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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, 2003                                            
| 
|  |  | OR                                                                                      
| 
|o |  | 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 o

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes o No x

As of August 8, 2003, the registrant had outstanding 22,131,253 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     
|                             |                                                                                               | 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                           
|                             | Item 4. Controls and Procedures                                                              
|PART IIOTHER INFORMATION   
|                             | Item 1. Legal Proceedings                                                                    
|                             | Item 2. 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 31.1                
|EXHIBIT 31.2                
|EXHIBIT 32.1                



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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 INCOME                      |  |  | 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 |  |  | 10 | 
|           |  | Item 3. Quantitative And Qualitative Disclosures About Market Risk                            |  |  | 23 | 
|           |  | Item 4. Controls and Procedures                                                               |  |  | 23 | 
|PART II   |  | OTHER INFORMATION                                                                             |  |  | 24 | 
|           |  | Item 1. Legal Proceedings                                                                     |  |  | 24 | 
|           |  | Item 2. Changes In Securities And Use Of Proceeds                                             |  |  | 24 | 
|           |  | Item 3. Defaults Upon Senior Securities                                                       |  |  | 24 | 
|           |  | Item 4. Submission Of Matters To A Vote Of Security Holders                                   |  |  | 24 | 
|           |  | Item 5. Other Information                                                                     |  |  | 24 | 
|           |  | Item 6. Exhibits And Reports On Form 8-K                                                      |  |  | 24 | 
|SIGNATURES |  |                                                                                               |  |  |    |  | 25 | 

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PART IFINANCIAL INFORMATION




ITEM 1. FINANCIAL STATEMENTS




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

|                                       |                                                                                                                      |                             |                                             |         |          |       |       |               |        |       | 
|-------------------------------------- | -------------------------------------------------------------------------------------------------------------------- | --------------------------- | ------------------------------------------- | ------- | -------- | ----- | ----- | ------------- | ------ | ----- | 
|                                       |                                                                                                                      |                             |                                             |         | JUNE
30, |       |       | SEPTEMBER 30, |       
|                                       |                                                                                                                      |                             |                                             |         | 2003     |       |       | 2002          |       
|                                       |                                                                                                                      |                             |                                             |         |          |       |       |               |       
|ASSETS:                                |                                                                                                                      |                             |                                             |         |          |       |       |              
|Current assets:                        |                                                                                                                      |                             |                                             |         |          |       |       |              
|                                       | Cash and cash equivalents                                                                                            |                             | $                                           | 1,812   |          |       | $     | 4,009         |       
|                                       | Restricted cash and cash equivalents                                                                                 |                             |                                             | 675     |          |       |       | 675           |       
|                                       | Investments                                                                                                          |                             |                                             | 1,600   |          |       |       |              |       
|                                       |                                                                                                                      |                             |                                             |         |          |      
|                                       |                                                                                                                      | Total cash and investments  |                                             |         | 4,087    |       |       |               | 4,684  |      
|                                       | Accounts receivable, net of allowances                                                                               |                             |                                             | 680     |          |       |       | 1,825         |       
|                                       | Prepaid expenses and other current assets                                                                            |                             |                                             | 181     |          |       |       | 737           |       
|                                       |                                                                                                                      |                             |                                             |         |          |      
|                                       |                                                                                                                      | Total current assets        |                                             |         | 4,948    |       |       |               | 7,246  |      
|Property and equipment, net            |                                                                                                                      |                             | 638                                         |         |          |       | 1,249 |              
|Other assets, net                      |                                                                                                                      |                             | 140                                         |         |          |       | 140   |              
|                                       |                                                                                                                      |                             |                                             |         |          |      
|                                       |                                                                                                                      |                             | Total assets                                |         | $        | 5,726 |       |               | $      | 8,635 | 
|                                       |                                                                                                                      |                             |                                             |         |          |       |      
|LIABILITIES AND SHAREHOLDERS DEFICIT: |                                                                                                                      |                             |                                             |         |          |       |       |              
|Current liabilities:                   |                                                                                                                      |                             |                                             |         |          |       |       |              
|                                       | Accounts payable                                                                                                     |                             | $                                           | 161     |          |       | $     | 262           |       
|                                       | Accrued payroll and benefits                                                                                         |                             |                                             | 359     |          |       |       | 452           |       
|                                       | Customer deposits                                                                                                    |                             |                                             | 607     |          |       |       | 101           |       
|                                       | Other accrued liabilities                                                                                            |                             |                                             | 386     |          |       |       | 366           |       
|                                       | Deferred revenue                                                                                                     |                             |                                             | 4,913   |          |       |       | 8,179         |       
|                                       | Note payable                                                                                                         |                             |                                             |        |          |       |       | 58            |       
|                                       | Current portion of capital lease obligations                                                                         |                             |                                             |        |          |       |       | 21            |       
|                                       |                                                                                                                      |                             |                                             |         |          |      
|                                       |                                                                                                                      | Total current liabilities   |                                             |         | 6,426    |       |       |               | 9,439  |      
|Deferred revenue                       |                                                                                                                      |                             | 1,069                                       |         |          |       | 863   |              
|Other non-current liabilities          |                                                                                                                      |                             | 67                                          |         |          |       | 105   |              
|                                       |                                                                                                                      |                             |                                             |         |          |      
|                                       |                                                                                                                      | Total liabilities           |                                             |         | 7,562    |       |       |               | 10,407 |      
|                                       |                                                                                                                      |                             |                                             |         |          |      
|Shareholders deficit:                 |                                                                                                                      |                             |                                             |         |          |       |       |              
|                                       | Preferred stock, no par value; 50,000 shares
authorized, no shares issued and outstanding                            |                             |                                             |        |          |       |       |              |       
|                                       | Common stock, no par value; 250,000 shares
authorized, 22,131 and 22,104 shares issued and
outstanding, respectively |                             |                                             | 92,180  |          |       |       | 92,176        |       
|                                       | Notes receivable from shareholders, net of allowances                                                                |                             |                                             | (37     | )        |       |       | (41           | )     
|                                       | Deferred stock compensation                                                                                          |                             |                                             | (3      | )        |       |       | (415          | )     
|                                       | Accumulated other comprehensive loss                                                                                 |                             |                                             | (18     | )        |       |       | (102          | )     
|                                       | Accumulated deficit                                                                                                  |                             |                                             | (93,958 | )        |       |       | (93,390       | )     
|                                       |                                                                                                                      |                             |                                             |         |          |      
|                                       |                                                                                                                      | Total shareholders deficit |                                             |         | (1,836   | )     |       |               | (1,772 | )    
|                                       |                                                                                                                      |                             |                                             |         |          |      
|                                       |                                                                                                                      |                             | Total liabilities and shareholders deficit |         | $        | 5,726 |       |               | $      | 8,635 | 
|                                       |                                                                                                                      |                             |                                             |         |          |       |      

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

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N2H2, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands except per share amounts)

|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |       |       |   |        |       |        | 
|------------------------------------------- | ------------------------------------------------ | ------------------------ | ------ | ------------------ | ----- | - | ----------------- | ----- | ----- | ---- | ------ | ----- | ----- | - | ------ | ----- | ------ | 
|                                            |                                                  |                          |        | THREE MONTHS ENDED |       |   | NINE MONTHS ENDED |      
|                                            |                                                  |                          |        | JUNE 30,           |       |   | JUNE 30,          |      
|                                            |                                                  |                          |        |                    |       |   |                   |      
|                                            |                                                  |                          |        | 2003               |       |   | 2002              |       |       | 2003 |        |       | 2002  |  
|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |       |       |  
|Revenues:                                   |                                                  | $                        | 3,098  |                    |       | $ | 2,991             |       |       | $    | 9,222  |       |       | $ | 8,556  |      
|Operating expenses:                         |                                                  |                          |        |                    |       |   |                   |       |       |      |        |       |       |   |        |      
|                                            | Internet filtering services and customer support |                          |        | 581                |       |   |                   | 852   |       |      |        | 1,749 |       |   |        | 2,528 |       
|                                            | Sales and marketing                              |                          |        | 1,126              |       |   |                   | 1,606 |       |      |        | 3,809 |       |   |        | 5,266 |       
|                                            | General and administrative                       |                          |        | 814                |       |   |                   | 851   |       |      |        | 2,440 |       |   |        | 2,719 |       
|                                            | Research and development                         |                          |        | 396                |       |   |                   | 487   |       |      |        | 1,130 |       |   |        | 1,375 |       
|                                            | Depreciation and amortization                    |                          |        | 147                |       |   |                   | 472   |       |      |        | 625   |       |   |        | 1,515 |       
|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |      
|                                            |                                                  |                          | 3,064  |                    |       |   | 4,268             |       |       |      | 9,753  |       |       |   | 13,403 |      
|                                            | Loss on disposal of property and equipment       |                          |        |                   |       |   |                   | 28    |       |      |        | 22    |       |   |        | 97    |       
|                                            | Loss on sale of N2H2 Pty Limited                 |                          |        |                   |       |   |                   |      |       |      |        | 61    |       |   |        |      |       
|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |      
|                                            |                                                  | Total operating expenses |        |                    | 3,064 |   |                   |       | 4,296 |      |        |       | 9,836 |   |        |       | 13,500 | 
|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |      
|Income (loss) from operations               |                                                  |                          | 34     |                    |       |   | (1,305            | )     |       |      | (614   | )     |       |   | (4,944 | )    
|Interest income, net of interest expense    |                                                  |                          | 14     |                    |       |   | 27                |       |       |      | 46     |       |       |   | 97     |      
|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |      
|Net income (loss)                           |                                                  | $                        | 48     |                    |       | $ | (1,278            | )     |       | $    | (568   | )     |       | $ | (4,847 | )    
|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |      
|Foreign currency translation gain (loss)    |                                                  |                          | (3     | )                  |       |   | 1                 |       |       |      | 35     |       |       |   | 25     |      
|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |      
|Comprehensive income (loss)                 |                                                  | $                        | 45     |                    |       | $ | (1,277            | )     |       | $    | (533   | )     |       | $ | (4,822 | )    
|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |      
|Net income (loss) per share:                |                                                  |                          |        |                    |       |   |                   |       |       |      |        |       |       |   |        |      
|Basic net income (loss) per share           |                                                  | $                        | 0.00   |                    |       | $ | (0.06             | )     |       | $    | (0.03  | )     |       | $ | (0.22  | )    
|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |      
|Diluted net income (loss) per share         |                                                  | $                        | 0.00   |                    |       | $ | (0.06             | )     |       | $    | (0.03  | )     |       | $ | (0.22  | )    
|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |      
|Basic weighted average shares outstanding   |                                                  |                          | 22,131 |                    |       |   | 21,919            |       |       |      | 22,023 |       |       |   | 21,814 |      
|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |      
|Diluted weighted average shares outstanding |                                                  |                          | 22,826 |                    |       |   | 21,919            |       |       |      | 22,023 |       |       |   | 21,814 |      
|                                            |                                                  |                          |        |                    |       |   |                   |       |       |      |        |      

