##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 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 August 12, 2002, the registrant had outstanding 22,089,627 shares of
common stock, no par value.





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TABLE OF CONTENTS



|                              |                                                                                                |                                                                        |  |  |  |  |  | 
|----------------------------- | ---------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------- |  |  |  |  |  | 
|PART I FINANCIAL INFORMATION
|                              | ITEM 1. FINANCIAL STATEMENTS                                                                  
|                              |                                                                                                | CONDENSED CONSOLIDATED BALANCE SHEETS                                 
|                              |                                                                                                | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
|                              |                                                                                                | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS                       
|                              |                                                                                                | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                  
|                              | ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
|                              | ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            
|PART II OTHER INFORMATION   
|                              | ITEM 1. LEGAL PROCEEDINGS                                                                     
|                              | ITEM 2(d). CHANGES IN SECURITIES AND USE OF PROCEEDS                                          
|                              | ITEM 3. DEFAULTS UPON SENIOR SECURITIES                                                       
|                              | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                   
|                              | ITEM 5. OTHER INFORMATION                                                                     
|                              | ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K                                                      
|SIGNATURES                   
|EXHIBIT 10.1                 
|EXHIBIT 10.2                 
|EXHIBIT 99.1                 
|EXHIBIT 99.2                 



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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 |  |  | 8  | 
|                              
|                               |  | Item 3. |    | Quantitative And Qualitative Disclosures About Market Risk                            |  |  | 21 | 
|                              
|PART II  OTHER INFORMATION    |  |         | 22 |                                                                                      
|                              
|                               |  | Item 1. |    | Legal Proceedings                                                                     |  |  | 22 | 
|                              
|                               |  | Item 2. |    | Changes In Securities And Use Of Proceeds                                             |  |  | 22 | 
|                              
|                               |  | Item 3. |    | Defaults Upon Senior Securities                                                       |  |  | 22 | 
|                              
|                               |  | Item 4. |    | Submission Of Matters To A Vote Of Security Holders                                   |  |  | 22 | 
|                              
|                               |  | Item 5. |    | Other Information                                                                     |  |  | 22 | 
|                              
|                               |  | Item 6. |    | Exhibits And Reports On Form 8-K                                                      |  |  | 22 | 
|                              
|SIGNATURES                     |  |         | 23 |                                                                                      

