |                                                                                                                                  |                            | Total liabilities and shareholders equity |         | $        | 15,159 |               |         | $      | 44,111 | 
|                                                  |                                                                                                                                  |                            |                                            |         |          |        |               |        

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

3



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##### Table of Contents






N2H2, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND
COMPREHENSIVE LOSS
(unaudited, in thousands except share and per share data)

|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |       |         |        |  
|------------------------------------------------------------------------------------- | --------------------------------------- | ------------------------------------------------ | ------------------------ | ----- | ------------------ | ----- | ----------------- | ----- | ------- | ------ | ---------- | ----- | ------- | ------ | ---------- | ----- | ------- | ------ | -
|                                                                                      |                                         |                                                  |                          |       | THREE MONTHS ENDED |       | NINE MONTHS ENDED
|                                                                                      |                                         |                                                  |                          |       | JUNE 30,           |       | JUNE 30,         
|                                                                                      |                                         |                                                  |                          |       |                    |       |                  
|                                                                                      |                                         |                                                  |                          |       | 2001               |       | 2000              |       | 2001    |        | 2000      
|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |           
|Revenues:                                                                             |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      |                                         | Internet filtering and consulting services       |                          | $     | 1,926              |       |                   | $     | 2,628   |        |            | $     | 5,881   |        |            | $     | 6,442   |       
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      |                                         | Advertising                                      |                          |       | 89                 |       |                   |       | 696     |        |            |       | 509     |        |            |       | 2,063   |       
|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|                                                                                      |                                         |                                                  | Total Revenues           |       |                    | 2,015 |                   |       |         | 3,324  |            |       |         | 6,390  |            |       |         | 8,505  |  
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|Operating expenses:                                                                   |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      |                                         | Internet filtering services and customer support |                          |       | 1,179              |       |                   |       | 1,713   |        |            |       | 4,181   |        |            |       | 4,908   |       
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      |                                         | Educational content and advertising costs        |                          |       | 34                 |       |                   |       | 751     |        |            |       | 703     |        |            |       | 971     |       
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      |                                         | Sales and marketing                              |                          |       | 2,408              |       |                   |       | 6,257   |        |            |       | 10,139  |        |            |       | 13,396  |       
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      |                                         | General and administrative                       |                          |       | 1,434              |       |                   |       | 2,683   |        |            |       | 4,547   |        |            |       | 6,852   |       
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      |                                         | Research and development                         |                          |       | 1,281              |       |                   |       | 1,171   |        |            |       | 3,386   |        |            |       | 3,528   |       
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      |                                         | Depreciation and amortization                    |                          |       | 1,245              |       |                   |       | 1,558   |        |            |       | 3,737   |        |            |       | 2,829   |       
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      |                                         | Write-down of acquired intangible assets         |                          |       | 1,396              |       |                   |       |        |        |            |       | 1,396   |        |            |       |        |       
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      |                                         | Write-down of technology licenses                |                          |       | 513                |       |                   |       |        |        |            |       | 513     |        |            |       |        |       
|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|                                                                                      |                                         |                                                  | Total operating expenses |       |                    | 9,490 |                   |       |         | 14,133 |            |       |         | 28,602 |            |       |         | 32,484 |  
|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|Loss from Operations                                                                  |                                         |                                                  | (7,475                   | )     |                    |       | (10,809           | )     |         |        | (22,212    | )     |         |        | (23,979    | )    
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|Interest income, net of interest expense                                              |                                         |                                                  | 64                       |       |                    |       | 483               |       |         |        | 445        |       |         |        | 1,615      |      
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|Loss on disposal of property and equipment                                            |                                         |                                                  | (122                     | )     |                    |       |                  |       |         |        | (293       | )     |         |        |           |      
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|Write-down of investment                                                              |                                         |                                                  |                         |       |                    |       |                  |       |         |        | (3,000     | )     |         |        |           |      
|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|Loss before change in accounting policy                                               |                                         |                                                  | (7,533                   | )     |                    |       | (10,326           | )     |         |        | (25,060    | )     |         |        | (22,364    | )    
|Cumulative effect of change in accounting policy                                      |                                         |                                                  |                         |       |                    |       |                  |       |         |        | (3,554     | )     |         |        |           |      
|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|Net loss                                                                              |                                         | $                                                | (7,533                   | )     |                    | $     | (10,326           | )     |         | $      | (28,614    | )     |         | $      | (22,364    | )    
|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|Foreign currency translation loss                                                     |                                         |                                                  | 10                       |       |                    |       | (26               | )     |         |        | (78        | )     |         |        | (26        | )    
|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|Comprehensive loss                                                                    |                                         | $                                                | (7,523                   | )     |                    | $     | (10,352           | )     |         | $      | (28,692    | )     |         | $      | (22,390    | )    
|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|Basic and diluted net loss per share:                                                 |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      | Loss before change in accounting policy |                                                  | $                        | (0.35 | )                  |       | $                 | (0.47 | )       |        | $          | (1.16 | )       |        | $          | (1.04 | )      
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      | Effect of change in accounting policy   |                                                  |                          |      |                    |       |                   |      |         |        |            | (0.16 | )       |        |            |      |        
|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|                                                                                      |                                         |                                                  | Net loss per share       |       | $                  | (0.35 | )                 |       | $       | (0.47  | )          |       | $       | (1.32  | )          |       | $       | (1.04  | )
|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|Basic and diluted weighted average shares
outstanding                                 |                                         |                                                  | 21,683,000               |       |                    |       | 21,869,259        |       |         |        | 21,703,960 |       |         |        | 21,573,066 |      
|                                                                                      |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|Pro forma amounts assuming the change in
accounting policy was applied retroactively: |                                         |                                                  |                          |       |                    |       |                   |       |         |        |            |       |         |        |            |      
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      |                                         | Net loss                                         |                          | $     | (7,533             | )     |                   | $     | (11,042 | )      |            | $     | (28,614 | )      |            | $     | (25,651 | )     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                      |                                         | Basic and diluted net loss per share             |                          | $     | (0.35              | )     |                   | $     | (0.50   | )      |            | $     | (1.32   | )      |            | $     | (1.19   | )     