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

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

|                                                                                          |                                                                |   |                |        |   |      |        |        |  
|----------------------------------------------------------------------------------------- | -------------------------------------------------------------- | - | -------------- | ------ | - | ---- | ------ | ------ | -
|                                                                                          |                                                                |   | NINE MONTHS    |       
|                                                                                          |                                                                |   | ENDED JUNE 30, |       
|                                                                                          |                                                                |   |                |       
|                                                                                          |                                                                |   | 2003           |        |   | 2002 |       
|                                                                                          |                                                                |   |                |        |   |      |       
|Cash flows from operating activities:                                                     |                                                                |   |                |        |   |      |        |       
|Net loss                                                                                  |                                                                | $ | (568           | )      |   | $    | (4,847 | )     
|Adjustments to reconcile net loss to net cash provided by (used
by) operating activities: |                                                                |   |                |        |   |      |        |       
|                                                                                          | Depreciation and amortization                                  |   |                | 625    |   |      |        | 1,515  |  
|                                                                                          | Amortization of deferred stock compensation                    |   |                | 413    |   |      |        | 1,367  |  
|                                                                                          | Change in accounting policy related to the adoption of SAB 101 |   |                | (217   | ) |      |        | (657   | )
|                                                                                          | Loss on disposal of property and equipment                     |   |                | 22     |   |      |        | 97     |  
|                                                                                          | Loss on sale of N2H2 Pty Limited                               |   |                | 61     |   |      |        |       |  
|                                                                                          | Interest on shareholder loans                                  |   |                | (15    | ) |      |        | (16    | )
|Changes in operating assets and liabilities:                                              |                                                                |   |                |        |   |      |        |       
|                                                                                          | Accounts receivable                                            |   |                | 1,145  |   |      |        | 770    |  
|                                                                                          | Prepaid expenses and other current assets                      |   |                | 556    |   |      |        | 532    |  
|                                                                                          | Other assets                                                   |   |                | (4     | ) |      |        |       |  
|                                                                                          | Accounts payable                                               |   |                | (101   | ) |      |        | (634   | )
|                                                                                          | Accrued liabilities                                            |   |                | 433    |   |      |        | (301   | )
|                                                                                          | Deferred revenue                                               |   |                | (2,843 | ) |      |        | (1,419 | )
|                                                                                          | Other non-current liabilities                                  |   |                | (38    | ) |      |        |       |  
|                                                                                          |                                                                |   |                |        |   |     
|Net cash used by operating activities:                                                    |                                                                |   | (531           | )      |   |      | (3,593 | )     
|                                                                                          |                                                                |   |                |        |   |     
|Cash flows from investing activities:                                                     |                                                                |   |                |        |   |      |        |       
|                                                                                          | Maturities of investments                                      |   |                | 1,000  |   |      |        |       |  
|                                                                                          | Purchases of investments                                       |   |                | (2,600 | ) |      |        |       |  
|                                                                                          | Payments received on notes receivable from shareholders        |   |                | 18     |   |      |        | 22     |  
|                                                                                          | Additions to property and equipment                            |   |                | (45    | ) |      |        | (141   | )
|                                                                                          | Proceeds from sale of property and equipment                   |   |                | 1      |   |      |        | 13     |  
|                                                                                          |                                                                |   |                |        |   |     
|Net cash used by investing activities                                                     |                                                                |   | (1,626         | )      |   |      | (106   | )     
|                                                                                          |                                                                |   |                |        |   |     
|Cash flows from financing activities:                                                     |                                                                |   |                |        |   |      |        |       
|                                                                                          | Issuance of common stock                                       |   |                | 4      |   |      |        | 6      |  
|                                                                                          | Exercise of stock options                                      |   |                |       |   |      |        | 1      |  
|                                                                                          | Payments under capital lease obligations                       |   |                | (21    | ) |      |        | (170   | )
|                                                                                          | Repayments of notes payable                                    |   |                | (58    | ) |      |        | (42    | )
|                                                                                          |                                                                |   |                |        |   |     
|Net cash used by financing activities                                                     |                                                                |   | (75            | )      |   |      | (205   | )     
|                                                                                          |                                                                |   |                |        |   |     
|                                                                                          | Effects of exchange rate changes                               |   |                | 35     |   |      |        | 25     |  
|                                                                                          |                                                                |   |                |        |   |     
|Net decrease in cash                                                                      |                                                                |   | (2,197         | )      |   |      | (3,879 | )     
|Cash, beginning of period                                                                 |                                                                |   | 4,009          |        |   |      | 5,979  |       
|                                                                                          |                                                                |   |                |        |   |     
|Cash, end of period                                                                       |                                                                | $ | 1,812          |        |   | $    | 2,100  |       
|                                                                                          |                                                                |   |                |        |   |     
|SUPPLEMENTAL
DISCLOSURE OF CASH FLOW INFORMATION                                          |                                                                |   |                |        |   |      |        |       
|Cash paid for interest                                                                    |                                                                | $ | 1              |        |   | $    | 10     |       
|                                                                                          |                                                                |   |                |        |   |     

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

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



|1. |  | BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
|-- |  | ---------------------------------------------------------

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, consisting only of normal
recurring adjustments necessary for their fair presentation in conformity with
accounting principles generally accepted in the United States of America.
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 three and
nine-month periods ended June 30, 2003 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 of
Financial Condition and Results of Operations herein, as well as with the
financial statements and notes thereto included in the Companys annual report
on Form 10-K for the year ended September 30, 2002 as filed with the Securities
and Exchange Commission on December 19, 2002.

Except for the quarter ended June 30, 2003, N2H2 has incurred net losses
in each quarter from inception and has an accumulated shareholders deficit.
In fiscal 2002, the Company incurred net losses of $6.6 million and used $1.8
million of cash in its operating activities. For the nine-months ended June
30, 2003, the Company incurred operating losses of $568,000 and used $531,000
of cash in its operating activities. The Company anticipates that it will have
a net loss for full-year fiscal 2003 as the Company continues to develop its
distribution channels and customer base. Management believes that existing cash
and investments, together with cash generated from operations, will be
sufficient to sustain the Companys operations for at least the next twelve
months. If cash generated from operations is insufficient to satisfy the
Companys longer-term liquidity requirements, the Company may seek to further
reduce expenses, sell additional equity or debt securities, or obtain a credit
facility to continue operations beyond twelve months from the date of this
filing. Alternatively, the Company may seek another acquiror. The incurring of
indebtedness would result in increased fixed obligations and could result in
covenants that would restrict the Companys operations. The Company has not
made arrangements to obtain additional financing and there can be no assurance
that financing will be available in amounts or on acceptable terms, if at all.

Proposed Acquisition

On July 29, 2003, the Company and Secure Computing Corporation (Secure)
announced the signing of an agreement that provided for the acquisition of the
Company by Secure through a merger of the Company with a wholly owned
subsidiary of Secure. The acquisition is subject to a number of customary
conditions, including approval by the Companys shareholders. The financial and
other information regarding the Company contained in this report do not give
any effect to or make any adjustment for the anticipated completion of the
acquisition.

Principles of Consolidation

The consolidated financial statements include the accounts of N2H2, Inc.
and its wholly owned subsidiary, N2H2, Ltd. Through February 23, 2003, the
financial statements also include the accounts of N2H2 Pty Limited, formerly a
subsidiary of N2H2 Inc. All inter-company accounts and transactions have been
eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts
of assets and liabilities and disclosure of contingent assets and liabilities
at the date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ from
those estimates.

Revenue Recognition

The Companys revenues are derived primarily from sales of Internet
filtering subscriptions. A smaller portion of its revenue also comes from
installation and maintenance fees. The Company recognizes revenue in accordance
with Statement of Position No. 97-2,

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Software Revenue Recognition (SOP 97-2). Accordingly, revenue is
recognized when persuasive evidence of an arrangement exists, the product or
service has been delivered, the fee is fixed and determinable, and collection
is reasonably assured.

Subscription revenues represent the fees associated with the right to use
the Companys software and/or hardware, and to access the Companys filtering
updates. Maintenance revenues represent fees associated with technical support
services provided to customers. Subscription and maintenance agreements are
generally 12, 24 or 36 months in duration. Subscription and maintenance
revenues are recognized on a straight-line basis over the life of the
agreement. Amounts billed in advance of services provided are recorded as
deferred revenue. The Companys revenue growth is significantly influenced by
subscription renewals, and a decrease in renewals could negatively impact the
Companys revenue.

Installation revenues represent one-time fees associated with the
customization and installation of the Companys software on customer servers.
Installation services are billed upon completion and are recognized over the
expected life of the customer relationship in accordance with Staff Accounting
Bulletin No. 101, Revenue Recognition in Financial Statements. The Company
estimates the expected life of its customer relationships based on a number of
factors, including customer type and customer history. Estimates of expected
customer lives are assessed on an ongoing basis. A material change in the
estimated customer life could significantly impact the rate at which the
Company recognizes these revenues.

Research and development

Technological feasibility of N2H2 software solutions is reached shortly before
the software is released to customers. Costs incurred between technological
feasibility and the release to customers are not material, and accordingly, the
Company expenses all research and development costs when incurred.

Stock-based compensation

The Company accounts for employee stock-based compensation under the
provisions of Accounting Principles Board Opinion No. 25 (APB 25) and related
interpretations. Statement of Financial Accounting Standards No. 123 (SFAS 123)
permits the use of either a fair-value based method or the intrinsic value
method under APB No. 25 to account for employee stock-based compensation
arrangements. Companies that elect to use the intrinsic value method provided
in APB No. 25 are required to disclose the pro forma net income (loss) and net
income (loss) per share that would have resulted from the use of the fair value
method.

Reclassifications

Certain reclassifications of prior year balances have been made for
consistent presentation with the current year. These reclassifications have
not impacted previously reported net loss, shareholders equity or cash flows.



|2. |  | NET INCOME (LOSS) PER SHARE
|-- |  | ---------------------------

Basic net income (loss) per share is computed on the basis of the weighted
average number of common shares outstanding. Diluted net income (loss) per
share includes common equivalent shares during the period, if dilutive.

