##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2002

OR

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

COMMISSION FILE NUMBER 0-26825

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

WASHINGTON
(STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION)

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

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

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

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

As of May 7, 2002, the registrant had outstanding 22,089,327 shares of
common stock, no par value.





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TABLE OF CONTENTS



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



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##### Table of Contents



N2H2, INC.

TABLE OF CONTENTS

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

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PART IFINANCIAL INFORMATION




ITEM 1. FINANCIAL STATEMENTS




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

|                                                  |                                                                                                                      |                                  |                                            |         |           |       |               |         |       |        | 
|------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------- | -------------------------------- | ------------------------------------------ | ------- | --------- | ----- | ------------- | ------- | ----- | ------ | 
|                                                  |                                                                                                                      |                                  |                                            |         | March 31, |       | September 30,
|                                                  |                                                                                                                      |                                  |                                            |         | 2002      |       | 2001         
|                                                  |                                                                                                                      |                                  |                                            |         |           |       |              
|ASSETS:                                           |                                                                                                                      |                                  |                                            |         |           |       |               |        
|Current assets:                                   |                                                                                                                      |                                  |                                            |         |           |       |               |        
|                                                  | Cash and cash equivalents                                                                                            |                                  | $                                          | 3,585   |           |       | $             | 5,979   |      
|                                                  | Restricted cash and cash equivalents                                                                                 |                                  |                                            | 675     |           |       |               | 675     |      
|                                                  | Accounts receivable, net of allowances                                                                               |                                  |                                            | 748     |           |       |               | 2,066   |      
|                                                  | Prepaid expenses and other current assets                                                                            |                                  |                                            | 430     |           |       |               | 774     |      
|                                                  |                                                                                                                      |                                  |                                            |         |           |       |               |         |       |        | 
|                                                  |                                                                                                                      | Total current assets             |                                            |         | 5,438     |       |               |         | 9,494 |       
|Property and equipment, net                       |                                                                                                                      |                                  | 2,137                                      |         |           |       | 3,136         |        
|Other assets                                      |                                                                                                                      |                                  | 140                                        |         |           |       | 140           |        
|                                                  |                                                                                                                      |                                  |                                            |         |           |       |               |         |       |        | 
|                                                  |                                                                                                                      |                                  | Total assets                               |         | $         | 7,715 |               |         | $     | 12,770 | 
|                                                  |                                                                                                                      |                                  |                                            |         |           |       |               |         |       |        | 
|LIABILITIES AND SHAREHOLDERS EQUITY:             |                                                                                                                      |                                  |                                            |         |           |       |               |        
|Current liabilities:                              |                                                                                                                      |                                  |                                            |         |           |       |               |        
|                                                  | Accounts payable                                                                                                     |                                  | $                                          | 294     |           |       | $             | 807     |      
|                                                  | Accrued payroll & benefits                                                                                           |                                  |                                            | 434     |           |       |               | 738     |      
|                                                  | Other accrued liabilities                                                                                            |                                  |                                            | 337     |           |       |               | 342     |      
|                                                  | Deferred revenue                                                                                                     |                                  |                                            | 4,820   |           |       |               | 6,136   |      
|                                                  | Note Payable                                                                                                         |                                  |                                            | 6       |           |       |               | 42      |      
|                                                  | Current portion of capital lease obligations                                                                         |                                  |                                            | 120     |           |       |               | 203     |      
|                                                  |                                                                                                                      |                                  |                                            |         |           |       |               |         |       |        | 
|                                                  |                                                                                                                      | Total current liabilities        |                                            |         | 6,011     |       |               |         | 8,268 |       
|                                                  |                                                                                                                      |                                  |                                            |         |           |       |               |         |       |        | 
|Deferred revenue                                  |                                                                                                                      |                                  | 952                                        |         |           |       | 1,296         |        
|Capital lease obligations, net of current portion |                                                                                                                      |                                  |                                           |         |           |       | 29            |        
|                                                  |                                                                                                                      |                                  |                                            |         |           |       |               |         |       |        | 
|                                                  |                                                                                                                      |                                  | Total liabilities                          |         |           | 6,963 |               |         |       | 9,593  | 
|                                                  |                                                                                                                      |                                  |                                            |         |           |       |               |         |       |        | 
|Shareholders equity:                             |                                                                                                                      |                                  |                                            |         |           |       |               |        
|                                                  | Preferred stock, no par value; 50,000 shares authorized                                                              |                                  |                                            |         |           |       |               |         |      
|                                                  |                                                                                                                      | No shares issued and outstanding |                                            |         |          |       |               |         |      |       
|                                                  | Common stock, no par value; 250,000 shares authorized,
22,089 and 22,060 shares issued and outstanding,
respectively |                                  |                                            | 92,173  |           |       |               | 92,166  |      
|                                                  | Notes receivable from shareholders, net of allowances                                                                |                                  |                                            | (55     | )         |       |               | (48     | )    
|                                                  | Deferred stock compensation                                                                                          |                                  |                                            | (910    | )         |       |               | (2,030  | )    
|                                                  | Accumulated other comprehensive loss                                                                                 |                                  |                                            | (103    | )         |       |               | (127    | )    
|                                                  | Accumulated deficit                                                                                                  |                                  |                                            | (90,353 | )         |       |               | (86,784 | )    
|                                                  |                                                                                                                      |                                  |                                            |         |           |       |               |         |       |        | 
|                                                  |                                                                                                                      | Total shareholders equity       |                                            |         | 752       |       |               |         | 3,177 |       
|                                                  |                                                                                                                      |                                  |                                            |         |           |       |               |         |       |        | 
|                                                  |                                                                                                                      |                                  | Total liabilities and shareholders equity |         | $         | 7,715 |               |         | $     | 12,770 | 
|                                                  |                                                                                                                      |                                  |                                            |         |           |       |               |         |       |        | 