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

4



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##### Table of Contents






N2H2, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)


|                                                                            |                                                               |                                                                               |         |                |         |      |         |        |        |  
|--------------------------------------------------------------------------- | ------------------------------------------------------------- | ----------------------------------------------------------------------------- | ------- | -------------- | ------- | ---- | ------- | ------ | ------ | -
|                                                                            |                                                               |                                                                               |         | NINE MONTHS   
|                                                                            |                                                               |                                                                               |         | ENDED JUNE 30,
|                                                                            |                                                               |                                                                               |         |               
|                                                                            |                                                               |                                                                               |         | 2001           |         | 2000
|                                                                            |                                                               |                                                                               |         |                |         |     
|Cash flows from operating activities:                                       |                                                               |                                                                               |         |                |         |      |         |       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Net loss                                                                    |                                                               | $                                                                             | (28,614 | )              |         | $    | (22,364 | )     
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Adjustments to reconcile net loss to net cash used by operating activities: |                                                               |                                                                               |         |                |         |      |         |       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Depreciation and amortization                                                 |         |                | 3,737   |      |         |        | 2,828  |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Amortization of deferred stock compensation                                   |         |                | 3,077   |      |         |        | 2,884  |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Change in accounting policy                                                   |         |                | 1,463   |      |         |        |       |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Loss on disposal of property and equipment                                    |         |                | 293     |      |         |        |       |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Write-down of investment                                                      |         |                | 3,000   |      |         |        |       |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Write-down of acquired intangible assets                                      |         |                | 1,396   |      |         |        |       |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Write-down of technology licenses                                             |         |                | 513     |      |         |        |       |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Shareholder loans forgiven                                                    |         |                | 447     |      |         |        |       |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Interest on shareholder loans                                                 |         |                | (63     | )    |         |        |       |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Changes in operating assets and liabilities:                                |                                                               |                                                                               |         |                |         |      |         |       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Accounts receivable                                                           |         |                | 1,532   |      |         |        | (977   | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Prepaid expenses and other current assets                                     |         |                | 863     |      |         |        | 511    |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Other assets                                                                  |         |                | (18     | )    |         |        | (613   | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Accounts payable                                                              |         |                | (1,612  | )    |         |        | (246   | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Royalties payable                                                             |         |                | (198    | )    |         |        | 98     |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Accrued liabilities                                                           |         |                | (79     | )    |         |        | 493    |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Deferred revenue                                                              |         |                | 1,503   |      |         |        | (1,066 | )
|                                                                            |                                                               |                                                                               |         |                |         |      |         |       
|Net cash used by operating activities:                                      |                                                               |                                                                               | (12,760 | )              |         |      | (18,452 | )     
|                                                                            |                                                               |                                                                               |         |                |         |      |         |       
|Cash flows from investing activities:                                       |                                                               |                                                                               |         |                |         |      |         |       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Maturities of investments                                                     |         |                | 27,892  |      |         |        | 32,756 |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Purchases of investments                                                      |         |                | (13,100 | )    |         |        | (6,000 | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Additions to property and equipment                                           |         |                | (1,389  | )    |         |        | (8,146 | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Proceeds from sale of property and equipment                                  |         |                | 32      |      |         |        |       |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Notes receivable from shareholders                                            |         |                |        |      |         |        | (793   | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Transaction costs incurred for iseek, Ltd. acquisition , net of cash acquired |         |                |        |      |         |        | (229   | )
|                                                                            |                                                               |                                                                               |         |                |         |      |         |       
|Net cash provided by investing activities                                   |                                                               |                                                                               | 13,435  |                |         |      | 17,588  |       
|                                                                            |                                                               |                                                                               |         |                |         |      |         |       
|Cash flows from financing activities:                                       |                                                               |                                                                               |         |                |         |      |         |       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Issuance of common stock                                                      |         |                | 4       |      |         |        |       |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Exercise of stock options and warrants                                        |         |                | 62      |      |         |        | 493    |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Payments under capital lease obligations                                      |         |                | (142    | )    |         |        | (908   | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Borrowings under notes payable                                                |         |                |        |      |         |        | 2,000  |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Repayments of notes payable                                                   |         |                | (4,722  | )    |         |        | (111   | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            |                                                               | Cash restricted to secure line of credit                                      |         |                | (675    | )    |         |        |       |  
|                                                                            |                                                               |                                                                               |         |                |         |      |         |       
|Net cash used by financing activities                                       |                                                               |                                                                               | (5,473  | )              |         |      | 1,474   |       
|                                                                            |                                                               |                                                                               |         |                |         |      |         |       
|                                                                            |                                                               | Effects of exchange rate changes                                              |         |                | (78     | )    |         |        | (26    | )
|                                                                            |                                                               |                                                                               |         |                |         |      |         |       
|Net decrease in cash                                                        |                                                               |                                                                               | (4,876  | )              |         |      | 584     |       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Cash, beginning of period                                                   |                                                               |                                                                               | 7,993   |                |         |      | 7,743   |       
|                                                                            |                                                               |                                                                               |         |                |         |      |         |       
|Cash, end of period                                                         |                                                               | $                                                                             | 3,117   |                |         | $    | 8,327   |       
|                                                                            |                                                               |                                                                               |         |                |         |      |         |       
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION                            |                                                               |                                                                               |         |                |         |      |         |       
|                                                                            | Cash paid for interest                                        |                                                                               | $       | 71             |         |      | $       | 348    |       
|                                                                            | Stock received for notes receivable from shareholders         |                                                                               | $       | 645            |         |      | $       |       |       
|                                                                            | Stock and warrants issued for iseek Ltd. acquisition          |                                                                               | $       |               |         |      | $       | 17,359 |       
|                                                                            | Intangible assets acquired from iseek Ltd.                    |                                                                               | $       |               |         |      | $       | 8,580  |       
|                                                                            | Deferred compensation recorded upon acquisition of iseek Ltd. |                                                                               | $       |               |         |      | $       | 8,910  |       
|                                                                            | Assets acquired from iseek Ltd.                               |                                                                               | $       |               |         |      | $       | 152    |       
|                                                                            | Liabilities acquired from iseek Ltd.                          |                                                                               | $       |               |         |      | $       | 54     |       