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

|             |                                                    |                                     |   |                                       |      |  |                |        |       |      |   |        |       |   |   |        |       |  
|------------ | -------------------------------------------------- | ----------------------------------- | - | ------------------------------------- | ---- |  | -------------- | ------ | ----- | ---- | - | ------ | ----- | - | - | ------ | ----- | -
|             |                                                    |                                     |   | THREE MONTHS                          |      |  | NINE MONTHS    |       
|             |                                                    |                                     |   | ENDED JUNE 30,                        |      |  | ENDED JUNE 30, |       
|             |                                                    |                                     |   |                                       |      |  |                |       
|             |                                                    |                                     |   | 2003                                  |      |  | 2002           |        |       | 2003 |   |        | 2002  |  
|             |                                                    |                                     |   |                                       |      |  |                |        |       |      |   |        |       |  
|             |                                                    |                                     |   | (in thousands, except per share data) |     
|Numerator:   |                                                    |                                     |   |                                       |      |  |                |        |       |      |   |        |       |   |   |       
|             | Net income (loss)                                  |                                     | $ | 48                                    |      |  | $              | (1,278 | )     |      | $ | (568   | )     |   | $ | (4,847 | )    
|Denominator: |                                                    |                                     |   |                                       |      |  |                |        |       |      |   |        |       |   |   |       
|             | Basic weighted average common
shares outstanding   |                                     |   | 22,131                                |      |  |                | 21,919 |       |      |   | 22,023 |       |   |   | 21,814 |      
|             |                                                    |                                     |   |                                       |      |  |                |        |       |      |   |       
|             |                                                    | Basic net income (loss) per share   |   | $                                     | 0.00 |  |                | $      | (0.06 | )    |   | $      | (0.03 | ) |   | $      | (0.22 | )
|             |                                                    |                                     |   |                                       |      |  |                |        |       |      |   |        |      
|             | Diluted weighted average common
shares outstanding |                                     |   | 22,826                                |      |  |                | 21,919 |       |      |   | 22,023 |       |   |   | 21,814 |      
|             |                                                    |                                     |   |                                       |      |  |                |        |       |      |   |       
|             |                                                    | Diluted net income (loss) per share |   | $                                     | 0.00 |  |                | $      | (0.06 | )    |   | $      | (0.03 | ) |   | $      | (0.22 | )
|             |                                                    |                                     |   |                                       |      |  |                |        |       |      |   |        |      

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The calculation of diluted net income per share for the three-months ended
June 30, 2003 reflects the dilutive effect of common stock equivalents for
stock options and warrants computed by the treasury stock method. Warrants for
539,280 shares and options for 2,885,005 shares have been excluded from the
calculation of diluted net income per share for the three-months ended June 30,
2003 because they are anti-dilutive. Warrants for 539,280 shares and options
for 5,021,808 shares have been excluded from the calculation of diluted loss
per share for the nine-months ended June 30, 2003 because they are
anti-dilutive. Warrants for 539,280 shares, options for 4,007,836 shares, and
170,596 restricted shares have been excluded from the calculation of diluted
loss per share for periods ended June 30, 2002 because they are anti-dilutive.



|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 at the beginning of fiscal 2001, in accordance
with the provisions of SAB 101, the Company began deferring installation
revenue over the expected life of the customer relationship. 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 expected life of the customer relationships. The
amount of related deferred revenue, which was recognized as revenue during the
nine-month periods ended June 30, 2003 and 2002 was $217,000 and $657,000,
respectively. The remaining related deferred revenue of $12,000 will be
recognized in the fourth quarter of fiscal 2003.



|4. |  | RESTRICTED CASH AND CASH EQUIVALENTS
|-- |  | ------------------------------------

The Company has $675,000 of restricted cash pledged as collateral for a
letter of credit related to the Companys leased office space in the amount of
$665,000, expiring on July 31, 2005, and a $10,000 deposit held by Comerica for
the issuance of corporate credit cards. The restriction will remain in effect
through the term of these commitments, although it will be reduced per the
terms of the letter of credit agreement, which reduces the security requirement
from $665,000 to $450,000 on August 1, 2003 and again to $250,000 on August 1,
2004. Alternatively, the Company may seek to obtain a line of credit to
underwrite these obligations, which would release the restriction and allow the
company to access the balance for use in operations.



|5. |  | RELATED PARTY TRANSACTION
|-- |  | -------------------------

On February 23, 2003, the Company sold the assets and liabilities of its
Australian subsidiary, N2H2 Pty Limited, for $31,000 to one of its directors
who was the original owner of the entity. N2H2 Pty Limited functioned as a
sales office in Queensland, Australia for N2H2s Internet filtering and
monitoring solutions. Simultaneous with the sale, the Company entered into a
non-exclusive distribution agreement with the purchaser. Under the
distribution agreement, the purchaser will continue to sell, distribute and
support N2H2s software and subscriptions to customers within Australia and New
Zealand. The Company recorded a loss on the sale of $61,000.



|6. |  | STOCK-BASED COMPENSATION
|-- |  | ------------------------

The Company has provided below the pro forma disclosures of the effect on
net income (loss) and net income (loss) per share as if SFAS No. 123, as
amended by SFAS No. 148, had been applied in measuring compensation expense for
all periods presented.

|                                                                                                                             |  |   |                                       |   |  |               |        |   |      |   |      |      |  |   |        |   | 
|---------------------------------------------------------------------------------------------------------------------------- |  | - | ------------------------------------- | - |  | ------------- | ------ | - | ---- | - | ---- | ---- |  | - | ------ | - | 
|                                                                                                                             |  |   | THREE MONTHS                          |   |  | NINE MONTHS   |       
|                                                                                                                             |  |   | ENDED JUNE 30,                        |   |  | ENDED JUNE 30 |       
|                                                                                                                             |  |   |                                       |   |  |               |       
|                                                                                                                             |  |   | 2003                                  |   |  | 2002          |        |   | 2003 |   |      | 2002 | 
|                                                                                                                             |  |   |                                       |   |  |               |        |   |      |   |      |      | 
|                                                                                                                             |  |   | (in thousands, except per share data) |  
|Net income (loss), as reported                                                                                               |  | $ | 48                                    |   |  | $             | (1,278 | ) |      | $ | (568 | )    |  | $ | (4,847 | )
|Add: Stock-based employee compensation expense
included in reported net loss, net of related tax
effects                     |  |   |                                      |   |  |               |       |   |      |   |     |      |  |   | 6      |  
|Deduct: Total stock-based compensation expense
determined under fair value method for all awards,
net of related tax effects |  |   | (88                                   | ) |  |               | (133   | ) |      |   | (275 | )    |  |   | 1,193  |  
|                                                                                                                             |  |   |                                       |   |  |               |        |   |      |   |      |     
|Pro forma net loss                                                                                                           |  | $ | (40                                   | ) |  | $             | (1,411 | ) |      | $ | (843 | )    |  | $ | (3,648 | )
|                                                                                                                             |  |   |                                       |   |  |               |        |   |      |   |      |     

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|                    |                                                  |  |   |       |   |  |   |       |   |  |   |       |   |  |   |       |  
|------------------- | ------------------------------------------------ |  | - | ----- | - |  | - | ----- | - |  | - | ----- | - |  | - | ----- | -
|Earnings per share: |                                                  |  |   |       |   |  |   |       |   |  |   |       |   |  |   |      
|                    | Basic net income (loss) per share, as reported   |  | $ | 0.00  |   |  | $ | (0.06 | ) |  | $ | (0.03 | ) |  | $ | (0.22 | )
|                    |                                                  |  |   |       |   |  |   |       |   |  |   |      
|                    | Basic net income (loss) per share, pro forma     |  | $ | (0.00 | ) |  | $ | (0.06 | ) |  | $ | (0.04 | ) |  | $ | (0.17 | )
|                    |                                                  |  |   |       |   |  |   |       |   |  |   |      
|                    | Diluted net income (loss) per share, as reported |  | $ | 0.00  |   |  | $ | (0.06 | ) |  | $ | (0.03 | ) |  | $ | (0.22 | )
|                    |                                                  |  |   |       |   |  |   |       |   |  |   |      
|                    | Diluted net income (loss) per share, pro forma   |  | $ | (0.00 | ) |  | $ | (0.06 | ) |  | $ | (0.04 | ) |  | $ | (0.17 | )
|                    |                                                  |  |   |       |   |  |   |       |   |  |   |      



|7. |  | SUBSEQUENT EVENTS
|-- |  | -----------------

In conjunction with the July 29, 2003 merger agreement, N2H2 and Secure
have agreed to provide certain severance benefits to N2H2 employees who may be
identified for termination in relation to the change-in-control. The total
amount of severance benefits to be paid will be based upon decisions that will
be made in future periods relating to which employees, if any, will be
terminated in relation to the change-in-control. Such severance benefits will
be accrued and expensed if an employee is identified for termination. In
addition, certain stock options will vest at an accelerated rate upon the
successful completion of the proposed acquisition. If the merger is not
completed for any reason, N2H2 could be required to pay Secure Computing an
$800,000 termination fee, plus, in some cases, Secures expenses of the merger
up to a maximum of $350,000.



|8. |  | RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
|-- |  | -----------------------------------------

In November 2002, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others. FIN 45 elaborates on the disclosures to be made by the guarantor about
its obligations under certain guarantees that it has issued. It also requires
that a guarantor recognize, at the inception of a guarantee, a liability for
the fair value of the obligation undertaken in issuing the guarantee. The
initial recognition and measurement provisions of this interpretation are
applicable on a prospective basis to guarantees issued or modified after
December 31, 2002, while the disclosure requirements are effective for
financial statements ending after December 15, 2002. Adoption of FIN 45 did not
have a material impact on the Companys financial statements.

In December 2002, FASB issued Statement of Financial Accounting Standards
No. 148 (SFAS 148), Accounting for Stock-Based Compensation  Transition and
Disclosure. SFAS 148 amends SFAS 123, Accounting for Stock-Based Compensation,
to provide alternative methods of transition for an entity that voluntarily
changes to the fair value based method of accounting for stock-based
compensation. It also amends the disclosure provisions of that statement. The
disclosure provisions of SFAS 148 are effective for financial statements issued
for fiscal periods beginning after December 15, 2002 and will become effective
for the Company commencing with the second quarter of the 2003 fiscal year. The
Company does not currently have plans to change to the fair value method of
accounting for its stock-based compensation.