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

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

|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |       |       |        |       |  
|----------------------------------------------------- | --------------------------------------- | ------------------------------------------------ | ------------------------ | ------------------ | ----- | ------------------ | ------- | ---------------- | ----- | ----- | ------ | ----- | ----- | ----- | ------- | ----- | ----- | ------ | ----- | -
|                                                      |                                         |                                                  |                          |                    |       | THREE MONTHS ENDED |         | SIX MONTHS ENDED
|                                                      |                                         |                                                  |                          |                    |       | March 31,          |         | March 31,       
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                 
|                                                      |                                         |                                                  |                          |                    |       | 2002               |         | 2001             |       | 2002  |        | 2001 
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |      
|Revenues:                                             |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|                                                      |                                         | Internet filtering and consulting services       |                          | $                  | 2,672 |                    |         | $                | 1,772 |       |        | $     | 5,565 |       |         | $     | 3,955 |       
|                                                      |                                         | Advertising                                      |                          |                    |      |                    |         |                  | 118   |       |        |       |      |       |         |       | 420   |       
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|                                                      |                                         |                                                  | Total Revenues           |                    |       | 2,672              |         |                  |       | 1,890 |        |       |       | 5,565 |         |       |       | 4,375  |      
|Operating expenses:                                   |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|                                                      |                                         | Internet filtering services and customer support |                          |                    | 829   |                    |         |                  | 1,515 |       |        |       | 1,675 |       |         |       | 3,002 |       
|                                                      |                                         | Educational content and advertising costs        |                          |                    |      |                    |         |                  | 56    |       |        |       |      |       |         |       | 669   |       
|                                                      |                                         | Sales and marketing                              |                          |                    | 1,861 |                    |         |                  | 3,673 |       |        |       | 3,660 |       |         |       | 7,731 |       
|                                                      |                                         | General and administrative                       |                          |                    | 883   |                    |         |                  | 1,644 |       |        |       | 1,868 |       |         |       | 3,114 |       
|                                                      |                                         | Research and development                         |                          |                    | 451   |                    |         |                  | 1,088 |       |        |       | 888   |       |         |       | 2,104 |       
|                                                      |                                         | Depreciation and amortization                    |                          |                    | 510   |                    |         |                  | 1,226 |       |        |       | 1,044 |       |         |       | 2,492 |       
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|                                                      |                                         |                                                  | Total operating expenses |                    |       | 4,534              |         |                  |       | 9,202 |        |       |       | 9,135 |         |       |       | 19,112 |      
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|Loss from operations                                  |                                         |                                                  | (1,862                   | )                  |       |                    | (7,312  | )                |       |       | (3,570 | )     |       |       | (14,737 | )    
|Interest income, net                                  |                                         |                                                  | 26                       |                    |       |                    | 138     |                  |       |       | 70     |       |       |       | 381     |      
|Loss on disposal of property and equipment            |                                         |                                                  | (68                      | )                  |       |                    | (15     | )                |       |       | (69    | )     |       |       | (171    | )    
|Impairment of investment                              |                                         |                                                  |                         |                    |       |                    | (3,000  | )                |       |       |       |       |       |       | (3,000  | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|Loss before change in accounting policy               |                                         |                                                  | (1,904                   | )                  |       |                    | (10,189 | )                |       |       | (3,569 | )     |       |       | (17,527 | )    
|Cumulative effect of change in accounting policy      |                                         |                                                  |                         |                    |       |                    |        |                  |       |       |       |       |       |       | (3,554  | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|Net loss                                              |                                         | $                                                | (1,904                   | )                  |       | $                  | (10,189 | )                |       | $     | (3,569 | )     |       | $     | (21,081 | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|Foreign currency translation gain (loss)              |                                         |                                                  |                         |                    |       |                    | (104    | )                |       |       | 24     |       |       |       | (88     | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|Comprehensive loss                                    |                                         | $                                                | (1,904                   | )                  |       | $                  | (10,293 | )                |       | $     | (3,545 | )     |       | $     | (21,169 | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|Basic and diluted net loss per share:                 |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|                                                      | Loss before change in accounting policy |                                                  | $                        | (0.09              | )     |                    | $       | (0.47            | )     |       | $      | (0.16 | )     |       | $       | (0.81 | )    
|                                                      | Effect of change in accounting policy   |                                                  |                          |                   |       |                    |         |                 |       |       |        |      |       |       |         | (0.16 | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|                                                      |                                         |                                                  |                          | Net loss per share |       | $                  | (0.09   | )                |       | $     | (0.47  | )     |       | $     | (0.16   | )     |       | $      | (0.97 | )
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      
|Basic and diluted weighted average shares
outstanding |                                         |                                                  | 21,798                   |                    |       |                    | 21,459  |                  |       |       | 21,761 |       |       |       | 21,714  |      
|                                                      |                                         |                                                  |                          |                    |       |                    |         |                  |       |       |        |       |       |       |         |      