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


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##### Table of Contents






N2H2, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)



|1. |  | BASIS OF PRESENTATION
|-- |  | ---------------------

The accompanying condensed consolidated financial statements of N2H2, Inc.
and subsidiaries (the Company) are unaudited. In the opinion of management, the
financial statements include all adjustments necessary for their fair
presentation in conformity with generally accepted accounting principles.
Preparing financial statements requires management to make estimates and
assumptions that affect the reported amounts of assets, liabilities, revenue,
and expenses and the disclosure of contingent assets and liabilities. Actual
results may differ from these estimates. Operating results for the nine-month
period ended June 30, 2001 are not necessarily indicative of results to be
expected for a full year. The information included in this Form 10-Q should be
read in conjunction with Managements Discussion and Analysis and financial
statements and notes thereto included in the Companys annual report on Form
10-K for the year ended September 30, 2000.

Certain reclassifications of prior year balances have been made for
consistent presentation with the current year. Such reclassifications had no
effect on net loss, cash flows or shareholders equity as previously reported.

In the prior year, the Company made two adjustments to the fiscal year
2000 recorded amounts of intangible assets related to the February 23, 2000
acquisition of iseek Pty Limited (iseek). The changes consist of a
reclassification of $8.9 million from goodwill to deferred stock compensation
in recognition of shares issued to the founders of iseek which are held in
employment escrow, and a $1.3 million addition to acquired intangible assets in
recognition of warrants issued as part of the purchase consideration. The
effect of these adjustments on the prior period reported results of operations
and financial position were as follows:

|                                      |  |                                       |        |                   |  |             |        |            |  |   |        |   |  |   |        |  
|------------------------------------- |  | ------------------------------------- | ------ | ----------------- |  | ----------- | ------ | ---------- |  | - | ------ | - |  | - | ------ | -
|                                      |  | THREE MONTHS ENDED                    |        | NINE MONTHS ENDED
|                                      |  | JUNE 30, 2000                         |        | JUNE 30, 2000    
|                                      |  |                                       |        |                  
|                                      |  | As Reported                           |        | As Revised        |  | As Reported |        | As Revised
|                                      |  |                                       |        |                   |  |             |        |           
|                                      |  | (in thousands, except per share data)
|Net loss                              |  | $                                     | 9,347  |                   |  | $           | 10,326 |            |  | $ | 21,059 |   |  | $ | 22,364 |  
|                                     
|                                     
|                                     
|                                     
|Earnings per share, basic and diluted |  | $                                     | (0.42  | )                 |  | $           | (0.47  | )          |  | $ | (0.96  | ) |  | $ | (1.04  | )
|                                     
|                                     
|                                     
|                                     
|Total assets                          |  | $                                     | 63,658 |                   |  | $           | 56,513 |            |  | $ | 63,658 |   |  | $ | 56,513 |  
|                                     
|                                     
|                                     
|                                     
|Total shareholders equity            |  | $                                     | 57,286 |                   |  | $           | 50,141 |            |  | $ | 57,286 |   |  | $ | 50,141 |  

The increase in net loss is the result of an accelerated amortization
method used for deferred compensation. None of these changes had a cash impact
to the Company.



|2. |  | NET LOSS PER SHARE
|-- |  | ------------------

Basic net loss per share is computed on the basis of the weighted average
number of common shares outstanding. Diluted net loss per share includes common
equivalent shares during the period, if dilutive. As the Company had a net loss
attributable to common shareholders in each of the periods presented, basic and
diluted net loss per share are the same.

The components of basic and diluted loss per share were as follows:

|             |                                                              |                                      |   |                                       |       |                |   |         |       |      |   |         |       |   |   |         |       |  
|------------ | ------------------------------------------------------------ | ------------------------------------ | - | ------------------------------------- | ----- | -------------- | - | ------- | ----- | ---- | - | ------- | ----- | - | - | ------- | ----- | -
|             |                                                              |                                      |   | THREE MONTHS                          |       | NINE MONTHS   
|             |                                                              |                                      |   | ENDED JUNE 30,                        |       | ENDED JUNE 30,
|             |                                                              |                                      |   |                                       |       |               
|             |                                                              |                                      |   | 2001                                  |       | 2000           |   | 2001    |       | 2000
|             |                                                              |                                      |   |                                       |       |                |   |         |       |     
|             |                                                              |                                      |   | (in thousands, except per share data)
|Numerator:   |                                                              |                                      |   |                                       |       |                |   |         |       |      |   |         |       |   |   |        
|            
|            
|            
|            
|             | Net loss                                                     |                                      | $ | (7,533                                | )     |                | $ | (10,326 | )     |      | $ | (28,614 | )     |   | $ | (22,364 | )    
|            
|            
|            
|            
|Denominator: |                                                              |                                      |   |                                       |       |                |   |         |       |      |   |         |       |   |   |        
|            
|            
|            
|            
|             | Basic and diluted weighted average
common shares outstanding |                                      |   | 21,683                                |       |                |   | 21,869  |       |      |   | 21,704  |       |   |   | 21,573  |      
|             |                                                              |                                      |   |                                       |       |                |   |         |       |      |   |         |       |   |   |        
|             |                                                              | Basic and diluted net loss per share |   | $                                     | (0.35 | )              |   | $       | (0.47 | )    |   | $       | (1.32 | ) |   | $       | (1.04 | )
|             |                                                              |                                      |   |                                       |       |                |   |         |       |      |   |         |       |   |   |        

A total of 341,192 restricted shares, warrants of 539,280 and options of
4,145,215 have been excluded from the calculation of diluted loss per share at
June 30,2001 because they are anti-dilutive.