In January 2003, the FASB issued Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities. This interpretation of Accounting
Research Bulletin No. 51, Consolidated Financial Statements, addresses
consolidation by business enterprises of variable interest entities. FIN 46
defines the concept of variable interests and requires existing
unconsolidated variable interest entities to be consolidated by their primary
beneficiaries if the entities do not effectively disperse risks among the
parties involved. This interpretation applies immediately to variable interest
entities created after January 31, 2003. It applies in the first fiscal year or
interim period beginning after June 15, 2003, to variable interest entities in
which an enterprise holds a variable interest that it acquired before February
1, 2003. The Company does not expect that the adoption of FIN 46 will have a
material impact on its financial statements.

In January 2003, the Emerging Issues Task Force issued EITF Issue No. 00-21,
Accounting for Revenue Arrangements with Multiple Deliverables. This consensus
addresses certain aspects of accounting by a vendor of arrangements under which
it will perform multiple revenue-generating activities, specifically, how to
determine whether an arrangement involving multiple deliverables contains more
than one unit of accounting. EITF Issue No. 00-21 is effective for revenue
arrangements entered into in fiscal periods beginning after June 15, 2003 or
entities may elect to report the change in accounting as a cumulative-effect
adjustment in accordance with APB Opinion No. 20, Accounting Changesand SFAS
No. 3, Reporting Accounting Changes in Interim Financial Statements, with early
application of this consensus permitted. The Company does not expect that the
adoption of EITF Issue No. 00-21 will have a material impact on its financial
statements.

In May 2003, the FASB issued Statement of Financial Accounting Standards
No.150 (FAS 150), Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity. FAS 150 improves the accounting
for certain financial instruments that, under previous guidance, issuers could
account for as equity. FAS 150 requires that those instruments be classified as
liabilities in statements of financial position. FAS 150 is effective for
financial instruments entered into or modified after May 31,
2003 and

9



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otherwise is effective at the beginning of the fourth quarter of 2003. The
Company does not expect the provisions of FAS 150 to have a material impact on
its financial statements.




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

FORWARD LOOKING INFORMATION

Our disclosure and analysis in this report contain forward-looking
statements, which provide our current expectations or forecasts of future
events. Forward-looking statements in this report include, without limitation:



| |  |  | statements about our future capital requirements, our future cash flows and the sufficiency of our
existing cash, cash equivalents, investments and available bank borrowings to meet these
requirements;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | information concerning possible or assumed future results of operations, trends in financial
results and business plans, including those relating to earnings growth and revenue growth;                 
|
| |  |  | statements about the level of our costs and operating expenses relative to our revenues;                                                                                                                 
|
| |  |  | statements about the expected closing of our acquisition by Secure Computing Corporation, or Secure;                                                                                                     
|
| |  |  | other statements about our plans, objectives, expectations and intentions; and                                                                                                                           
|
| |  |  | other statements that are not historical facts.                                                                                                                                                          

Words such as believes, anticipates and intends may identify
forward-looking statements, but the absence of these words does not necessarily
mean that a statement is not forward-looking. Forward-looking statements are
subject to known and unknown risks and uncertainties and are based on
potentially inaccurate assumptions that could cause actual results to differ
materially from those expected or implied by the forward-looking statements.
Our actual results could differ materially from those anticipated in the
forward-looking statements for many reasons, including the factors described in
the section entitled Important Factors That May Affect Our Business, Our
Results of Operations and Our Stock Price in this report. Other factors
besides those described in this report could also affect actual results. You
should carefully consider the factors described in the section entitled
Important Factors That May Affect Our Business, Our Results of Operations and
Our Stock Price in evaluating our forward-looking statements.

You should not unduly rely on these forward-looking statements, which
speak only as of the date of this report. We undertake no obligation to
publicly revise any forward-looking statement to reflect circumstances or
events after the date of this report, or to reflect the occurrence of
unanticipated events. You should, however, review the factors and risks we
describe in the reports we file from time to time with the Securities and
Exchange Commission, or SEC.

OVERVIEW

N2H2 is an international Internet monitoring and filtering company. Our
solutions help customers control, manage and understand their Internet use by
filtering Web content, monitoring Internet access and delivering concise
reports on user activity. These safeguards are designed to enable
organizations of any size to mitigate potential legal liability, increase user
productivity and optimize network bandwidth.

Our Bess® and Sentian filtering solutions are powered by our
premium-quality filtering database  a list recognized by independent and
respected third-parties as the most effective in the industry. N2H2 is based in
Seattle, Washington and serves millions of users worldwide. Our software
solutions are Cisco Verified, Microsoft Gold Certified, Red Hat Enterprise
Linux Certified and Check Point OPSEC compliant and are available for major
platforms and devices.

As a leading provider of Internet content filtering to schools, we are
attempting to leverage our expertise in filtering large-scale networks within
sensitive environments via additional channel presence and expansion plans for
corporations, governments, and other organizations. We have customers in
several countries including Australia, Canada, Chile, the Dominican Republic,
Japan, Mexico, the United Kingdom and the United States. To cover these
markets, we use a combination of our own sales force and various resellers,
both domestic and international.

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Our prospects are subject to the risks, expenses, and difficulties
encountered by companies in the rapidly evolving Internet market. As of June
30, 2003, we had incurred aggregate operating losses of approximately $94.0
million from inception. These losses have been funded primarily through the
issuance of common stock. Pending completion of the proposed acquisition, we
intend to continue to seek opportunities to grow revenue and improve
efficiencies in our operations to reduce operating losses.

PROPOSED ACQUISITION

On July 29, 2003, N2H2 and Secure announced the signing of a merger
agreement for Secure to acquire N2H2 through the merger of a wholly owned
subsidiary of Secure with and into N2H2. Under the terms of the merger
agreement, all of the outstanding shares of N2H2 common stock will be exchanged
for Secure common stock, at a ratio of 0.0841 shares of Secure common stock for
each outstanding share of N2H2 common stock. The proposed merger is subject to
the satisfaction of customary closing conditions, including the approval of
N2H2s shareholders, and is expected to close during the fourth calendar
quarter of 2003.

Except for the quarter ended June 30, 2003, we have experienced net losses
from inception and have an accumulated shareholders deficit. In fiscal 2002,
we incurred operating losses of $6.6 million and used $1.8 million of cash in
its operating activities. For the nine-months ended June 30, 2003, we incurred
operating losses of $568,000 and used $531,000 of cash in its operating
activities. We anticipate that we will have a net loss for full-year fiscal
2003 as we continue to develop our distribution channels and customer base. If
the acquisition is not consummated, we believe that existing cash and
investments, together with cash generated from operations, will be sufficient
to sustain our operations for at least the next twelve months. If cash
generated from operations is insufficient to satisfy our longer-term liquidity
requirements, we may seek to further reduce expenses, sell additional equity or
debt securities, or obtain a credit facility to continue operations beyond
twelve months from the date of this filing. Alternatively, we may seek another
acquiror. The incurring of indebtedness would result in increased fixed
obligations and could result in covenants that would restrict our operations.
We have not made arrangements to obtain additional financing and there can be
no assurance that financing will be available in amounts or on acceptable
terms, if at all.

RESULTS OF OPERATIONS  THREE MONTHS ENDED JUNE 30, 2003

Revenue

We generate our revenue primarily from subscriptions for our Internet
filtering, monitoring, and reporting services. A smaller portion of our revenue
also comes from installation and maintenance fees.

Revenue increased by 4% to $3.1 million for the quarter, compared to $3.0
million for the comparable period in the prior fiscal year. Revenue increased
primarily as a result of adding new customers, primarily in the corporate and
education markets. Our growing network of resellers continues to build momentum
and contribute to our increased revenue. The increase in revenue was partially
offset by a decline in revenue recognized in conjunction with the adoption of
SAB 101. The amount of related SAB 101 revenue recognized during the quarter
was $45,000, down from $116,000 in the same quarter of the prior year.
Excluding these amounts, revenue from customers increased 6% over the same
quarter of the prior year.

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, costs associated
with building and maintaining our database, collocation, bandwidth, and an
allocation of corporate facilities costs.

Internet filtering services and customer support costs decreased by 32% to
$581,000 for the quarter, compared to $852,000 for the comparable period in the
prior fiscal year. The decrease is primarily due to reductions in employee
count that took place in the fourth quarter of fiscal 2002. We anticipate that
Internet filtering services and customer support costs will remain materially
consistent with current levels through the earlier of the remainder of the
fiscal year or the consummation of our proposed acquisition by Secure.

Sales and marketing

Sales and marketing expenses consist primarily of salaries, commissions
and stock compensation expense for personnel engaged in selling and marketing
functions, and various marketing programs, such as public relations,
advertising, and lead generation. Sales and marketing also includes an
allocation of corporate facilities costs.

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Sales and marketing expenses decreased by 30% to $1.1 million for the
quarter, from $1.6 million for the comparable period in the prior fiscal year.
The decrease is primarily due to reduced deferred stock compensation expense.
Deferred stock compensation was amortized using an accelerated method, which
resulted in higher expense in fiscal 2002 as compared to 2003. Deferred stock
compensation became fully amortized during the preceding quarter, thus
eliminating this expense for the current and future periods. The decrease is
also due in part to reductions in the employee count that took place in the
fourth quarter of fiscal 2002. We anticipate that overall sales and marketing
expenses will remain materially consistent with current quarter levels through
the earlier of the remainder of the fiscal year or the consummation of our
proposed acquisition by Secure.

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, insurance
costs, and an allocation of corporate facilities costs.

General and administrative expenses decreased by 4% to $814,000 for the
quarter, from $851,000 for the comparable period in the prior fiscal year. This
decrease is due in part to reductions in administrative staffing that took
place in the fourth quarter of fiscal 2002. We also incurred less bad debt
expense, as the improved financial stability of our customer base resulted in
an improved collection rate. We anticipate that general and administrative
expenses will increase in future quarters as a result of increasing expenses
associated with being a public company and expenses incurred in conjunction
with our proposed acquisition by Secure.

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 filtering and monitoring products and enhancing existing
products. Product costs related to internal research and development have been
expensed as incurred.

Research and development expenses decreased by 19% to $396,000 for the
quarter, from $487,000 for the comparable period in the prior fiscal year.
This decrease is due primarily to reductions in employee count that took place
in the fourth quarter of fiscal 2002, and our reduced usage of contractors and
third party service providers in the development of our products. We
anticipate that research and development costs will remain materially
consistent with current levels through the earlier of the remainder of the
fiscal year or the consummation of our proposed acquisition by Secure.