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)

|                                                                            |                                                       |                                              |        |                 |        |      |         |     |         |  
|--------------------------------------------------------------------------- | ----------------------------------------------------- | -------------------------------------------- | ------ | --------------- | ------ | ---- | ------- | --- | ------- | -
|                                                                            |                                                       |                                              |        | SIX MONTHS     
|                                                                            |                                                       |                                              |        | ENDED MARCH 31,
|                                                                            |                                                       |                                              |        |                
|                                                                            |                                                       |                                              |        | 2002            |        | 2001
|                                                                            |                                                       |                                              |        |                 |        |     
|Cash flows from operating activities:                                       |                                                       |                                              |        |                 |        |      |         |    
|Net loss                                                                    |                                                       | $                                            | (3,569 | )               |        | $    | (21,081 | )  
|Adjustments to reconcile net loss to net cash used by operating activities: |                                                       |                                              |        |                 |        |      |         |    
|                                                                            |                                                       | Depreciation and amortization                |        |                 | 1,044  |      |         |     | 2,492   |  
|                                                                            |                                                       | Amortization of deferred stock compensation  |        |                 | 1,119  |      |         |     | 2,548   |  
|                                                                            |                                                       | Change in accounting policy                  |        |                 | (540   | )    |         |     | 2,018   |  
|                                                                            |                                                       | Loss on disposal of property and equipment   |        |                 | 69     |      |         |     | 171     |  
|                                                                            |                                                       | Impairment of investment                     |        |                 |        |      |         |     | 3,000   |  
|                                                                            |                                                       | Shareholder loans forgiven                   |        |                 |       |      |         |     | 73      |  
|                                                                            |                                                       | Interest on shareholder loans                |        |                 | (7     | )    |         |     | (47     | )
|Changes in operating assets and liabilities:                                |                                                       |                                              |        |                 |        |      |         |    
|                                                                            |                                                       | Accounts receivable                          |        |                 | 1,318  |      |         |     | 1,073   |  
|                                                                            |                                                       | Prepaid expenses and other current assets    |        |                 | 344    |      |         |     | 634     |  
|                                                                            |                                                       | Other assets                                 |        |                 |       |      |         |     | (14     | )
|                                                                            |                                                       | Accounts payable                             |        |                 | (513   | )    |         |     | (1,154  | )
|                                                                            |                                                       | Accrued liabilities                          |        |                 | (309   | )    |         |     | (127    | )
|                                                                            |                                                       | Deferred revenue                             |        |                 | (1,120 | )    |         |     | 1,344   |  
|                                                                            |                                                       |                                              |        |                 |        |      |         |    
|Net cash used by operating activities:                                      |                                                       |                                              | (2,164 | )               |        |      | (9,070  | )  
|                                                                            |                                                       |                                              |        |                 |        |      |         |    
|Cash flows from investing activities:                                       |                                                       |                                              |        |                 |        |      |         |    
|                                                                            |                                                       | Maturities of investments                    |        |                 |       |      |         |     | 21,191  |  
|                                                                            |                                                       | Purchases of investments                     |        |                 |       |      |         |     | (13,100 | )
|                                                                            |                                                       | Additions to property and equipment          |        |                 | (125   | )    |         |     | (1,106  | )
|                                                                            |                                                       | Proceeds from sale of property and equipment |        |                 | 12     |      |         |     | 18      |  
|                                                                            |                                                       |                                              |        |                 |        |      |         |    
|Net cash (used in) provided by investing activities                         |                                                       |                                              | (113   | )               |        |      | 7,003   |    
|                                                                            |                                                       |                                              |        |                 |        |      |         |    
|Cash flows from financing activities:                                       |                                                       |                                              |        |                 |        |      |         |    
|                                                                            |                                                       | Issuance of common stock                     |        |                 | 6      |      |         |     | 4       |  
|                                                                            |                                                       | Exercise of stock options                    |        |                 | 1      |      |         |     | 53      |  
|                                                                            |                                                       | Payments under capital lease obligations     |        |                 | (112   | )    |         |     | (88     | )
|                                                                            |                                                       | Repayments of notes payable                  |        |                 | (36    | )    |         |     | (793    | )
|                                                                            |                                                       |                                              |        |                 |        |      |         |    
|Net cash used by financing activities                                       |                                                       |                                              | (141   | )               |        |      | (824    | )  
|                                                                            |                                                       |                                              |        |                 |        |      |         |    
|                                                                            |                                                       | Effects of exchange rate changes             |        |                 | 24     |      |         |     | (88     | )
|                                                                            |                                                       |                                              |        |                 |        |      |         |    
|Net decrease in cash                                                        |                                                       |                                              | (2,394 | )               |        |      | (2,979  | )  
|Cash, beginning of period                                                   |                                                       |                                              | 5,979  |                 |        |      | 7,993   |    
|                                                                            |                                                       |                                              |        |                 |        |      |         |    
|Cash, end of period                                                         |                                                       | $                                            | 3,585  |                 |        | $    | 5,014   |    
|                                                                            |                                                       |                                              |        |                 |        |      |         |    
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION                            |                                                       |                                              |        |                 |        |      |         |    
|                                                                            | Cash paid for interest                                |                                              | $      | 8               |        |      | $       | 116 |        
|                                                                            |                                                       |                                              |        |                 |        |      |         |    
|                                                                            | Stock received for notes receivable from shareholders |                                              | $      |                |        |      | $       | 645 |        
|                                                                            |                                                       |                                              |        |                 |        |      |         |    

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
six-month periods ended March 31, 2002 are not necessarily indicative of
results to be expected for a full year. The information included in this Form
10-Q should be read in conjunction with Managements Discussion and Analysis
and financial statements and notes thereto included in the Companys annual
report on Form 10-K for the year ended September 30, 2001 as filed with the
Securities and Exchange Commission on December 26, 2001.