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##### Table of Contents





|3. |  | CHANGE IN ACCOUNTING POLICY
|-- |  | ---------------------------

In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB
101). SAB 101 requires that up-front installation fees be deferred and
recognized over the term of the customer relationship. In fiscal 2000 and
previous years, the Company recognized installation revenue upon completion of
the installation. Effective October 1, 2000, in accordance with the provisions
of SAB 101, the Company began deferring installation revenue over the expected
life of the customer relationship periods. The adoption of SAB 101 resulted in
a one-time, non-cash charge of $3.6 million on October 1, 2000 for the
cumulative effect of the change in accounting policy. The cumulative effect
was recorded as deferred revenue and is being recognized as revenue over the
remaining customer relationship periods. The net effect of the change on the
nine-month period ended June 30, 2001 was to increase the net loss by $1.5
million ($0.07 per share), comprised of the $3.6 million cumulative effect of
the change in accounting policy ($0.16 per share), net of $2.1 million of the
related deferred revenue which was recognized as revenue during the period
($0.09 per share). The remainder of the related deferred revenue will be
recognized as revenue as follows: $0.5 million over the remainder of fiscal
2001, $0.8 million in fiscal 2002 and $0.2 million in fiscal 2003.



|4. |  | SEVERANCE EXPENSE
|-- |  | -----------------

During the quarter, the Company reduced the overall level of world-wide
staffing by over 30%. The reduction in force resulted in one-time severance
charges of $0.8 million during the quarter.



|5. |  | IMPAIRMENT LOSSES
|-- |  | -----------------

During the quarter, the Company recorded a $1.4 million write down of the
carrying value of intangible assets acquired as part of the iseek purchase.
The impairment loss is a result of iseeks operations not meeting expected
forecasts. Accordingly, the Company has scaled-back the subsidiary operations
to a substantially reduced level. The impairment charge was calculated as the
excess of the present value of future cash flows over the carrying value of the
intangible assets.

During the quarter, the Company recorded a $0.5 million write down on
software license agreements which will not be used as part of future product
offerings. The impairment charge represented the total net carrying value of
the technology licenses.

During the quarter ended March 31, 2001, the Company recorded a $3.0
million impairment loss on a strategic investment in a privately held company.
The loss represented the Companys entire investment in the common stock of the
company. The impairment was recorded based on currently available financial
information of the investee company.



|6. |  | RELATED PARTY TRANSACTIONS
|-- |  | --------------------------

During the quarter, the Company entered into an agreement with a former
officer of the Company to withhold severance consideration due to the officer
under employment contract in exchange for forgiveness of certain amounts owed
to the Company under notes receivable. The Company recorded a charge to
compensation expense of $374,000 representing the portion of the loans
forgiven. The remaining loan balance at June 30, 2001 of $292,000 is due under
a revised promissory note commencing on July 30, 2001, which bears interest at
6.875% per annum. The balance due at June 30, 2001 is entirely offset by the
reserve for shareholder loans.

During the quarter ended December 31, 2000, the Company entered into
agreements with two officers of the Company, one current and one former, to
accept certain shares of N2H2 common stock held by the officers in exchange for
forgiveness of amounts due to the Company under notes receivable. As a result
of these transactions, a total of 808,000 shares of common stock were
repurchased by the Company at prices between $1.00 and $1.50 per share. The
excess of the repurchase price over the market value at the date of repurchase
of $343,000 was applied against the previously recorded reserve for shareholder
loans.



|7. |  | TERMINATION OF BORROWING FACILITY
|-- |  | ---------------------------------

In April 2001, Imperial Bank notified the Company that it was in violation
of certain covenants specified in the loan agreement dated September 20, 2000.
As a result, the company paid off the entire loan balance of $3.9 million in
May 2001.

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##### Table of Contents





|8. |  | RESTRICTED CASH AND CASH EQUIVALENTS
|-- |  | ------------------------------------

The Company has a revolving line of credit facility with Imperial Bank,
which allows for draws of 80% of eligible accounts receivable, up to a maximum
short-term borrowing of $2.5 million if specified conditions are met. Current
commitments against the line of credit consist of an irrevocable standby letter
of credit for our leased office space in the amount of $665,000, which expires
on July 31, 2005, and a $10,000 deposit held by Imperial Bank for the issuance
of corporate credit cards. The total of these commitments is in excess of our
borrowing base as of June 30, 2001. To cover the over-advance against the line
of credit, we established a $675,000, 30-day, automatically renewing
certificate of deposit, which is pledged as collateral to Imperial Bank. The
cash restriction will remain in effect until such time as our over-advance is
cured.



|9. |  | RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
|-- |  | -----------------------------------------

In June 2001, the Financial Accounting Standards Boards Emerging Issues
Task Force (EITF) issued EITF 00-23  Issues Related to the Accounting for
Stock Compensation under APB Opinion No. 25 and FASB Interpretation No. 44.
EITF 00-23 provides clarification on a number of practice issues related to
accounting for stock compensation. The Company does not expect EITF 00-23 to
have a material effect on its results of operations or financial position.