Depreciation and amortization

Depreciation and amortization expenses decreased by 69% to $147,000 for
the quarter, from $472,000 for the comparable period in the prior fiscal year.
This decrease is due to certain of our fixed assets and leasehold improvements
becoming fully depreciated.

Interest income and expense

Interest income consists primarily of interest earned on our cash
equivalents and short-term investments. Interest expense in the prior year
consists of interest paid on our note payable and our capital lease
obligations. There was no interest expense for the current quarter. Net
interest income decreased by 48% to $14,000, from $27,000 for the comparable
period in the prior fiscal year. The decrease is due to our reduced combined
cash and investment balances, offset by a decrease in interest expense due to
the elimination of our note payable and capital lease obligations.

RESULTS OF OPERATIONS  NINE MONTHS ENDED JUNE 30, 2003

Revenue

Revenue increased by 8% to $9.2 million for the nine-month period,
compared to $8.6 million for the comparable period in the prior fiscal year.
Revenue increased due to the addition of new customers, primarily in the
corporate and education markets. Our growing network of resellers continues to
build momentum and contribute to our increased revenue. The increase in
revenue was partially offset by a decline in revenue recognized in conjunction
with the adoption of SAB 101. The amount of related SAB 101 revenue recognized
during the period was $217,000, down from $657,000 in the same period of the
prior year. Excluding these amounts, revenue from customers increased 14% over
the same quarter of the prior year.

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Internet filtering services and customer support costs

Internet filtering services and customer support costs decreased by 31% to
$1.7 million for the nine-month period, compared to $2.5 million for the
comparable period in the prior fiscal year. The decrease is primarily due to
reductions in employee count that took place in the fourth quarter of fiscal
2002.

Sales and marketing

Sales and marketing expenses decreased by 28% to $3.8 million for the
nine-month period, from $5.3 million for the comparable period in the prior
fiscal year. The decrease is primarily due to reduced deferred stock
compensation expense. Deferred stock compensation was being amortized using an
accelerated method, which resulted in higher expense in fiscal 2002 as compared
to 2003. Deferred stock compensation became fully amortized during the
preceding quarter, thus eliminating this expense for future periods. The
decrease is also due in part to reductions in the employee count that took
place in the fourth quarter of fiscal 2002.

General and administrative

General and administrative expenses decreased by 10% to $2.4 million for
the nine-month period, from $2.7 million for the comparable period in the prior
fiscal year. This decrease is due in part to reductions in administrative
staffing that took place in the fourth quarter of fiscal 2002. We also realized
cost savings on Internet connectivity and collocation fees by changing vendors
and negotiating more favorable terms in fiscal 2002, and we incurred less bad
debt expense as the improved financial stability of our customer base resulted
in an improved collection rate.

Research and development

Research and development expenses decreased by 18% to $1.1 million for the
nine-month period, from $1.4 million for the comparable period in the prior
fiscal year. This decrease is primarily due to reductions in employee count
that took place in the fourth quarter of fiscal 2002, and our reduced usage of
contractors and third party service providers in the development of our
products.

Depreciation and amortization

Depreciation and amortization expenses decreased by 59% to $625,000 for
the nine-month period, from $1.5 million for the comparable period in the prior
fiscal year. This decrease is due to certain of our fixed assets and leasehold
improvements becoming fully depreciated.

Loss on disposal of property and equipment

We incurred a $22,000 loss on disposal of property and equipment resulting
from the abandonment of certain servers that we are no longer using in our
operations.

Loss on sale of N2H2 Pty Limited

On February 23, 2003, we sold the assets and liabilities of our Australian
subsidiary, N2H2 Pty Limited, for $31,000 to one of its directors who was the
original owner of the entity. N2H2 Pty Limited functioned as a sales office in
Queensland, Australia for N2H2s Internet filtering and monitoring solutions.
Simultaneous with the sale, we entered into a non-exclusive distribution
agreement with the purchaser. Under the distribution agreement, the purchaser
will continue to sell, distribute and support N2H2s software and subscriptions
to customers within Australia and New Zealand. We recorded a loss on the sale
of $61,000.

Interest income and expense

Net interest income decreased by 52% to $46,000, from $97,000 for the
comparable period in the prior fiscal year. The decrease is due to our reduced
combined cash and investment balances, offset by a decrease in interest expense
due to the elimination of our note payable and capital lease obligations.

LIQUIDITY AND CAPITAL RESOURCES

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As of June 30, 2003, we had $4.1 million in cash and investments, which
consisted of cash and cash equivalents of $2.5 million (including restricted
cash of $675,000) and short term investments of $1.6 million, compared to $4.7
million (including restricted cash of $675,000) at September 30, 2002. The
decrease in cash and cash equivalents is primarily due to cash used to fund
operations, combined with minor purchases of computer equipment and payments
under capital lease and note payable obligations. Operating activities
consumed $531,000 for the nine-month period, compared to $3.6 million for the
comparable period in the prior fiscal year.

Investing activities consumed $1.6 million for the nine-month period,
compared to $106,000 for the comparable period of the prior fiscal year.
Investing activities consist primarily of purchases of short-term investments,
combined with minor purchases of computer equipment, partially offset by
amounts collected on our note receivable from shareholder. The additions to
property and equipment during the period consist of computers purchased to
support internal operations. We anticipate a small increase in equipment
purchases in future quarters to support our internal operations and our growing
customer base.

Financing activities consumed $75,000 for the nine-month period, compared
to $205,000 for the comparable period of the prior fiscal year. Financing
activities consist of payments under capital lease and note payable
obligations, partially offset by proceeds from the issuance of common stock
under our employee stock purchase plan. Restricted cash of $675,000 is pledged
as collateral for a letter of credit related to our leased office space in the
amount of $665,000, expiring on July 31, 2005, and a $10,000 deposit held by
Comerica for the issuance of corporate credit cards. The restriction will
remain in effect through the term of these commitments. Alternatively, if the
proposed acquisition by Secure is not completed, we may seek to obtain a line
of credit to underwrite these obligations.

Except for the quarter ended June 30, 2003, we have experienced
significant net operating losses from inception. In fiscal 2002, we incurred
operating losses of $6.6 million and used $1.8 million of cash in our operating
activities. For the nine-months ended June 30, 2003, we incurred operating
losses of $568,000 and used $531,000 of cash in our operating activities. On
July 29, 2003, we announced the signing of an agreement that provided for the
acquisition of N2H2 by Secure. The acquisition is subject to a number of
customary conditions, including approval by N2H2 shareholders. If the
acquisition is not consummated, we believe that our existing cash and
investments, together with cash generated from operations, will be sufficient
to sustain our operations for at least the next 12 months. If our cash
generated from operations is insufficient to satisfy our longer-term liquidity
requirements, we may seek to further reduce expenses, sell additional equity or
debt securities, or obtain a credit facility to continue operations beyond
twelve months from the date of this filing. Alternatively, we may seek another
buyer for N2H2. The incurring of indebtedness would result in increased fixed
obligations and could result in covenants that would restrict our operations.
We have not made arrangements to obtain additional financing and we cannot
assure you that financing will be available in amounts or on terms acceptable
to us, if at all. If the proposed acquisition by Secure is not consummated, we
may not be able to find another buyer for N2H2 on a timely basis or on
acceptable terms. If the proposed merger transaction does not occur, and
revenues generated from operations are insufficient to satisfy our long-term
liquidity requirements and we are not successful in further reducing expenses
or raising additional funds on acceptable terms when needed, our business would
not succeed.

Following is a summary of our significant unconditional contractual
obligations and commercial commitments:

|                         |                  |  |                        |           |  |        |           |           |           |  |   |           |  |  |         |   |  |       |  |   | 
|------------------------ | ---------------- |  | ---------------------- | --------- |  | ------ | --------- | --------- | --------- |  | - | --------- |  |  | ------- | - |  | ----- |  | - | 
|                         |                  |  | Payments Due by Period |          
|                         |                  |  |                        |          
|                         |                  |  |                        |           |  |        | Less than |           |           |  |   |           |  |  |         |   |  | After | 
|                         |                  |  |                        |           |  |        |           |           |           |  |   |           |  |  |         |   |  |       | 
|                         |                  |  | Total                  |           |  | 1 year |           |           | 1-3 years |  |   | 4-5 years |  |  | 5 years |  
|                         |                  |  |                        |           |  |        |           |           |           |  |   |           |  |  |         |  
|Contractual Obligations: |                  |  |                        |           |  |        |           |           |           |  |   |           |  |  |         |   |  |       |  |  
|                         | Operating Leases |  | $                      | 2,382,000 |  |        | $         | 1,083,000 |           |  | $ | 1,299,000 |  |  |         |  |  |       |  |  | 

The above contractual lease obligations include sublease proceeds in the
amount of $424,000, which will be received ratably over the remaining term of
the master lease.

IMPORTANT FACTORS THAT MAY AFFECT OUR BUSINESS, OUR RESULTS OF OPERATIONS AND
OUR STOCK PRICE

We may be unable to obtain additional funding and any funding we do obtain
could dilute our shareholders ownership interest.

Our future revenues may be insufficient to support the expenses of our
operations and the expansion of our business. If the merger is not completed,
we may therefore need to raise additional capital to finance our operations.
If we cannot raise funds on acceptable terms, we may not be able to develop or
enhance our products and services, take advantage of future opportunities or
respond to competitive pressures or unanticipated requirements. In addition,
if the merger is not completed and if we cannot raise funds on
14Table of Contents

acceptable terms and do not achieve and maintain profitability on a
consistent basis, we may be forced to reduce or cease operations or find
another buyer.

We believe that our existing cash and cash equivalents will be sufficient
to meet our capital requirements for at least the next twelve months. However,
if the merger is not completed, we may seek additional funds before that time
through public or private equity financing, by obtaining a credit facility or
from other sources to fund our operations and pursue our business strategy. We
have no commitment for any financing, and may be unable to obtain financing on
favorable terms, if at all. If the merger is not completed, we may not be able
to find, on a timely basis, if at all, another buyer willing to offer
acceptable terms. Any failure of the merger to be completed may in itself make
it even more difficult to obtain financing or find another buyer. If we obtain
a credit facility, the incurring of indebtedness would result in increased
fixed obligations and could result in covenants that would restrict our
operations. If we issue additional equity securities, our shareholders may
experience significant dilution, and the new equity securities may have rights,
preferences or privileges senior to those of existing holders of our common
stock.

We have a history of losses and may not be able to achieve or maintain
profitability on a consistent basis, which could force us to reduce or cease
operations.