The Company has experienced significant net operating losses since
inception. In fiscal 2001, the Company incurred operating losses of $28.7
million and used $12.3 million of cash in its operating activities. Management
expects that operating losses will continue through fiscal 2002 as the Company
continues to develop its product offerings and customer base. Management
expects that negative cash flows will continue at least through the third
quarter of fiscal 2002. If the Company fails to develop revenues from new
products and expand its customer base, it will require additional debt or
equity financing to continue its operations beyond twelve months from the date
of this filing. Such financing may not be available on acceptable terms or at
all.

Effective March 21, 2002, the Companys common stock began trading on the
Over-The-Counter Bulletin Board under the symbol NTWO. On March 20, 2002,
the Company received notification from the Nasdaq National Market that the
Companys common stock would be delisted from Nasdaq effective at opening of
the market on March 21, 2002 for failure to meet Nasdaq listing requirements as
set forth in Marketplace Rule 4450(a)(3). The delisting may have a material
adverse affect on the liquidity of the shares held by the Companys
shareholders, and may restrict the Companys ability to raise additional
capital.

Principles of Consolidation

The consolidated financial statements include the accounts of N2H2, Inc.
and its wholly owned subsidiaries, N2H2, Ltd. and N2H2 Pty Limited (formerly
Iseek Pty Limited). 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 from its filtering, Internet
management, and content delivery services. These primarily consist of filtering
subscriptions, installation fees, maintenance fees and historically,
advertising.

Subscription revenues represent the fees associated with the right to use
the Companys software and/or hardware, and access to filtering updates.
Subscription revenues are recognized over the life of the subscription
contract. Subscription sales billed in advance of services provided are
recorded as deferred revenue.

Installation revenues represent fees associated with the customization and
installation of the Companys software on customer servers. Installation
revenues are recognized over the expected life of the customer relationship in
accordance with Staff Accounting Bulletin No. 101, Revenue Recognition in
Financial Statements.

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Maintenance revenues represent fees associated with technical support
services provided to customers. Maintenance revenues are recognized over the
life of the maintenance contract. Maintenance contracts billed in advance of
services provided are recorded as deferred revenue.

Advertising revenue contracts based on the number of impressions displayed
or click-throughs provided were recognized as services were rendered. All
contracts with advertisers were concluded or cancelled during fiscal 2001.

Reclassifications

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

2. NET LOSS PER SHARE

Basic net loss per share is computed on the basis of the weighted average
number of common shares outstanding, and excludes restricted shares of 170,596
and 379,104 at March 31, 2002 and March 31, 2001, respectively. Diluted net
loss per share includes common equivalent shares during the period, if
dilutive. As the Company had a net loss in each of the periods presented, basic
and diluted net loss per share are the same.

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

|             |                                                              |                                      |   |                                       |       |                 |   |         |       |      |   |        |       |   |   |         |       |  
|------------ | ------------------------------------------------------------ | ------------------------------------ | - | ------------------------------------- | ----- | --------------- | - | ------- | ----- | ---- | - | ------ | ----- | - | - | ------- | ----- | -
|             |                                                              |                                      |   | THREE MONTHS                          |       | SIX MONTHS     
|             |                                                              |                                      |   | ENDED MARCH 31,                       |       | ENDED MARCH 31,
|             |                                                              |                                      |   |                                       |       |                
|             |                                                              |                                      |   | 2002                                  |       | 2001            |   | 2002    |       | 2001
|             |                                                              |                                      |   |                                       |       |                 |   |         |       |     
|             |                                                              |                                      |   | (in thousands, except per share data)
|Numerator:   |                                                              |                                      |   |                                       |       |                 |   |         |       |      |   |        |       |   |   |        
|             | Net loss                                                     |                                      | $ | (1,904                                | )     |                 | $ | (10,189 | )     |      | $ | (3,569 | )     |   | $ | (21,081 | )    
|Denominator: |                                                              |                                      |   |                                       |       |                 |   |         |       |      |   |        |       |   |   |        
|             | Basic and diluted weighted average
common shares outstanding |                                      |   | 21,798                                |       |                 |   | 21,459  |       |      |   | 21,761 |       |   |   | 21,714  |      
|             |                                                              |                                      |   |                                       |       |                 |   |         |       |      |   |        |       |   |   |        
|             |                                                              | Basic and diluted net loss per share |   | $                                     | (0.09 | )               |   | $       | (0.47 | )    |   | $      | (0.16 | ) |   | $       | (0.97 | )
|             |                                                              |                                      |   |                                       |       |                 |   |         |       |      |   |        |       |   |   |        

Warrants for 539,280 shares and options for 3,015,406 shares have been
excluded from the calculation of diluted loss per share at March 31, 2002
because they are anti-dilutive. Warrants for 539,280 shares and options for
4,068,767 shares have been excluded from the calculation of diluted loss per
share at March 31, 2001 because they were 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 periods. The
adoption of SAB 101 resulted in a one-time, non-cash charge of $3.6 million on
October 1, 2000 for the cumulative effect of the change in accounting policy.
The cumulative effect was recorded as deferred revenue and is being recognized
as revenue over the remaining customer relationship periods. The amount of
related deferred revenue which was recognized as revenue during the six-month
periods ended March 31, 2002 and 2001 was $542,000 and $1,536,000,
respectively. The remainder of the related deferred revenue will be recognized
as revenue as follows: $222,000 over the remainder of fiscal 2002 and $229,000
in fiscal 2003.