In July 2001, the Financial Accounting Standards Board (FASB) Issued
Financial Accounting Standard 141  Business Combinations (FAS 141). FAS 141,
effective July 1, 2001, requires all business combinations to be accounted for
as a purchase and it establishes rigorous criteria for the identification and
recording of intangible assets. The Company does not expect the adoption of
FAS 141 to have a material effect on its results of operations or financial
position for previously executed business combinations.

In July 2001, the FASB issued Financial Accounting Standard 142  Goodwill
and Intangible Assets (FAS 142). FAS 142, effective for fiscal years beginning
after December 15, 2001, defines requirements for the treatment of goodwill.
Under FAS 142, goodwill is considered to have an indefinite life and is
therefore subject to impairment accounting rather than amortization. As the
Company does not have any recorded goodwill as of June 30, 2001, FAS 142 is not
expected to have a material effect on the Companys results of operations or
financial position.

8



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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

FORWARD LOOKING INFORMATION

Statements made in this filing that are not historical facts are
forward-looking statements. Forward-looking statements include, but are not
limited to, statements containing the words will, should, expect, plan, intend,
anticipate, believe, estimate, predict, potential, believes or continue, the
negative of such terms or other comparable terminology. Actual results may
differ materially from those projected in any forward-looking statements. Such
forward-looking statements are subject to various known and unknown risks and
uncertainties and are therefore not a guarantee of future performance. The
potential risks and uncertainties which could cause actual results to differ
materially include, but are not limited to, the competitive nature of the
Internet filtering industry, changes in domestic market conditions, the success
of our brand and systems development efforts, the absence of patent protection
for our technology, the fact that others have patented various filtering
technologies, customer acceptance of our services, products and fee structures,
the potential delisting of our stock from the Nasdaq National Market System,
and our ability to successfully sublease our headquarters office space at terms
acceptable to us. Further information on the factors and risks that could
affect our business, financial condition and results of operations are included
in Part I, Item 1 to the Companys Form 10-K for the year ended September 30,
2000, which has been filed with the Securities and Exchange Commission and is
available at http://www.sec.gov.

OVERVIEW

N2H2 is an Internet access management company specializing in fast and
scalable filtering solutions. Our Internet filtering is designed to optimize
Web access and enable organizations to limit potential legal liability,
conserve bandwidth and increase user productivity.

At the time of this filing, our stock price has closed below $1.00 for
more than 90 consecutive business days. A minimum bid price of $1.00 is
required for continued listing on the Nasdaq National Market System. As a
result, Nasdaq notified us on June 26, 2001 of its intention to delist our
stock, pending a hearing for appeal. We appealed Nasdaqs decision and have
completed a hearing in which we presented our plan to raise the stock price
above $1.00, including the restructuring our existing revenue model, the
expansion of our product line and its target audience, and the development of
our indirect sales channel. We have not yet been notified of the outcome of
our appeal. We are in compliance with all other Nasdaq listing requirements.
If our stock were delisted, the delisting would most likely have a material
adverse affect on the price of our common stock, would adversely affect the
liquidity of the shares held by our shareholders, and would severely restrict
any ability we may have to raise additional capital.

RESULTS OF OPERATIONS  THREE MONTHS ENDED JUNE 30, 2001

Revenues

We generate our revenues from installation and subscription fees charged
for our filtering services, consulting fees, and through June 30, 2001,
advertising fees.

Internet filtering and consulting services revenues decreased by 27% to
$1.9 million for the quarter, compared to $2.6 million for the comparable
period in the prior fiscal year. The decrease reflects the effect of adopting
SAB 101 during the first quarter of the fiscal year. Effective October 1, 2000,
in accordance with the provisions of SAB 101, we began deferring installation
revenue over the expected life of the customer relationship. As a result,
comparisons between fiscal 2001 and fiscal 2000 will show a slower growth rate
of revenues between these years. In addition, due to our strategic move away
from the advertising model, sales efforts during the quarter were largely
focused on converting school customers from the advertising model to our
subscription fee-based model. These conversions have resulted in contracts
that will be billed and begin being recognized in the fourth quarter of the
fiscal year.

Advertising revenue decreased by 87% to $89,000 for the quarter, compared
to $696,000 for the comparable period in the prior fiscal year. In the quarter
ended December 31, 2000, we ended the promotion of our advertising model and
began converting customers to our subscription fee-based model. Accordingly,
all contracts with advertisers have been concluded or cancelled during the
quarter. Advertising revenue is expected to be eliminated for future periods.

9



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Internet filtering services and customer support costs

Internet filtering services and customer support costs consist of the
costs of Website review, technical installation and support, search engine and
Web hosting services, bandwidth, and an allocation of corporate facilities
costs. Internet filtering services and customer support costs decreased by 31%
to $1.2 million for the quarter, compared to $1.7 million for the comparable
period in the prior fiscal year. The decrease is primarily due to reduced
level of staffing and personnel-related expenses during the quarter. In
addition, we renegotiated key vendor contracts to obtain more favorable terms.

Educational content and advertising costs

Educational content and advertising costs consist of advertising
commissions, and in prior quarters also included product license fees.
Educational content and advertising costs decreased by 95% to $34,000 for the
quarter, compared to $751,000 for the comparable period in the prior fiscal
year. The decrease is due to the conclusion of our advertising-based filtering
model and the corresponding cancellation of a certain contract in which we
agreed to exchange advertising services for a license to market and use
specific educational content in our promotion of filtering subscriptions. The
original contract term was to continue for ten quarters through June 30, 2002.
As a result of our strategic move away from the advertising model, this
contract was cancelled effective January 1, 2001, without penalty. Educational
content and advertising costs are expected to be eliminated for future periods.