2



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##### Table of Contents






PART I  FINANCIAL INFORMATION




ITEM 1. FINANCIAL STATEMENTS




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

|                                                  |                                                                                                                      |                                  |                                            |         |          |       |               |         |       |        | 
|------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------- | -------------------------------- | ------------------------------------------ | ------- | -------- | ----- | ------------- | ------- | ----- | ------ | 
|                                                  |                                                                                                                      |                                  |                                            |         | June 30, |       | September 30,
|                                                  |                                                                                                                      |                                  |                                            |         | 2002     |       | 2001         
|                                                  |                                                                                                                      |                                  |                                            |         |          |       |              
|ASSETS:                                           |                                                                                                                      |                                  |                                            |         |          |       |               |        
|Current assets:                                   |                                                                                                                      |                                  |                                            |         |          |       |               |        
|                                                  | Cash and cash equivalents                                                                                            |                                  | $                                          | 2,100   |          |       | $             | 5,979   |      
|                                                  | Restricted cash and cash equivalents                                                                                 |                                  |                                            | 675     |          |       |               | 675     |      
|                                                  | Accounts receivable, net of allowances                                                                               |                                  |                                            | 1,296   |          |       |               | 2,066   |      
|                                                  | Prepaid expenses and other current assets                                                                            |                                  |                                            | 242     |          |       |               | 774     |      
|                                                  |                                                                                                                      |                                  |                                            |         |          |       |               |        
|                                                  |                                                                                                                      | Total current assets             |                                            |         | 4,313    |       |               |         | 9,494 |       
|Property and equipment, net                       |                                                                                                                      |                                  | 1,652                                      |         |          |       | 3,136         |        
|Other assets                                      |                                                                                                                      |                                  | 140                                        |         |          |       | 140           |        
|                                                  |                                                                                                                      |                                  |                                            |         |          |       |               |        
|                                                  |                                                                                                                      |                                  | Total assets                               |         | $        | 6,105 |               |         | $     | 12,770 | 
|                                                  |                                                                                                                      |                                  |                                            |         |          |       |               |        
|LIABILITIES AND SHAREHOLDERS EQUITY:             |                                                                                                                      |                                  |                                            |         |          |       |               |        
|Current liabilities:                              |                                                                                                                      |                                  |                                            |         |          |       |               |        
|                                                  | Accounts payable                                                                                                     |                                  | $                                          | 173     |          |       | $             | 807     |      
|                                                  | Accrued payroll & benefits                                                                                           |                                  |                                            | 423     |          |       |               | 738     |      
|                                                  | Other accrued liabilities                                                                                            |                                  |                                            | 356     |          |       |               | 342     |      
|                                                  | Deferred revenue                                                                                                     |                                  |                                            | 4,475   |          |       |               | 6,136   |      
|                                                  | Note payable                                                                                                         |                                  |                                            |        |          |       |               | 42      |      
|                                                  | Current portion of capital lease obligations                                                                         |                                  |                                            | 62      |          |       |               | 203     |      
|                                                  |                                                                                                                      |                                  |                                            |         |          |       |               |        
|                                                  |                                                                                                                      | Total current liabilities        |                                            |         | 5,489    |       |               |         | 8,268 |       
|                                                  |                                                                                                                      |                                  |                                            |         |          |       |               |        
|Deferred revenue                                  |                                                                                                                      |                                  | 881                                        |         |          |       | 1,296         |        
|Capital lease obligations, net of current portion |                                                                                                                      |                                  |                                           |         |          |       | 29            |        
|                                                  |                                                                                                                      |                                  |                                            |         |          |       |               |        
|                                                  |                                                                                                                      |                                  | Total liabilities                          |         |          | 6,370 |               |         |       | 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,
22,090 and 22,060 shares issued and outstanding,
respectively |                                  |                                            | 92,173  |          |       |               | 92,166  |      
|                                                  | Notes receivable from shareholders, net of allowances                                                                |                                  |                                            | (42     | )        |       |               | (48     | )    
|                                                  | Deferred stock compensation                                                                                          |                                  |                                            | (663    | )        |       |               | (2,030  | )    
|                                                  | Accumulated other comprehensive loss                                                                                 |                                  |                                            | (102    | )        |       |               | (127    | )    
|                                                  | Accumulated deficit                                                                                                  |                                  |                                            | (91,631 | )        |       |               | (86,784 | )    
|                                                  |                                                                                                                      |                                  |                                            |         |          |       |               |        
|                                                  |                                                                                                                      | Total shareholders equity       |                                            |         | (265     | )     |               |         | 3,177 |       
|                                                  |                                                                                                                      |                                  |                                            |         |          |       |               |        
|                                                  |                                                                                                                      |                                  | Total liabilities and shareholders equity |         | $        | 6,105 |               |         | $     | 12,770 | 
|                                                  |                                                                                                                      |                                  |                                            |         |          |       |               |        