Except for the quarter ended June 30, 2003, we have incurred net losses in
each quarter since our formation in 1995. We incurred net losses of $881,000
for 1997, $2.6 million for 1998, $7.7 million for 1999, $39.3 million for 2000,
$35.5 million for 2001, $6.6 million for 2002 and $568,000 for the nine months
ended June 30, 2003. If we remain an independent company and fail to achieve or
maintain profitability on a consistent basis, our stock price will decline, our
future capital-raising efforts will be impaired and we may be forced to reduce
or cease operations.

Although we achieved a profit in the quarter ended June 30, 2003, we will
have to maintain or grow our revenues to achieve and maintain profitability on
a consistent basis. We may not be able to maintain or grow our revenues to
achieve consistent profitability. If the merger is not completed, and our
financial condition does not improve, some potential customers may question our
viability, which may hamper our ability to sell our solutions.

Economic conditions could adversely affect our revenue growth.

Our revenue growth and potential for profitability depend on the overall
demand for Internet filtering and monitoring solutions, which is impacted by
general economic and business conditions. A softening of demand for computer
software generally caused by the weakened economy, both domestic and
international, has affected our sales and may continue to result in decreased
revenues and growth rates. As a result of the economic downturn, we may also
experience difficulties in collecting outstanding accounts receivable from our
customers. In addition, the terrorist attacks on the United States in 2001,
the armed conflicts that have followed, and the threat of additional future
armed conflicts have increased economic, political and other uncertainties,
which could adversely affect our sales and thus our revenue growth. The
slowdown in the domestic and international economies, as well as the effects of
terrorist activity and armed conflict, may continue to cause customers and
potential customers to delay their decisions about purchasing our solutions, to
reduce the amount they purchase or to cancel their orders, which could
adversely affect our business and operating results.

Our quarterly financial results fluctuate and could fall below expectations of
securities analysts and investors, resulting in a decrease in our stock price.

Our quarterly operating results have fluctuated significantly in the past
and are likely to continue to fluctuate in the future. If our operating
results fall below the expectations of securities analysts and investors, it
could result in a decrease in our stock price. Operating results vary from
quarter to quarter, depending on a number of factors, many of which are outside
our control, including:



| |  |  | general economic conditions, which may affect our customers
investment levels in enterprise software such as our solutions;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the rate of market acceptance of new product introductions;                                                                 
|
| |  |  | budget and spending decisions by our customers;                                                                             
|
| |  |  | subscription renewal rates of our existing customers;                                                                       

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| |  |  | our ability to compete in the highly competitive Internet filtering solutions market;                                                                               
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the loss of any key technical, sales, customer support or management personnel and the timing of any new hires;                                                     
|
| |  |  | our ability to develop, introduce and market new products and product versions on a timely basis;                                                                   
|
| |  |  | our ability to successfully expand our operations, and the
amount and timing of expenditures related to this expansion;                                             
|
| |  |  | the tendency of our educational customers to budget and make
purchases on the basis of a fiscal school year beginning in the
fourth fiscal quarter of each year; and
|
| |  |  | the length of our sales cycle, which varies substantially from
customer to customer.                                                                                

As a result of all these factors, we cannot predict our revenues with any
significant degree of certainty, and future product revenues may differ from
historical patterns. Even though we cannot predict our revenues with
certainty, we base our decisions regarding operating expenses on anticipated
revenue trends. Many of our expenses are relatively fixed, and we cannot
quickly reduce spending if our resources are lower than expected. As a result,
revenue shortfalls could result in significantly lower income or greater loss
than anticipated for any given period, which could result in a decrease in our
stock price.

If potential customers do not accept our Internet filtering and monitoring
solutions, our business will not succeed.

We currently expect the substantial majority of our future revenues to be
generated through sales of our Bess and Sentian Internet filtering and
monitoring solutions. As a result, factors adversely affecting the pricing or
demand for Internet filtering and monitoring solutions, such as competition or
technological change, could affect our operating results. In addition, many of
our Bess and Sentian solutions, having been introduced in fiscal 2002, are
relatively new and unproven and may not achieve market acceptance. Because
these solutions are relatively new, we cannot accurately predict the rate at
which customers will renew their annual subscriptions. In addition, due to the
uncertainty caused by the merger, our customers may decide to defer or cancel
purchasing decisions.

If existing customers do not renew their subscription agreements, our business
will not succeed.

Our future success depends on the rate at which existing customers renew
their subscription contracts. Our customers have no obligation to renew their
subscriptions upon expiration. Because our Bess and Sentian solutions are
relatively new, we cannot predict with certainty the rate at which customers
will renew their annual subscriptions. We may be unable to generate
significant revenue from renewals and, as a result, our operating results could
fall below the expectations of analysts and investors, which could cause our
stock price to decline.

If our solutions fail to correctly categorize potentially objectionable
content, public perception of our solutions could be harmed.

We will not succeed unless the marketplace is confident that our solutions
effectively filter and monitor Internet content. We rely on a combination of
automated filtering technology and human review to categorize Web site content
for use by our filtering and monitoring solutions. The total number of Web
sites and partial Web sites is growing rapidly. We cannot be sure that our
technologies will correctly categorize all potentially objectionable Internet
content for our clients, thus causing over- or under-blocking. Our categorized
database also may not contain substantially all of the material available on
the Internet fitting into any one of our content categories. In addition, our
customers may not agree with our categorization determinations. Our failure to
effectively categorize and filter Internet content according to our customers
expectations could result in lost customers and generate negative publicity
that would impair the growth of our business and our efforts to increase
positive associations with our brand.

If we are unable to compete successfully in the Internet filtering and
monitoring market, our business will not succeed.

The market for our solutions is intensely competitive and rapidly
changing. Many of our competitors are larger than we are and have
substantially greater resources. Our major competitors and their respective
products are Surf Control  SuperScout and CyberPatrol, Websense  Websense
Enterprise, Elron Software  Internet Manager, Symantec  I-Gear, Secure
Computing  SmartFilter and 8e6 Technologies  X-Stop. We also face
competition from a number of smaller competitors.

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In the future, we may face increased competition from vendors of
Internet-related hardware and software that enhance their solutions or develop
separate solutions that include functions that are currently provided in our
solutions. If Internet filtering and monitoring functions become standard
features of Internet-related hardware or software, the demand for our solutions
will decrease. Furthermore, even if our solutions offered greater
functionality and are more effective than solutions offered by Internet-related
hardware or software vendors, potential customers might accept this limited
functionality instead of purchasing our solutions.

Some of our competitors filtering and monitoring solutions are
significantly less expensive than our solutions. This lower cost, along with
other factors, may lead to greater market acceptance of our competitors
solutions than for our solutions. Increased competition or our failure to
compete effectively could force us to reduce our prices or the quality of our
offerings. It could also reduce our market share and adversely impact the
profitability of our business. In addition, many of our competitors have
longer operating histories, greater name recognition, larger customer bases and
significantly greater financial, technical, marketing and other resources than
we do. Furthermore, a number of our competitors have recently been acquired by
other large technology companies, which enhances their resources. We believe
that there will be further consolidation among our competitors. As a result,
they may be able to adapt more quickly to new technologies and customer needs,
devote greater resources to promoting or selling their solutions, initiate and
withstand substantial price competition, take advantage of acquisition or other
strategic opportunities more readily or develop and expand their solution
offerings more quickly than we do. In addition, our competitors may form
strategic relationships with each other and with other companies in attempts to
compete more successfully against us. These relationships may take the form of
strategic investments, joint marketing agreements, licenses or other
contractual arrangements, any of which may increase our competitors ability,
relative to ours, to address customer needs with their solutions and that may
enable them to rapidly increase their market share.

We may be subject to third-party claims resulting from termination of our
advertising contracts.

During 2001, we terminated the advertising-based revenue model that we had
previously offered to schools. In connection with the termination of our
advertising-based revenue model, we have unilaterally terminated certain
advertising contracts. As a result, we may be subject to breach of contract
claims, although we have not received notice of any such claims. Even if none
of these claims is successful, the litigation could result in substantial costs
to us and divert managements time and attention away from business operations.

If we are unable to develop and maintain effective long-term relationships with
key resellers, or if our resellers fail to perform, our ability to sell our
solutions will be limited.

During 2001, we significantly reduced our direct sales staff and began to
develop our reseller channel for selling solutions to corporations and
government entities. If the merger is not completed, in order to establish
market share in our target markets and increase revenue, we will need to
substantially increase the distribution of our solutions through successful new
relationships with prestigious resellers. If the merger is not completed, our
sales and revenue growth opportunities would be limited if:



| |  |  | we are unable to develop and maintain effective, long-term relationships with existing and potential key resellers;             
| | - |  | --------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | our existing and potential key
resellers endorse solutions or technologies other than our solutions;
or                         
|
| |  |  | our existing and potential key resellers do not have or do not
devote the resources necessary to effectively sell our solutions.

Because our relationships with our existing resellers are relatively new
and unproven, we cannot predict the degree to which these resellers will
succeed in marketing and selling our solutions. Many of our existing and
potential resellers have similar, and often more established, relationships
with our competitors. In addition, due to the uncertainty created by the
merger, these existing resellers may decide to defer or cancel purchasing or
partnership decisions. Our existing and potential resellers, many of which
have significantly greater resources than we have, may in the future market
solutions that compete with our solutions or reduce or discontinue their
relationships with us or their support of our solutions.

If we do not retain our key employees and management team, our ability to
execute our business strategy will be limited.

If the merger is not completed, our future performance will depend largely
on the efforts of our key technical, sales, customer support and managerial
personnel and on our ability to retain them. In addition, if the merger is not
completed, our ability to execute

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our business strategy will depend on our ability to recruit additional
experienced management personnel and to retain our existing executive officers.
Our key employees are not obligated to continue their employment with us and
could leave at any time. Our key employees may experience uncertainty about
their future role with Secure until Secures strategies with regard to us are
announced and, as a result, we may have more difficulty in retaining them
pending completion or termination of the merger. We have announced severance
and other compensation arrangements designed to minimize the effects of the
merger on our employee retention. However, if these measures are ineffective
and we are unable to retain these key employees and executive officers, our
financial performance could be harmed due to our lack of capacity. We could
also experience deterioration in service levels or decreased customer
satisfaction.

Competition for qualified personnel in the software and technology markets
is particularly intense. Many of the companies we compete against for
experienced personnel have greater resources than we do. In addition, due to
the trading prices of our common stock and our delisting from the Nasdaq
National Market, our employees may perceive our equity incentives such as stock
options as less attractive. In that case, our ability to attract or retain
employees may be adversely affected and we may be required to increase the
level of cash compensation paid to existing and new employees, which could
materially increase our operating expenses.