Sales and marketing

Sales and marketing expenses consist primarily of salaries, commissions,
stock compensation expense, marketing brochures, trade show costs, direct
mailing programs, advertising, public relations and travel. Sales and
marketing also includes an allocation of corporate facilities costs.

Sales and marketing expenses decreased by 62% to $2.4 million for the
quarter, from $6.3 million for the comparable period in the prior fiscal year.
The decrease is due in part to our reduced direct sales staffing and related
expenses, as we have shifted a large portion of our sales efforts to an
indirect sales channel in which we will leverage resellers to increase our
customer base. In addition, deferred stock compensation expense related to the
employment of two executives of iseek, our Australian sales office, has
declined as a result of an accelerated method of amortization. Renegotiations
of various marketing contracts and the elimination of sales and marketing
expenditures related to the advertising-based filtering program have also
contributed to the decrease in total sales and marketing expense.

General and administrative

General and administrative expenses consist primarily of salaries,
benefits and related costs for executive, finance, human resources and
administrative personnel, third party professional service fees and an
allocation of corporate facilities costs.

General and administrative expenses decreased by 47% to $1.4 million for
the quarter, from $2.7 million for the comparable period in the prior fiscal
year. This decrease is primarily due to significant reductions in
administrative staffing and related personnel costs. In addition, amortization
of deferred stock compensation has declined due to the cancellation of certain
stock options for employees who are no longer with the Company. Further, we
have reduced our spending on professional services and other support functions
in a continued effort to operate within a more disciplined cost structure.

Research and development

Research and development costs consist primarily of salaries and benefits
for software developers, consulting fees and an allocation of corporate
facilities costs. Research and development activities consist primarily of
developing new products and enhancing existing products. Product costs related
to internal research and development have been expensed as incurred. Research
and development expenses have remained relatively consistent at $1.3 million
for the quarter, from $1.2 million for the comparable period in the prior
fiscal year.

Depreciation and amortization

Depreciation and amortization consist primarily of depreciation on all
fixed assets and amortization of acquired intangible assets. Depreciation and
amortization expenses decreased by 20% to $1.2 million for the quarter, from
$1.6 million for the comparable period in the prior fiscal year. The decrease
is due to reduced amortization of intangible assets acquired from iseek
resulting from an impairment charge taken on those assets in the fourth quarter
of the prior fiscal year. Due to additional impairment charges taken
on intangible assets during the current quarter, amortization of intangible
assets has been substantially eliminated for future periods. Depreciation has
remained relatively consistent from the comparable period of the prior fiscal
year.

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Write-down of acquired intangible assets

During the quarter, we recorded a $1.4 million write down of the carrying
value of intangible assets acquired as part of the iseek purchase. The
impairment loss is a result of iseeks operations not meeting expected
forecasts. Accordingly, we have scaled-back the subsidiary operations to a
substantially reduced level. The impairment charge was calculated as the
excess of the present value of future cash flows over the carrying value of the
intangible assets.

Write-down of technology licenses

During the quarter, we recorded a $0.5 million write down on software
license agreements which will not be used as part of our future product
offerings. The impairment charge represented the total net carrying value of
the technology licenses.

Interest income and expense

Interest income consists primarily of interest earned on our
held-to-maturity investments. Interest expense consists of interest paid on
our loan balances from Imperial Bank. Net interest income has decreased by 87%
to $64,000, from $483,000 for the comparable period in the prior fiscal year.
The decrease is due to our reduced investment balance. Interest expense has
remained materially consistent with the comparable period of the prior fiscal
year. However, as the entire bank debt with Imperial Bank has been paid off
during the quarter, interest expense in future quarters will be substantially
reduced.

Loss on disposal of property and equipment

During the quarter, we disposed of various internal-use office equipment
and furniture that was not needed to support our reduced level of staffing and
facility space. The $122,000 loss on disposal represents the excess of the net
carrying value of the assets disposed of over the proceeds received upon sale.

RESULTS OF OPERATIONS  NINE MONTHS ENDED JUNE 30, 2001

Revenues

Internet filtering and consulting services revenues for the nine-month
period decreased by 9% to $5.9 million, from $6.4 million for the comparable
period in the prior fiscal year. The decrease reflects the effect of adopting
SAB 101 during the first quarter of the fiscal year. Effective October 1, 2000,
in accordance with the provisions of SAB 101, we began deferring installation
revenue over the expected life of the customer relationship. As a result,
comparisons between fiscal 2001 and fiscal 2000 will show a slower growth rate
of revenues between these years. In addition, due to our strategic move away
from the advertising-based filtering model, sales efforts during the quarter
were largely focused on converting school customers from the advertising model
to our subscription fee-based model. These conversions have resulted in
contracts that will be billed and begin being recognized in the fourth quarter
of the fiscal year, when the advertising model is officially concluded. The
decrease in revenue has been partially offset by the growth in new customers
during the period.

Advertising revenues for the nine-month period decreased by 75% to $0.5
million, from $2.1 million for the comparable period in the prior fiscal year.
During the period, we ended the promotion of our advertising model and began
converting customers to our subscription fee-based model. Accordingly, all
contracts with advertisers have been concluded or cancelled during the period.
Advertising revenue is expected to be eliminated for future periods.

Internet filtering services and customer support costs

Internet filtering services and customer support costs for the nine-month
period decreased by 15% to $4.2 million, from $4.9 million for the comparable
period in the prior fiscal year. The decrease is primarily due to the reduced
level of staffing and personnel-related expenses during the period. In
addition, we renegotiated key vendor contracts to obtain more favorable terms.

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Educational content and advertising costs

Educational content and advertising costs for the nine-month period
decreased by 28% to $0.7 million, from $1.0 million for the comparable period
in the prior fiscal year. The decrease is due to the conclusion of our
advertising-based filtering model. As such, educational content and advertising
costs are expected to be eliminated for future periods.