4. RESTRICTED CASH AND CASH EQUIVALENTS

The Company has $675,000 in restricted cash which is pledged as collateral
for a letter of credit related to its 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.

5. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

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

In July 2001, the FASB issued Financial Accounting Standard 143 
Accounting for Asset Retirement Obligations (FAS 143). FAS 143, effective for
fiscal years beginning after June 15, 2002, addresses financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs. It applies to legal
obligations associated with the retirement of long-lived assets that result
from acquisition, construction, development, and (or) the normal operation of a
long-lived asset, except for certain obligations of lessees. The Company does
not expect the standard to have a material effect on its results of operations
or financial position.

In August 2001, the FASB issued Financial Accounting Standard 144 
Accounting for the Impairment or Disposal of Long-Lived Assets (FAS 144). FAS
144, effective for fiscal years beginning after December 15, 2001, addresses
financial accounting and reporting for the impairment or disposal of long-lived
assets. The Company does not expect the standard to have a material effect on
its results of operations or financial position.

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

FORWARD LOOKING INFORMATION

Statements made in this filing that are not historical facts are
forward-looking statements. Forward-looking statements include, but are not
limited to, statements containing the words will, should, expect, plan, intend,
anticipate, believe, estimate, predict, potential, believes or continue, the
negative of such terms or other comparable terminology. Actual results may
differ materially from those projected in any forward-looking statements. Such
forward-looking statements are subject to various known and unknown risks and
uncertainties and are therefore not a guarantee of future performance. The
potential risks and uncertainties which could cause actual results to differ
materially include, but are not limited to, the competitive nature of the
Internet filtering industry, changes in domestic or international market
conditions, the success of our brand and systems development efforts, the
absence of patent protection for our technology, the fact that others have
patented various filtering technologies, and customer acceptance of our
services, products and fee structures. Further information on the factors and
risks that could affect our business, financial condition and results of
operations are included in Part I, Item 1 to the Companys Form 10-K for the
year ended September 30, 2001, which has been filed with the Securities and
Exchange Commission and is available at http://www.sec.gov.

OVERVIEW

We are an Internet access management company, providing fast and scalable
filtering solutions that conserve bandwidth, increase user productivity, and
seek to limit potential legal liability of our customers. Our Internet
filtering is designed to enable organizations (enterprises, Internet Service
Providers (ISPs), and schools) to control costs through customizable filtering
levels that are designed to allow access to only the Web content most relevant
to their specific environment.

We have experienced significant net operating losses since our inception.
In fiscal 2001, we incurred operating losses of $28.7 million and used $12.3
million of cash in our operating activities. We expect that operating losses
will continue through fiscal 2002 as we continue to develop our product
offerings and customer base. We expect that negative cash flows will continue
at least through the third quarter of fiscal 2002. If we fail to develop
revenues from new products and expand our customer base, we will require
additional debt or equity financing to continue our operations beyond twelve
months from the date of this filing. Such financing may not be available on
acceptable terms or at all.

Effective March 21, 2002, our common stock began trading on the
Over-The-Counter Bulletin Board under the symbol NTWO. On March 20, 2002, we
received notification from the Nasdaq National Market that our common stock
would be delisted from Nasdaq effective at opening of the market on March 21,
2002 for failure to meet Nasdaq listing requirements as set forth in
Marketplace Rule 4450(a)(3). The delisting may have a material adverse affect
on the liquidity of the shares held by our shareholders, and may restrict our
ability to raise additional capital.

Our significant accounting policies are described in Note 2 to the annual
consolidated financial statements included in our Form 10-K for the year ended
September 30, 2001. We believe the following critical accounting policies
affect our more significant judgments and estimates used in the preparation of
our consolidated financial statements.

Revenue Recognition.

We derive our revenue from Internet filtering subscriptions, installation
fees, and maintenance fees. We recognize revenue from our filtering solutions
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
our software and/or hardware, and to access our filtering updates. Maintenance
revenues represent fees associated with technical support services provided to
customers. Subscription agreements and most maintenance services are evidenced
by signed contracts, which 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 contract. Invoices billed in advance of services provided
are recorded as deferred revenue. Upon expiration of the contract, customers
who wish to renew must do so at our then current rates. Our revenue growth is
significantly influenced by subscription renewals, and a decrease in renewals
could negatively impact our revenues.

Installation revenues represent one-time fees associated with the
customization and installation of our software on customer servers.
Installation services are billed upon completion and are recognized over the
expected life of the customer relationship in

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accordance with Staff Accounting Bulletin No. 101, Revenue Recognition in
Financial Statements. We estimate the expected life of our 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 we recognize these revenues.

Allowance for Doubtful Accounts.

We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. We
estimate the allowance based on a number of factors, including historical
collection and write-off experience, the overall credit-worthiness of our
customer base, the aging of our accounts receivable and current market trends.
If the financial condition of our customers were to deteriorate, additional
allowances may be required.