If we do not expand our international operations and successfully overcome the
risks inherent in international business activities, the growth of our business
will be limited.

We currently have very limited international operations. If the merger is
not completed, to be successful in the long term, we must continue to expand
our international operations and enter new international markets. If we do
expand internationally, it will require significant management attention and
financial resources to develop sales and support channels. Even if we
successfully develop these channels, we may be unable to maintain or increase
international market demand for our solutions. In addition, our international
operations are subject to a number of risks inherent in international business
activities, including:



| |  |  | the cost and challenges of customizing services for local markets and foreign languages;                                                                                       
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | laws and business practices favoring local competitors;                                                                                                                        
|
| |  |  | dependence on local staff and vendors;                                                                                                                                         
|
| |  |  | compliance with multiple, conflicting and changing governmental
laws and regulations, including tax laws and regulations;                                                      
|
| |  |  | longer sales cycles;                                                                                                                                                           
|
| |  |  | possible delays or greater difficulty in accounts receivable collection;                                                                                                       
|
| |  |  | import and export restrictions and tariffs;                                                                                                                                    
|
| |  |  | exposure to foreign currency exchange rate fluctuations;                                                                                                                       
|
| |  |  | reduced protection of intellectual property rights; and                                                                                                                        
|
| |  |  | regional, economic, cultural and political conditions,
including the direct and indirect effects of terrorist activity and
armed conflict in countries in which we do business.

If the merger is not completed and we are unable to successfully manage
these risks, our international sales growth will be limited and our results of
operations will be seriously harmed. We do not currently engage in currency
hedging activities, but may do so in the future.

We may be unable to distribute our solutions abroad due to U.S. export laws,
which could cause us to lose sales.

The encryption technology contained in our solutions is subject to U.S.
export controls. These export controls limit our ability to distribute certain
encryption technologies outside of the United States. While we take
precautions against unlawful exportation, such export inadvertently may have
occurred in the past or may occur from time to time in the future, thereby
subjecting us to potential

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liability. Future legislation or regulation may further limit the
encryption technology that we can include in our solutions. In addition,
foreign governments have import and domestic use laws and regulations that
restrict the types of permitted encryption software distributed in their
countries. Such regulations could alter the design, production, distribution,
and use of our solutions. Finally, some foreign competitors are subject to
less stringent controls on exporting their encryption technologies. As a
result, they may be able to compete more effectively than we can in U.S. and
international markets.

Rapid changes in technology and industry standards could render our solutions
unmarketable or obsolete, and we may be unable to introduce new solutions in a
timely and successful way.

If the merger is not completed, to succeed, we will have to continually
change and improve our solutions in response to rapid technological
developments and changes in operating systems and hardware, software,
communication, browser and database technologies. We may be unable to
successfully and promptly develop these new solutions or achieve and maintain
market acceptance. The development of new, technologically advanced solutions
is a complex and uncertain process that requires great innovation and the
ability to anticipate technological and market trends. Because software
development is complex, it can require long development and testing periods.

Releasing new solutions prematurely may result in quality problems, and
releasing them late may result in loss of customer confidence and market share.
Unforeseen circumstances may cause schedule delays in the introduction of new
and enhanced solutions. When we do introduce new or enhanced solutions, we may
be unable to manage the transition from the older solutions and may be forced
to continue to support the older solutions at increased cost. In particular,
our education customers often have older technical environments, which require
us to maintain solutions that operate on multiple platforms.

If we delay release of our new solutions, or if these solutions fail to
achieve market acceptance when released, it could harm our reputation and our
ability to attract and retain customers. As a result, our revenues may
decline. In addition, customers may defer or forego purchases of our solutions
if we, or our competitors, introduce or announce new solutions or solution
enhancements.

Many of our solutions depend on third-party software or hardware.

Many of our solutions depend on third-party software or hardware
providers, including our solutions that run on Microsoft ISA, Microsoft Proxy
II, Novell Excelerator, Novell Border Manager, Cisco PIX Firewall, Cisco
Content Engine, and Check Point Firewall-1. We depend on these third parties
abilities to deliver and support reliable products, enhance their current
products, develop new products on a timely basis and respond to emerging
industry standards and other technological changes. If any of these third
parties cease production of these products, change the design of their product
such that it becomes incompatible with our solutions, delay the launch of
future products or open their proprietary interface to the public, we could
lose sales and could incur additional costs to design around the
incompatibility.

We may be unable to adequately protect our proprietary rights, which may limit
our ability to compete effectively.

Intellectual property is critical to our success, and we rely upon
trademark, copyright and trade secret laws in the United States and other
jurisdictions to protect our proprietary technology and brands. We rely
primarily on United States trade secret and copyright law to protect our
proprietary search technology. We also protect our proprietary rights through
the use of intellectual property agreements with employees and consultants,
which cover confidentiality, nondisclosure, and assignment of invention
matters. Some of our former employees and consultants who may have had access
to our proprietary information have not entered into these intellectual
property agreements, although we believe that all intellectual property that is
material to our business is covered by signed agreements. If we are incorrect
in this assessment, our business could be harmed.

Despite our efforts to protect our proprietary rights, unauthorized
parties may copy aspects of our solutions and obtain and use information that
we regard as proprietary. Other parties may breach confidentiality agreements
and other protective contracts we have entered into, and we may not become
aware of, or have adequate remedies in the event of, any breach. Trademark,
copyright, and trade secret protection may not be available to us in every
country in which our solutions are available. In addition, the laws of some
foreign countries may not be as protective of intellectual property rights as
United States laws, and mechanisms for enforcement of intellectual property
rights may be inadequate.

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Intellectual property claims and litigation could subject us to significant
liability for damages and result in invalidation of our proprietary rights.

In the future, we may have to resort to litigation to protect our
intellectual property rights or to determine the validity and scope of the
proprietary rights of others. In particular, we expect that as competition in
the market for Internet filtering and monitoring solutions increases and as the
number of patents relating to these solutions continues to increase, the
potential for patent infringement claims against us will increase. Any
litigation, regardless of its success, would likely result in significant
expense to us and divert the efforts of our management and development
personnel. In the event of an adverse result, we could be required to do one
or more of the following:



| |  |  | pay substantial damages, including treble damages;                                                                                                                                                                   
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | permanently cease use of any technology determined to be infringing;                                                                                                                                                 
|
| |  |  | obtain a license for the technology, which may be on unfavorable terms; or                                                                                                                                           
|
| |  |  | attempt to redesign our filtering and monitoring solutions to
avoid the infringement or to develop non-infringing technology, which
we might not be able to do at an acceptable price, in a timely
fashion or at all.

Our solutions may suffer from defects or errors, which could result in loss of
revenues, delayed or limited market acceptance of our solutions, increased
costs and damage to our reputation.

Complex software solutions such as ours frequently contain errors or
defects, especially when first introduced or when new versions are released.
Our customers are particularly sensitive to such defects and errors because
they rely on our solutions for providing a content-safe Internet environment.
Any significant defects or errors in our solutions may result in loss of
revenues or delay in market acceptance, diversion of development resources,
negative publicity, damage to our reputation or legal claims. Although our
agreements with customers typically contain provisions designed to limit
exposure to potential legal liability, these limitation of liability provisions
may not be completely effective. We have not experienced any liability claims
to date, but we cannot assure you that we will not face this type of claim in
the future. We maintain errors and omissions insurance, but we cannot assure
you that this insurance coverage will adequately cover us for any claims.

Our solutions may be vulnerable to security risks or service disruptions that
could harm our business.

Our servers are vulnerable to physical or electronic break-ins and service
disruptions, which could lead to interruptions, delays, loss of data or the
inability to process user requests. Such events could severely damage our
ability to service existing customers and activate new customers, and would be
very expensive to remedy and could damage our reputation, thereby discouraging
existing and potential customers from using our solutions. In the past we have
experienced unsuccessful attempts at electronic break-ins, but we may
experience successful break-ins in the future. Any such events could harm our
business.

We have an Internet hosting agreement with a third-party hosting provider
who houses the majority of our servers. Our network operations center is
situated at the hosting provider in a single geographic location, and not all
systems within this location are redundant. Our operations depend on the
hosting providers ability to protect our systems against damage from fire,
earthquake, power loss, flood, telecommunications failures, vandalism and other
malicious acts, and similar unexpected adverse events. Any major disruption in
our solutions could take a substantial amount of time to remedy, and could
diminish revenues, decrease customer and user confidence in our solutions and
limit the growth of our business.

If the use of the Internet in education and business does not grow, demand for
our solutions will be limited.

The success of our solutions in the education market will depend, in large
part, on the continued broad use and acceptance of the Internet as a source of
information in educational settings. Schools, teachers and parents may cease
to consider the Internet a viable research tool due to concerns over the
potential exposure of students to unsuitable material, even with filtering and
monitoring solutions such as ours, or because of inadequate development of
telecommunications and networking systems. Similarly, we are uncertain of the
extent to which businesses will use the Internet as a means of communication
and commerce and whether the market for Internet filtering and monitoring
solutions will continue to develop.

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The Internet could lose its viability due to delays in the development or
adoption of new standards and protocols to handle increased levels of Internet
activity or due to increased governmental regulation. Cutbacks in technology
funding could also limit use of the Internet in schools. If the necessary
Internet infrastructure and complementary products are not developed on a
timely basis, or if school and business use of the Internet experiences a
significant decline, demand for our solutions may be limited.

You may be unable to resell your shares at or above the price at which you
purchased them, and our stock price may be volatile.

Our common stock has traded on the Over-The-Counter Bulletin Board, or
OTC-BB, under the symbol NTWO.OB since March 21, 2002, after we were delisted
because we failed to meet the continued listing requirements of the Nasdaq
National Market. The OTC-BB is not an exchange, and trading in stocks on the
OTC-BB is often more sporadic and lower in volume than that in shares on the
national exchanges. As a result, stocks trading on the OTC-BB are often
subject to price fluctuations that are unrelated, or disproportional, to the
operating performance of the companies.