Sales and marketing

Sales and marketing expenses for the nine-month period decreased by 24% to
$10.1 million, from $13.4 million for the comparable period in the prior fiscal
year. The decrease is due in part to our reduced direct sales staffing and
related expenses, as we have shifted a large portion of our sales efforts to
the indirect channel. In addition, we have renegotiated various marketing
contracts and eliminated all sales and marketing expenditures related to the
advertising-based filtering program as we continue to streamline our marketing
efforts to focus on our core business. The decrease in sales and marketing
expenses has been partially offset by increased amortization of deferred stock
compensation, primarily in the first and second quarters of the current fiscal
year, related to the employment of two executives of iseek.

General and administrative

General and administrative expenses for the nine-month period decreased by
34% to $4.5 million, from $6.9 million for the comparable period in the prior
fiscal year. This decrease is primarily due to significant reductions in
administrative staffing and related personnel costs. In addition, amortization
of deferred stock compensation has declined significantly due to the
cancellation of certain stock options for employees who are no longer with the
Company. Further, we have reduced our spending on professional services and
other support functions in a continued effort to operate within a more
disciplined cost structure.

Research and development

Research and development expenses for the nine-month period have remained
relatively consistent at $3.4 million, from $3.5 million for the comparable
period in the prior fiscal year.

Depreciation and amortization

Depreciation and amortization expenses for the nine-month period increased
by 32% to $3.7 million, from $2.8 million for the comparable period in the
prior fiscal year. The increase is due to depreciation resulting from the
increased average fixed asset balances. The increase in total depreciation and
amortization expense is partially offset due to reduced amortization of
intangible assets acquired from iseek resulting from an impairment charge taken
on those assets in the fourth quarter of the prior fiscal year. Due to
additional impairment charges taken on intangible assets during the current
quarter, amortization of intangible assets has been substantially eliminated
for future periods.

Write-down of acquired intangible assets

During the period, we recorded a $1.4 million write down of the carrying
value of intangible assets acquired as part of the iseek purchase. The
impairment loss is a result of iseeks operations not meeting expected
forecasts. Accordingly, we have scaled-back the subsidiary operations to a
substantially reduced level. The impairment charge was calculated as the
excess of the present value of future cash flows over the carrying value of the
intangible assets.

Write-down of technology licenses

During the period, we recorded a $0.5 million write down on software
license agreements which will not be used as part of our future product
offerings. The impairment charge represented the total net carrying value of
the technology licenses.

Interest income and expense

Net interest income for the nine-month period decreased to $0.4 million,
from $1.6 million for the comparable period in the prior fiscal year. The
decrease is due to the decrease in our investment balance combined with the
debt incurred in the third and fourth quarters of fiscal 2000.

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Loss on disposal of property and equipment

During the nine-month period, we incurred a $293,000 loss on disposal of
property and equipment. The loss represents the net carrying value of certain
leasehold improvements which were written off in the first quarter of the
fiscal year upon amending our headquarters lease agreement to decrease the
total leased space. In addition, various internal-use office equipment and
furniture that were not needed to support our reduced level of staffing and
facility space were sold during the period.

Impairment of investment

During the period, we recorded a $3.0 million impairment loss on a
strategic investment in a privately held company. The loss represented our
entire investment in the common stock of the company. The impairment was
recorded based on currently available financial information of the investee
company.

Change in accounting policy

In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB
101). SAB 101 requires that up-front installation fees be deferred and
recognized over the term of the customer relationship. In fiscal 2000 and
previous years, we recognized installation revenue upon completion of the
installation. Effective October 1, 2000, in accordance with the provisions of
SAB 101, we began deferring installation revenue over the expected life of the
customer relationship periods. The adoption of SAB 101 resulted in a one-time,
non-cash charge of $3.6 million on October 1, 2000 for the cumulative effect of
the change in accounting policy. The cumulative effect was initially recorded
as deferred revenue and will be recognized as revenue over the remaining
customer relationship periods. The net effect of the change on the nine-month
period ended June 30, 2001 was to increase the net loss by $1.5 million ($0.07
per share), comprised of the $3.6 million cumulative effect of the change in
accounting policy ($0.16 per share), net of $2.1 million of the related
deferred revenue which was recognized as revenue during the period ($0.09 per
share). The remainder of the related deferred revenue will be recognized as
revenue as follows: $0.5 million over the remainder of fiscal 2001, $0.8
million in fiscal 2002 and $0.2 million in fiscal 2003.

LIQUIDITY AND CAPITAL RESOURCES

Cash and investments were $6.3 million or 42% of total assets at June 30,
2001, compared to $25.3 million or 57% of total assets at September 30, 2000.
The decrease in cash and investments is primarily due to cash used to fund
operations, combined with repayments of term loans with Imperial Bank.
Operating activities consumed $12.8 million for the nine-month period, compared
to $18.5 million for the comparable period of the prior fiscal year. We had
working capital of $3.6 million at June 30, 2001, compared to $22.4 million at
September 30, 2000. The decline in working capital is primarily due to our
operating loss for the period and the recording of deferred revenue with the
adoption of SAB 101.

Investing activities provided net cash flows of $13.4 million during the
nine-month period. This was a result of maturing investments, offset by
purchases of investments and additions to property and equipment. Additions to
property and equipment totaled $1.4 million during the period, compared to $8.1
million during the comparable period of the prior fiscal year. The additions
during the period primarily represent new proxy servers and other computer
hardware purchased to support the growth in customer base. As we continue to
shift our sales efforts towards our new line of software-only based filtering
products, we anticipate that purchases of equipment required to support our
customer base, internal infrastructure, and personnel through the next fiscal
year will be minimal.