Deferred Tax Assets.

We have experienced significant net operating losses since inception.
These losses have generated sizeable net operating loss carry-forwards
potentially available to offset future taxable income. A full valuation
allowance has been recorded against the deferred tax assets available to us for
use in future periods to reduce these assets to the amount expected to be
realized. However, if we were to determine that we would be able to realize our
deferred tax assets in the future, an adjustment to the deferred tax assets
would increase our income in the period such determination was made.

RESULTS OF OPERATIONS  THREE MONTHS ENDED MARCH 31, 2002

Revenues

We generate our revenues from installation, subscription and maintenance
fees charged for our Internet filtering services, consulting fees.

Internet filtering and consulting services revenues increased by 51% to
$2.7 million for the quarter, compared to $1.8 million for the comparable
period in the prior fiscal year. Due to our strategic move away from the
advertising model, sales efforts during the second half of fiscal 2001 were
largely focused on converting school customers from the advertising-based
filtering model to our subscription fee-based filtering model. These
conversions have resulted in a significant increase in our subscription
contracts with education customers. In addition, our new software plug-in
filtering solutions have added to our revenue base for fiscal 2002. Further,
we began to see additional revenue from corporate customers during the quarter
due to our reseller recruitment efforts.

During fiscal 2001, we terminated our advertising-based fee structure
previously offered to schools and converted over 70% of those customers to a
fee-paying subscription model. Accordingly, advertising revenue has been
eliminated.

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, system development
and network operations, search engine services, collocation, bandwidth, and an
allocation of corporate facilities costs. Internet filtering services and
customer support costs decreased by 45% to $0.8 million for the quarter,
compared to $1.5 million for the comparable quarter in the prior fiscal year.
The decrease is primarily due to reduced level of staffing and
personnel-related expenses. In addition, we renegotiated key vendor contracts
to obtain more favorable terms. We anticipate that Internet filtering services
and customer support costs will remain materially consistent through the
remainder of the fiscal year.

Educational content and advertising costs

Educational content and advertising costs previously consisted of product
license fees and advertiser commissions. Educational content and advertising
costs have been eliminated due to the conclusion of the advertising-based
filtering model.

Sales and marketing

Sales and marketing expenses consist primarily of salaries, commissions,
stock compensation expense, trade shows, market research, corporate brand
identification, public relations, advertising and travel. Sales and marketing
also includes an allocation of corporate facilities costs.

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Sales and marketing expenses decreased by 49% to $1.9 million for the
quarter, from $3.7 million for the comparable period in the prior fiscal year.
The decrease is due in part to our reduced direct sales staffing and related
expenses, as we have shifted a large portion of our sales efforts to an
indirect sales channel in which we will leverage resellers to increase our
customer base. In addition, deferred stock compensation expense related to the
employment of two executives of N2H2 Pty Limited, our Australian sales office,
has continued to decline. With our focus channeled toward our core competencies
of filtering, monitoring, and reporting solutions, we have eliminated sales and
marketing expenditures related to non-core products. This has further
contributed to the decrease in total sales and marketing expense. We expect
sales and marketing costs to increase slightly in the upcoming quarters as we
continue to build, train, and support our reseller channel and distribute our
new Sentian FS and Bess FS filtering products.

General and administrative

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

General and administrative expenses decreased by 46% to $0.9 million for
the quarter, from $1.6 million for the comparable period in the prior fiscal
year. This decrease is primarily due to reductions in administrative staffing
and related personnel costs. In addition, we have reduced our spending on
professional services and other support functions in our continued effort to
operate within a more disciplined cost structure. We anticipate that general
and administrative expenses will remain materially consistent with second
quarter levels through the remainder of the fiscal year.

Research and development

Research and development costs consist primarily of salaries and benefits
for software developers, consulting fees and an allocation of corporate
facilities costs. Research and development activities consist primarily of
developing new products and enhancing existing products. Product costs related
to internal research and development have been expensed as incurred.

Research and development expenses decreased by 59% to $0.5 million for the
quarter, from $1.1 million for the comparable period in the prior fiscal year.
This decrease is primarily the result of our reduced level of staffing and our
reduced usage of contractors and third party service providers in the
development of our products. With our development efforts now focused on our
core filtering, monitoring, and reporting solutions, we have eliminated
research and development activities related to all non-core products. We
anticipate that research and development costs will remain materially
consistent with second quarter levels through the remainder of the fiscal year.

Depreciation and amortization

Depreciation consists of depreciation on all fixed assets and leasehold
improvements. Amortization previously consisted of amortization of technology
licenses and acquired intangible assets. Depreciation and amortization expenses
decreased by 58% to $0.5 million for the quarter, from $1.2 million for the
comparable period in the prior fiscal year. In fiscal 2001, as a result of
changes in the Companys service model, we performed an impairment test as
required by SFAS 121 and recorded a full write-down of remaining field servers,
acquired intangible assets, and technology licenses. Accordingly, no
depreciation or amortization associated with those assets was recorded in
fiscal 2002.

Interest income and expense

Interest income consists primarily of interest earned on our cash
equivalents. Interest expense consists of interest paid on our note payable
and capital leases. Net interest income has decreased by 81% to $26,000, from
$138,000 for the comparable period in the prior fiscal year. The decrease is
due to our reduced cash and investment balance. Interest expense has been
substantially eliminated due to the repayment of all of our outstanding bank
debt during fiscal 2001.