The price of our common stock has historically been volatile, even before
it was delisted from Nasdaq, since our initial public offering in August 1999.
Our common stock reached a high of $33.13 per share on December 14, 1999 and
has traded as low as $0.11 per share on various occasions, most recently on
April 10, 2003. As a result of fluctuations in the price of our common stock,
you may be unable to sell your shares at or above the price at which you
purchased them. The trading price of our common stock could be subject to
fluctuations for a number of reasons, including:



| |  |  | actual or anticipated quarterly variations in operating results;                     
| | - |  | -------------------------------------------------------------------------------------
|
| |  |  | announcements of technological innovations or new solutions by us or our competitors;
|
| |  |  | changes in analysts earning projections or recommendations;                         
|
| |  |  | our failure to meet or exceed analyst estimates;                                     
|
| |  |  | announcements of technological innovations;                                          
|
| |  |  | the introduction of new solutions;                                                   
|
| |  |  | announcements regarding developments related to the merger;                          
|
| |  |  | proprietary rights litigation or other litigation; and                               
|
| |  |  | other events or factors, many of which are beyond our control.                       

In addition, stock prices for many technology companies fluctuate widely
for reasons that may be unrelated to operating results of these companies.
These fluctuations, as well as general economic, market and political
conditions, such as national or international currency and stock market
volatility, recessions or military conflicts, may materially and adversely
affect the market price of our common stock, regardless of our operating
performance, and may result in class action securities litigation against us
which, even if unsuccessful, would be costly to defend and distracting to
management.

RISKS RELATING TO THE PROPOSED ACQUISITION BY SECURE

The value of Secure common stock received in the merger will fluctuate.

The number of shares of Secure common stock that our shareholders will
receive in the merger will be based upon a fixed exchange ratio. The market
prices of Secure common stock and our common stock at the closing of the merger
will likely vary from the market prices at the date of the merger agreement.
The trading price of Secure common stock may be affected by factors different
from or in addition to the factors affecting the trading price of our common
stock.

The variation in the market price of Secure common stock and our common
stock may be caused by a number of factors, including changes in the
businesses, operations or prospects of Secure or us, the timing of the merger,
regulatory considerations and
21Table of Contents

general market and economic conditions. The exchange ratio will not be
adjusted by Secure and us as a result of any change in the market price of
Secure common stock or our common stock between the date of the merger
agreement and the date our shareholders receive shares of Secure common stock
in exchange for shares of our common stock. Accordingly, if the market value
of Secure common stock declines prior to the time the merger is completed, the
value of the merger consideration to be received by our shareholders will
decline.

Integration of our operations with those of Secure will be complex, costly and
time-consuming, and Secure may not realize all of the anticipated benefits of
the merger.

If the merger is completed, all holders of outstanding N2H2 shares (other
than shareholders who validly perfect dissenters rights under Washington law)
immediately prior to the merger will become holders of Secure common stock.
Neither we nor Secure can assure you that the integration of us with Secure
will result in the realization of the full benefits anticipated by Secure to
result from the merger.

The success of the merger will depend, in part, on the ability of Secure
to realize the anticipated opportunities, synergies and cost savings from
integrating the two businesses. Secures success in realizing these benefits
in a timely fashion depends upon the successful integration of our operations
with the operations of Secure. The integration of two independent companies is
a complex, costly and time-consuming process. The difficulties of combining
the operations of the companies include, among others:



| |  |  | consolidating research and development, manufacturing and distribution operations;                    
| | - |  | ------------------------------------------------------------------------------------------------------
|
| |  |  | coordinating sales and marketing functions;                                                           
|
| |  |  | consolidating administrative and corporate infrastructures;                                           
|
| |  |  | preserving research and development, distribution and marketing efforts;                              
|
| |  |  | consolidating promotion, vendor, partner, customer and other important relationships of Secure and us;
|
| |  |  | retaining key employees and integrating personnel;                                                    
|
| |  |  | minimizing the diversion of managements attention from ongoing business concerns;                    
|
| |  |  | minimizing the disruption of the ongoing business; and                                                
|
| |  |  | coordinating geographically separate organizations.                                                   

Failure to overcome these risks or any other problems encountered in
connection with the merger could slow the growth of Secure or lower the quality
of its services, which could reduce customer demand and have a negative impact
upon the price of the Secure common stock that our shareholders receive in the
merger.

The price of Secure common stock may be affected by factors different from
those affecting the price of our common stock.

Upon completion of the merger, holders of our common stock will become
holders of Secure common stock. Secures results of operations and business,
as well as the trading price of Secure common stock, may be affected by factors
different from or in addition to those affecting our results of operations and
business and the price of our common stock.

Failure to complete the merger could negatively impact the price of our common
stock and our future business and operations.

If the merger is not completed for any reason, we will be subject to a
number of risks that may affect the price of our common stock and our future
business and operations, including:



| |  |  | we could be required to pay Secure an $800,000 termination fee,
plus, in some cases, Secures expenses of the merger up to a maximum
of $350,000;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------

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| |  |  | the market price of shares of our common stock may decline to
the extent that the current market price reflects a market assumption
that the merger will be completed;                                                                                                                                           
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | costs related to the merger, including legal and accounting
fees, as well as a portion of the fees of Updata Capital, Inc., our
financial advisor, must be paid even if the merger is not completed;
and                                                                                                         
|
| |  |  | the diversion of management attention from our day-to-day
business and the unavoidable disruption to our employees and our
relationships with customers and partners during the period before
consummation of the merger may make it difficult for us to regain our
market position if the merger does not occur.

If the merger agreement is terminated and our board of directors seeks
another merger or business combination, we may be unable to find another
company willing to pay an equivalent or more attractive price than the price to
be paid by Secure in the merger.

The termination fee and the voting agreements may discourage other companies
from trying to acquire us.

In the merger agreement, we have agreed to pay a termination fee of
$800,000 plus, in some cases, expenses of up to $350,000, to Secure in
specified circumstances. In addition, all of our directors and executive
officers, who beneficially own an aggregate of approximately 32% of the our
common stock outstanding on the record date, have entered into agreements with
Secure whereby they have agreed to vote their shares in favor of approval of
the merger agreement and against any competing transaction. These agreements
could discourage other companies from trying to acquire us even though those
other companies might be willing to offer greater value to our shareholders
than Secure has offered in the merger agreement.




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 subsidiary. We have not hedged our translation
risk on these assets and liabilities. 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 amount of cash equivalents and investments at June 30, 2003 are
reasonable approximations of the fair value. As a result, we believe that the
market risk arising from our holdings of financial instruments is minimal.




ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures

The term disclosure controls and procedures is defined in Rules
13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, or the Exchange
Act. These rules refer to the controls and other procedures of a company that
are designed to ensure that the information required to be disclosed by a
company in the reports that it files or submits under the Exchange Act is
recorded, processed, summarized and reported within required time periods.
Disclosure controls and procedures include, without limitation, controls and
procedures designed to ensure that information required to be disclosed in our
Exchange Act reports is accumulated and communicated to management, including
our chief executive officer and chief financial officer, as appropriate to
allow timely decisions regarding required disclosure.

Our chief executive officer and our chief financial officer have evaluated
the effectiveness of our disclosure controls and procedures as of the end of
the period covered by this quarterly report, and they have concluded that, as
of that date, our disclosure controls and procedures were effective.

Changes in internal controls

There were no significant changes in our internal controls, or to our
knowledge, in other factors that have materially affected, or are reasonably
likely to materially affect, our disclosure controls and procedures subsequent
to the end of the period covered by this quarterly report.

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PART IIOTHER INFORMATION




ITEM 1. LEGAL PROCEEDINGS

On July 25, 2002, Benjamin Edelman filed suit against us in the U.S.
District Court for the District of Massachusetts. Mr. Edelman is purportedly a
computer researcher who desired to conduct a quantitative analysis of the
accuracy and comprehensiveness of our Bess and Sentian Internet filtering
and monitoring solutions. He sought a declaratory judgment not to be held
liable for breach of certain provisions of the license agreement as a result of
his proposed activities. In addition, Mr. Edelman sought a declaration that he
would not be prosecuted for violations of the Copyright Act of 1976, the
Digital Millennium Copyright Act, or laws protecting trade secrets if he were
to conduct his proposed analysis. Finally, Mr. Edelman sought to enjoin us
from initiating litigation against him on the basis of his proposed activities.
We filed a Motion to Dismiss this action, which was granted. Judgment was
entered in our favor on April 17, 2003. Mr. Edelman did not appeal.




ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

Not Applicable.




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      |  | Howard Philip Welt Employment Agreement dated May 18, 2003 between
Howard Philip Welt, Chief Executive Officer, and the registrant.                                                             
| |    |  | 10.2      |  | Change in Control Agreement executed March 26, 2003 between J. Paul
Quinn, Chief Financial Officer, and the registrant.                                                                         
| |    |  | 31.1      |  | Certification of Chief Executive Officer required by Rule 13a-14(a)
or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.                                                       
| |    |  | 31.2      |  | Certification of Chief Financial Officer required by Rule 13a-14(a)
or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.                                                       
| |    |  | 32.1      |  | Certification of Chief Executive Officer and Chief Financial Officer
required by Rule 13a-14(b) or Rule 15d-14(b) of the Securities
Exchange Act of 1934, as amended and 18 U.S.C. Section 1350.



| | b) |  | Reports on Form 8-K.                                                                                                                                                                                                                   
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |    |  | No reports on Form 8-K were filed during the quarter ended June 30,
2003. On April 24, 2003 we furnished a report on Form 8-K with
respect to our announcement of our financial operating results for
the quarter ended March 31, 2003.

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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 13, 2003 |  | By:        |  | /s/     Howard P. WeltHoward P. Welt
President and Chief Executive Officer
(principal executive officer)                                          
|                      
|Dated: August 13, 2003 |  | By:        |  | /s/     J. Paul QuinnJ. Paul Quinn
Vice President   Chief Financial Officer,
Secretary and Treasurer
(principal financial and accounting officer)

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EXHIBIT INDEX

|        |  |                                                                                                                                                                                                 
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT |  |                                                                                                                                                                                                 
|NO.     |  |                                                                                                                                                                                                 
|10.1    |  | Howard Philip Welt Employment Agreement dated May 18, 2003
between Howard Philip Welt, Chief Executive Officer, and
the registrant.                                                             
|10.2    |  | Change in Control Agreement executed March 26, 2003 between
J. Paul Quinn, Chief Financial Officer, and the registrant.                                                                         
|31.1    |  | Certification of Chief Executive Officer required by Rule
13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act
of 1934, as amended.                                                       
|31.2    |  | Certification of Chief Financial Officer required by Rule
13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act
of 1934, as amended.                                                       
|32.1    |  | Certification of Chief Executive Officer and Chief
Financial Officer required by Rule 13a-14(b) or Rule
15d-14(b) of the Securities Exchange Act of 1934, as
amended and 18 U.S.C. Section 1350.

26