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

3



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

|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |       |        |        |       |  
|----------------------------------------------------- | --------------------------------------- | ------------------------------------------------ | ------------------------ | ------------------ | ----- | ------------------ | ------ | ----------------- | ----- | ----- | ------ | ----- | ----- | ------ | ------- | ----- | ------ | ------ | ----- | -
|                                                      |                                         |                                                  |                          |                    |       | THREE MONTHS ENDED |        | NINE MONTHS ENDED
|                                                      |                                         |                                                  |                          |                    |       | June 30,           |        | June 30,         
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                  
|                                                      |                                         |                                                  |                          |                    |       | 2002               |        | 2001              |       | 2002  |        | 2001 
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |      
|Revenues:                                             |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|                                                      |                                         | Internet filtering and consulting services       |                          | $                  | 2,991 |                    |        | $                 | 1,926 |       |        | $     | 8,556 |        |         | $     | 5,881  |       
|                                                      |                                         | Advertising                                      |                          |                    |      |                    |        |                   | 89    |       |        |       |      |        |         |       | 509    |       
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|                                                      |                                         |                                                  | Total Revenues           |                    |       | 2,991              |        |                   |       | 2,015 |        |       |       | 8,556  |         |       |        | 6,390  |      
|Operating expenses:                                   |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|                                                      |                                         | Internet filtering services and customer support |                          |                    | 852   |                    |        |                   | 1,179 |       |        |       | 2,528 |        |         |       | 4,181  |       
|                                                      |                                         | Educational content and advertising costs        |                          |                    |      |                    |        |                   | 34    |       |        |       |      |        |         |       | 703    |       
|                                                      |                                         | Sales and marketing                              |                          |                    | 1,606 |                    |        |                   | 2,408 |       |        |       | 5,266 |        |         |       | 10,139 |       
|                                                      |                                         | General and administrative                       |                          |                    | 851   |                    |        |                   | 1,434 |       |        |       | 2,719 |        |         |       | 4,547  |       
|                                                      |                                         | Research and development                         |                          |                    | 487   |                    |        |                   | 1,281 |       |        |       | 1,375 |        |         |       | 3,386  |       
|                                                      |                                         | Depreciation and amortization                    |                          |                    | 472   |                    |        |                   | 1,245 |       |        |       | 1,515 |        |         |       | 3,737  |       
|                                                      |                                         | Impairment of acquired intangible assets         |                          |                    |      |                    |        |                   | 1,396 |       |        |       |      |        |         |       | 1,396  |       
|                                                      |                                         | Impairment of technology licenses                |                          |                    |      |                    |        |                   | 513   |       |        |       |      |        |         |       | 513    |       
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|                                                      |                                         |                                                  | Total operating expenses |                    |       | 4,268              |        |                   |       | 9,490 |        |       |       | 13,403 |         |       |        | 28,602 |      
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|Loss from operations                                  |                                         |                                                  | (1,277                   | )                  |       |                    | (7,475 | )                 |       |       | (4,847 | )     |       |        | (22,212 | )    
|Interest income, net                                  |                                         |                                                  | 27                       |                    |       |                    | 64     |                   |       |       | 97     |       |       |        | 445     |      
|Loss on disposal of property and equipment            |                                         |                                                  | (28                      | )                  |       |                    | (122   | )                 |       |       | (97    | )     |       |        | (293    | )    
|Impairment of investment                              |                                         |                                                  |                         |                    |       |                    |       |                   |       |       |       |       |       |        | (3,000  | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|Loss before change in accounting policy               |                                         |                                                  | (1,278                   | )                  |       |                    | (7,533 | )                 |       |       | (4,847 | )     |       |        | (25,060 | )    
|Cumulative effect of change in accounting policy      |                                         |                                                  |                         |                    |       |                    |       |                   |       |       |       |       |       |        | (3,554  | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|Net loss                                              |                                         | $                                                | (1,278                   | )                  |       | $                  | (7,533 | )                 |       | $     | (4,847 | )     |       | $      | (28,614 | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|Foreign currency translation gain (loss)              |                                         |                                                  | 1                        |                    |       |                    | 10     |                   |       |       | 25     |       |       |        | (78     | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|Comprehensive loss                                    |                                         | $                                                | (1,277                   | )                  |       | $                  | (7,523 | )                 |       | $     | (4,822 | )     |       | $      | (28,692 | )    
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|Basic and diluted net loss per share:                 |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|                                                      | Loss before change in accounting policy |                                                  | $                        | (0.06              | )     |                    | $      | (0.35             | )     |       | $      | (0.22 | )     |        | $       | (1.16 | )     
|                                                      | Effect of change in accounting policy   |                                                  |                          |                   |       |                    |        |                  |       |       |        |      |       |        |         | (0.16 | )     
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|                                                      |                                         |                                                  |                          | Net loss per share |       | $                  | (0.06  | )                 |       | $     | (0.35  | )     |       | $      | (0.22   | )     |        | $      | (1.32 | )
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      
|Basic and diluted weighted average shares
outstanding |                                         |                                                  | 21,919                   |                    |       |                    | 21,683 |                   |       |       | 21,814 |       |       |        | 21,704  |      
|                                                      |                                         |                                                  |                          |                    |       |                    |        |                   |       |       |        |       |       |        |         |      