RESULTS OF OPERATIONS  SIX MONTHS ENDED MARCH 31, 2002

Revenues

Internet filtering and consulting services revenues increased by 41% to
$5.6 million for the six-month period, compared to $4.0 million for the
comparable period in the prior fiscal year. Due to our strategic move away
from the advertising model, sales efforts

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during the second half of fiscal 2001 were largely focused on converting
school customers from the advertising-based filtering model to our subscription
fee-based filtering model. These conversions have resulted in a significant
increase in our subscription contracts with education customers. In addition,
our new software plug-in filtering solutions have added to our revenue base for
fiscal 2002. Further, we began to see additional revenue from corporate
customers during the period due to our reseller recruitment efforts.

During fiscal 2001, we terminated our advertising-based fee structure
previously offered to schools and converted over 70% of those customers to a
fee-paying subscription model. Accordingly, advertising revenue has been
eliminated.

Internet filtering services and customer support costs

Internet filtering services and customer support costs decreased by 44% to
$1.7 million for the six-month period, compared to $3.0 million for the
comparable period in the prior fiscal year. The decrease is primarily due to
reduced level of staffing and personnel-related expenses. In addition, we
renegotiated key vendor contracts to obtain more favorable terms. We anticipate
that Internet filtering services and customer support costs will remain
materially consistent through the remainder of the fiscal year.

Educational content and advertising costs

Educational content and advertising costs previously consisted of product
license fees and advertiser commissions. Educational content and advertising
costs have been eliminated due to the conclusion of the advertising-based
filtering model.

Sales and marketing

Sales and marketing expenses decreased by 53% to $3.7 million for the
six-month period, from $7.7 million for the comparable period in the prior
fiscal year. The decrease is due in part to our reduced direct sales staffing
and related expenses, as we have shifted a large portion of our sales efforts
to an indirect sales channel in which we will leverage resellers to increase
our customer base. In addition, deferred stock compensation expense related to
the employment of two executives of N2H2 Pty Limited, our Australian sales
office, has continued to decline. With our focus channeled toward our core
competencies of filtering, monitoring, and reporting solutions, we have
eliminated sales and marketing expenditures related to non-core products. This
has further contributed to the decrease in total sales and marketing expense.
We expect sales and marketing costs to increase slightly in the upcoming
quarters as we continue to build, train, and support our reseller channel and
distribute our new Sentian FS and Bess FS filtering products.

General and administrative

General and administrative expenses decreased by 40% to $1.9 million for
the six-month period, from $3.1 million for the comparable period in the prior
fiscal year. This decrease is primarily due to reductions in administrative
staffing and related personnel costs. In addition, we have reduced our
spending on professional services and other support functions in our continued
effort to operate within a more disciplined cost structure. We anticipate that
general and administrative expenses will remain materially consistent through
the remainder of the fiscal year.

Research and development

Research and development expenses decreased by 58% to $0.9 million for the
six-month period, from $2.1 million for the comparable period in the prior
fiscal year. This decrease is primarily the result of our reduced level of
staffing and our reduced usage of contractors and third party service providers
in the development of our products. With our development efforts now focused
on our core filtering, monitoring, and reporting solutions, we have eliminated
research and development activities related to all non-core products. We
anticipate that research and development costs will remain materially
consistent through the remainder of the fiscal year.

Depreciation and amortization

Depreciation and amortization expenses decreased by 58% to $1.0 million
for the quarter, from $2.5 million for the comparable period in the prior
fiscal year. In fiscal 2001, as a result of changes in the Companys service
model, we performed an impairment test as required by SFAS 121 and recorded a
full write-down of remaining field servers, acquired intangible assets, and
technology licenses. Accordingly, no depreciation or amortization associated
with those assets was recorded in fiscal 2002.

Interest income and expense

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Net interest income has decreased by 82% to $70,000 for the six-month
period, from $381,000 for the comparable period in the prior fiscal year. The
decrease is due to our reduced cash and investment balance. Interest expense
has been substantially eliminated due to the repayment of all of our
outstanding bank debt during fiscal 2001.

Write-down of investment

During fiscal 2001, we recorded a $3.0 million impairment loss on a
strategic investment in a privately held company. The loss represented our
entire investment in the common stock of that company. The impairment was
recorded based on currently available financial information of the investee
company.

LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents were $4.3 million (including restricted cash of
$675,000) or 55% of total assets at March 31, 2002, compared to $6.7 million
(including restricted cash of $675,000) or 52% of total assets at September 30,
2001. 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 $2.2 million for the six-month period, compared to $9.1 million for
the comparable period of the prior fiscal year.

Investing activities consumed $113,000 during the six-month period,
primarily as a result of additions to property and equipment. Additions to
property and equipment totaled $125,000 during the period, compared to
$1,106,000 during the comparable period of the prior fiscal year. The additions
to property and equipment during the period primarily consisted of computer
equipment purchased to provide additional backup and storage capacity for
electronic data. We anticipate that only minimal purchases of equipment will be
required to support our customers, internal operations and administrative
infrastructure throughout the remainder of fiscal 2002.

Financing activities consumed $141,000 during the period, due to payments
under capital lease and note payable obligations. In addition, $675,000 of our
total cash balance is restricted and 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.