Financing activities consumed $5.5 million during the nine-month period,
primarily due to repayment of the entire outstanding balance of equipment
advances with Imperial Bank. In April 2001, Imperial Bank notified the Company
that it was in violation of certain covenants specified in the loan agreement
dated September 20, 2000. As a result, the company paid off the entire loan
balance of $3.9 million in May 2001. However, we still maintain a revolving
line of credit facility with Imperial Bank, which allows for draws of 80% of
eligible accounts receivable, up to a maximum short-term borrowing of $2.5
million if specified conditions are met. Our current commitments against the
line of credit consist of an irrevocable standby letter of credit for our
leased office space in the amount of $665,000, which expires on July 31, 2005,
and a $10,000 deposit held by Imperial Bank for the issuance of corporate
credit cards. The total of these commitments is in excess of our borrowing
base as of June 30, 2001. To cover the over-advance against the line of
credit, we established a $675,000, 30-day, automatically renewing certificate
of deposit, which is pledged as collateral to Imperial Bank. The cash
restriction will remain in effect until such time as our over-advance is cured.

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Operating expenses will continue to consume a significant amount of our
cash resources. At historical rates of cash consumption, our current cash and
investment balance is insufficient to sustain our operations beyond four months
from the end of the third quarter. However, we have significantly reduced our level of spending during the
current period and we intend to realize additional cash savings through the
remainder of fiscal 2001. We have taken several cost-cutting measures that are
expected to result in further cash savings through the next fiscal year.
Specifically, we reduced world-wide headcount by more than 50% since the
beginning of the fiscal year, we have reduced our headquarter office space by
over 40% and are in the process of sub-leasing our entire headquarter premise
with the intent to move to a substantially less expensive office space, and we
have renegotiated or eliminated numerous contracts with a range of vendors. In
addition, sales efforts during the period were largely focused on converting
school customers from our free advertising model to our subscription fee-based
model. These conversions have resulted in over $4.0 million of contracts, most
of which will be billed and begin being recognized in the fourth quarter of the
fiscal year. With these changes, and assuming our more profitable
software-only filtering products are accepted by customers, we believe that our
cash and short-term investments on hand, together with cash generated from
operations, will be sufficient to meet our anticipated cash needs for the next
twelve months. If cash generated from operations is insufficient to satisfy
our longer-term liquidity requirements, we may seek to sell additional debt or
equity securities or attempt to re-obtain a credit facility. We have not made
arrangements to obtain additional debt or equity financing and under current
conditions, it would be very difficult to obtain financing in amounts or on
terms acceptable to us, if at all. If we are unable to raise additional funds
on acceptable terms when needed, our business, financial position and results
of operations would be seriously harmed.




ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk related to changes in foreign currency
exchange rates and interest rates relating to debt and investment instruments.
We have assets and liabilities denominated in certain foreign currencies
related to our international subsidiaries. We have not hedged our translation
risk on these assets and liabilities as we have the ability to hold them for an
indefinite period. We do not expect that a sudden or significant change in
foreign exchange rates would have a material impact on results of operations,
financial position or cash flows. We believe the reported amounts of cash
equivalents, investments and capital lease obligations at June 30, 2001 are
reasonable approximations of their fair values. As a result, we believe that
the market risk arising from our holdings of financial instruments is minimal.

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PART II OTHER INFORMATION




ITEM 1. LEGAL PROCEEDINGS

See discussion of Nasdaq proceedings in the Overview section of
Managements Discussion and Analysis.




ITEM 2(d). CHANGES IN SECURITIES AND USE OF PROCEEDS

At September 30, 2000 the Company had remaining net proceeds from its
initial public offering of $19.0 million. During the nine-months ended June 30,
2001, the Company used $12.8 million to fund its operating loss, leaving
remaining net proceeds of $6.2 million.




ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not Applicable.




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

Not Applicable.




ITEM 5. OTHER INFORMATION

Not Applicable.




ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



| | a) |  | Exhibits:
| | -- |  | ---------

| |  |  |      |  |                                                                                                                                                                
| |  |  | ---- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  |  | 10.1 |  | Severance Agreement and Release dated May 18, 2001 between Peter
Nickerson, President and Chief Executive Officer, and the registrant                          
|
|
|
|
| |  |  | 10.2 |  | Stock Option Agreement dated May 18, 2001 between Philip Welt,
President and Chief Executive Officer, and the registrant                                       
|
|
|
|
| |  |  | 10.3 |  | Severance Agreement and Release dated June 15, 2001 between Kevin
Fink, Chief Technology Officer, and the registrant                                           
|
|
|
|
| |  |  | 10.4 |  | Eighth Amendment, dated May 31, 2001, to Union Bank of California
Office Lease of March 12, 1999, between Walton Seattle Investors I,
L.L.C. and the registrant



| | b) |  | Reports on Form 8-K.                                                                                                            
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------
|
| |    |  | The Company filed a Form 8-K on May 21, 2001 regarding the
announcement of Philip Welt as President and Chief Executive
Officer.

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SIGNATURES

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

|                      |                                                                                 |                
|--------------------- | ------------------------------------------------------------------------------- | ---------------
|                      | N2H2, INC.                                                                     
|                     
|Dated: August 9, 2001 | By:                                                                             | /s/ Philip Welt
|                      |                                                                                
|                      | Philip Welt
President and Chief Executive Officer
(principal executive officer)

|                      |                                                                                                                              |                  
|--------------------- | ---------------------------------------------------------------------------------------------------------------------------- | -----------------
|Dated: August 9, 2001 | By:                                                                                                                          | /s/ J. Paul Quinn
|                      |                                                                                                                             
|                      | J. Paul Quinn
Vice President  Chief Financial Officer,
Secretary and Treasurer
(principal financial and accounting officer)

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