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

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

|                                                                            |                                                       |                                              |        |                |        |      |         |     |         |  
|--------------------------------------------------------------------------- | ----------------------------------------------------- | -------------------------------------------- | ------ | -------------- | ------ | ---- | ------- | --- | ------- | -
|                                                                            |                                                       |                                              |        | NINE MONTHS   
|                                                                            |                                                       |                                              |        | ENDED JUNE 30,
|                                                                            |                                                       |                                              |        |               
|                                                                            |                                                       |                                              |        | 2002           |        | 2001
|                                                                            |                                                       |                                              |        |                |        |     
|Cash flows from operating activities:                                       |                                                       |                                              |        |                |        |      |         |    
|Net loss                                                                    |                                                       | $                                            | (4,847 | )              |        | $    | (28,614 | )  
|Adjustments to reconcile net loss to net cash used by operating activities: |                                                       |                                              |        |                |        |      |         |    
|                                                                            |                                                       | Depreciation and amortization                |        |                | 1,515  |      |         |     | 3,737   |  
|                                                                            |                                                       | Amortization of deferred stock compensation  |        |                | 1,367  |      |         |     | 3,077   |  
|                                                                            |                                                       | Change in accounting policy                  |        |                | (657   | )    |         |     | 1,463   |  
|                                                                            |                                                       | Loss on disposal of property and equipment   |        |                | 97     |      |         |     | 293     |  
|                                                                            |                                                       | Impairment of investment                     |        |                |       |      |         |     | 3,000   |  
|                                                                            |                                                       | Impairment of acquired intangible assets     |        |                |       |      |         |     | 1,396   |  
|                                                                            |                                                       | Impairment of technology licenses            |        |                |       |      |         |     | 513     |  
|                                                                            |                                                       | Shareholder loans forgiven                   |        |                |       |      |         |     | 447     |  
|                                                                            |                                                       | Interest on shareholder loans                |        |                | (16    | )    |         |     | (63     | )
|Changes in operating assets and liabilities:                                |                                                       |                                              |        |                |        |      |         |    
|                                                                            |                                                       | Accounts receivable                          |        |                | 770    |      |         |     | 1,532   |  
|                                                                            |                                                       | Prepaid expenses and other current assets    |        |                | 532    |      |         |     | 863     |  
|                                                                            |                                                       | Other assets                                 |        |                |       |      |         |     | (18     | )
|                                                                            |                                                       | Accounts payable                             |        |                | (634   | )    |         |     | (1,810  | )
|                                                                            |                                                       | Accrued liabilities                          |        |                | (301   | )    |         |     | (79     | )
|                                                                            |                                                       | Deferred revenue                             |        |                | (1,419 | )    |         |     | 1,503   |  
|                                                                            |                                                       |                                              |        |                |        |      |         |    
|Net cash used by operating activities:                                      |                                                       |                                              | (3,593 | )              |        |      | (12,760 | )  
|                                                                            |                                                       |                                              |        |                |        |      |         |    
|Cash flows from investing activities:                                       |                                                       |                                              |        |                |        |      |         |    
|                                                                            |                                                       | Maturities of investments                    |        |                |       |      |         |     | 27,892  |  
|                                                                            |                                                       | Purchases of investments                     |        |                |       |      |         |     | (13,100 | )
|                                                                            |                                                       | Additions to property and equipment          |        |                | (141   | )    |         |     | (1,389  | )
|                                                                            |                                                       | Proceeds from sale of property and equipment |        |                | 13     |      |         |     | 32      |  
|                                                                            |                                                       | Notes receivable from shareholders           |        |                | 22     |      |         |     |        |  
|                                                                            |                                                       |                                              |        |                |        |      |         |    
|Net cash (used in) provided by investing activities                         |                                                       |                                              | (106   | )              |        |      | 13,435  |    
|                                                                            |                                                       |                                              |        |                |        |      |         |    
|Cash flows from financing activities:                                       |                                                       |                                              |        |                |        |      |         |    
|                                                                            |                                                       | Issuance of common stock                     |        |                | 6      |      |         |     | 4       |  
|                                                                            |                                                       | Exercise of stock options                    |        |                | 1      |      |         |     | 62      |  
|                                                                            |                                                       | Payments under capital lease obligations     |        |                | (170   | )    |         |     | (142    | )
|                                                                            |                                                       | Repayments of notes payable                  |        |                | (42    | )    |         |     | (4,722  | )
|                                                                            |                                                       | Cash restricted to secure line of credit     |        |                |       |      |         |     | (675    | )
|                                                                            |                                                       |                                              |        |                |        |      |         |    
|Net cash used by financing activities                                       |                                                       |                                              | (205   | )              |        |      | (5,473  | )  
|                                                                            |                                                       |                                              |        |                |        |      |         |    
|                                                                            |                                                       | Effects of exchange rate changes             |        |                | 25     |      |         |     | (78     | )
|                                                                            |                                                       |                                              |        |                |        |      |         |    
|Net decrease in cash                                                        |                                                       |                                              | (3,879 | )              |        |      | (4,876  | )  
|Cash, beginning of period                                                   |                                                       |                                              | 5,979  |                |        |      | 7,993   |    
|                                                                            |                                                       |                                              |        |                |        |      |         |    
|Cash, end of period                                                         |                                                       | $                                            | 2,100  |                |        | $    | 3,117   |    
|                                                                            |                                                       |                                              |        |                |        |      |         |    
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION                            |                                                       |                                              |        |                |        |      |         |    
|                                                                            | Cash paid for interest                                |                                              | $      | 10             |        |      | $       | 306 |        
|                                                                            |                                                       |                                              |        |                |        |      |         |    
|                                                                            | 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
nine-month periods ended June 30, 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 of
Financial Condition and Results of Operations herein, as well as the 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.