Operating expenses will continue to consume our cash resources. At recent
rates of cash consumption, our current cash and investment balance is
insufficient to sustain our operations beyond ten months from the end of the
second quarter. However, with current renewal rates, combined with the recent
launch of key new products and the progress weve made in developing our
reseller distribution channel, we anticipate that cash on hand, together with
cash generated from operations, will be sufficient to meet our cash needs for
the next twelve months. If cash generated from operations is insufficient to
satisfy our longer-term liquidity requirements, we may seek to sell additional
equity or debt securities or to obtain an additional credit facility. 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 we are unable to raise additional funds on acceptable terms when needed,
our business, financial position and results of operations would be seriously
harmed.

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 Lease  |  | $                      | 4,299,000 |        |  | $         | 1,209,000 |           |  | $       | 3,090,000 |  |  |  |  |       |  |  |  | 
|                         | Capital Leases   |  | $                      | 125,000   |        |  | $         | 125,000   |           |  |         |          |  |  |  |  |       |  |  |  | 
|Commercial Commitments:  |                  |  |                        |           |        |  |           |           |           |  |         |           |  |  |  |   |       |  |  |  
|                         | Letter of Credit |  | $                      | 665,000   |        |  |           |          |           |  | $       | 665,000   |  |  |  |  |       |  |  |  | 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk related to changes in foreign currency
exchange rates and interest rates relating to debt and investment instruments.
We have assets and liabilities denominated in certain foreign currencies
related to our international subsidiaries. We have not hedged our translation
risk on these assets and liabilities as we have the ability to hold them for an
indefinite period. We do not expect that a sudden or significant change in
foreign exchange rates would have a material impact on results of operations,
financial position or cash flows. We believe the reported amounts of cash
equivalents and capital lease obligations at March 31, 2002 are reasonable
approximations of their fair values. As a result, we believe that the market
risk arising from our holdings of financial instruments is minimal.

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PART IIOTHER INFORMATION




ITEM 1. LEGAL PROCEEDINGS

Not Applicable.




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

At September 30, 2001 the Company had remaining net proceeds from its
initial public offering of $6.2 million. During the six-months ended March 31,
2002, the Company used $2.2 million to fund its operating loss, leaving
remaining net proceeds of $4.0 million.




ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not Applicable.




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

The Company held its Annual Shareholders Meeting on March 14, 2002 at
which time the shareholders voted on the following proposals:



|(1) |  | To elect two Class II directors for a three-year term:
|--- |  | ------------------------------------------------------

|                   |  |                  |            |          |  |  |         | 
|------------------ |  | ---------------- | ---------- | -------- |  |  | ------- | 
|                   |  | Number of Shares
|                   |  |                 
|Name of Candidate  |  | For              |            | Withheld
|                   |  |                  |            |         
|Mark A. Segale     |  |                  | 17,307,204 |          |  |  | 157,706 | 
|Howard Philip Welt |  |                  | 17,312,539 |          |  |  | 152,371 | 

The aforesaid nominees have been elected as Directors for the term set
forth above.



|(2) |  | To approve an amendment to the Companys 1999 Non-employee Director Stock
Option Plan:
|--- |  | --------------------------------------------------------------------------------------

|        |  |  |            | 
|------- |  |  | ---------- | 
|For     |  |  | 11,233,698 | 
|Against |  |  | 292,756    | 

The foregoing proposal was approved.



|(3) |  | To approve an amendment to the Companys Employee Stock Purchase Plan:
|--- |  | ----------------------------------------------------------------------

|        |  |  |            | 
|------- |  |  | ---------- | 
|For     |  |  | 11,390,236 | 
|Against |  |  | 204,020    | 

The foregoing proposal was approved.



|(4) |  | To ratify the appointment of PricewaterhouseCoopers LLP as the Companys
independent accountants:
|--- |  | -------------------------------------------------------------------------------------------------

|        |  |  |            | 
|------- |  |  | ---------- | 
|For     |  |  | 17,363,654 | 
|Against |  |  | 74,691     | 

The foregoing proposal was approved.




ITEM 5. OTHER INFORMATION

Not Applicable.

15



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##### Table of Contents






ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



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

|     |  |                                                                                                                             
|---- |  | ----------------------------------------------------------------------------------------------------------------------------
|10.1 |  | Severance Agreement and Release dated April 17, 2002 between Elizabeth
Hall, Vice President  U.S. Sales, and the registrant



| | b) |  | Reports on Form 8-K.                                                                                                        
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------
|
| |    |  | The Company filed a Form 8-K on March 25, 2002 regarding the
delisting of N2H2s securities from the Nasdaq National Market.




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: May 13, 2002 | By:        | /s/ Philip Welt                                                                
|                    |            |                                                                                
|                    |            | Philip Welt
President and Chief Executive Officer
(principal executive officer)

|                    |     |                                                                                                                             
|------------------- | --- | ----------------------------------------------------------------------------------------------------------------------------
|Dated: May 13, 2002 | By: | /s/ J. Paul Quinn                                                                                                           
|                    |     |                                                                                                                             
|                    |     | J. Paul Quinn
Vice President  Chief Financial Officer,
Secretary and Treasurer
(principal financial and accounting officer)

16



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##### Table of Contents






EXHIBIT INDEX

|        |  |                                                                                                                             
|------- |  | ----------------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                             
|No.     |  | Description                                                                                                                 
|        |  |                                                                                                                             
|10.1    |  | Severance Agreement and Release dated April 17, 2002 between Elizabeth
Hall, Vice President  U.S. Sales, and the registrant

17