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. For the nine-months ended June 30,
2002, we incurred operating losses of $4.8 million and used $3.6 million of
cash in our operating activities. We expect that operating losses will continue
at least through the first quarter of fiscal 2003 as we continue to develop our
product offerings and customer base. 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.

On March 20, 2002, we received notification from the Nasdaq National
Market that N2H2 had failed to meet Nasdaq listing requirements as set forth in
Marketplace Rule 4450(a)(3). Our common stock was delisted from Nasdaq after
the close of trading on March 20, 2002. Effective with the opening of business
on March 21, 2002, our common stock began trading on the Over-The-Counter
Bulletin Board under the symbol NTWO. As a result of the delisting, it may
be more difficult to achieve liquidity of shares of our common stock, and the
delisting may also impair our 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 341,192 at June 30, 2002 and June 30, 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                          |       | NINE MONTHS   
|             |                                                              |                                      |   | ENDED JUNE 30,                        |       | ENDED JUNE 30,
|             |                                                              |                                      |   |                                       |       |               
|             |                                                              |                                      |   | 2002                                  |       | 2001           |   | 2002   |       | 2001
|             |                                                              |                                      |   |                                       |       |                |   |        |       |     
|             |                                                              |                                      |   | (in thousands, except per share data)
|Numerator:   |                                                              |                                      |   |                                       |       |                |   |        |       |      |   |        |       |   |   |        
|             | Net loss                                                     |                                      | $ | (1,278                                | )     |                | $ | (7,533 | )     |      | $ | (4,847 | )     |   | $ | (28,614 | )    
|Denominator: |                                                              |                                      |   |                                       |       |                |   |        |       |      |   |        |       |   |   |        
|             | Basic and diluted weighted average
common shares outstanding |                                      |   | 21,919                                |       |                |   | 21,683 |       |      |   | 21,814 |       |   |   | 21,704  |      
|             |                                                              |                                      |   |                                       |       |                |   |        |       |      |   |        |       |   |   |        
|             |                                                              | Basic and diluted net loss per share |   | $                                     | (0.06 | )              |   | $      | (0.35 | )    |   | $      | (0.22 | ) |   | $       | (1.32 | )
|             |                                                              |                                      |   |                                       |       |                |   |        |       |      |   |        |       |   |   |        

Warrants for 539,280 shares and options for 4,007,836 shares have been
excluded from the calculation of diluted loss per share at June 30, 2002
because they are anti-dilutive. Warrants for 539,280 shares and options for
4,088,563 shares have been excluded from the calculation of diluted loss per
share at June 30, 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 nine-month
periods ended June 30, 2002 and 2001 was $657,000 and $2,091,000, respectively.
The remainder of the related deferred revenue will be recognized as revenue as
follows: $106,000 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.




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

FORWARD LOOKING INFORMATION

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



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

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

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

OVERVIEW

N2H2 is an international Internet content filtering company. Our
filtering solutions help customers control, manage and understand their
Internet use by filtering Web content, monitoring Internet access and
delivering concise reports on user activity.

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These safeguards enable organizations of any size to mitigate potential
legal liability, increase user productivity and optimize network bandwidth.

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

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. For the nine-months ended June 30,
2002, we incurred operating losses of $4.8 million and used $3.6 million of
cash in our operating activities. We expect that operating losses will continue
at least through the first quarter of fiscal 2003 as we continue to develop our
product offerings and customer base. 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.

On March 20, 2002, we received notification from the Nasdaq National
Market that N2H2 had failed to meet Nasdaq listing requirements as set forth in
Marketplace Rule 4450(a)(3). Our common stock was delisted from Nasdaq after
the close of trading on March 20, 2002. Effective with the opening of business
on March 21, 2002, our common stock began trading on the Over-The-Counter
Bulletin Board under the symbol NTWO. As a result of the delisting, it may
be more difficult to achieve liquidity of shares of our common stock, and the
delisting may also impair our ability to raise additional capital.

On July 25, 2002, Benjamin Edelman filed suit against us in the U.S.
District Court for the District of Massachusetts. Mr. Edelman is purportedly a
computer researcher who seeks to conduct a quantitative analysis of the
accuracy and comprehensiveness of our Bess and Sentian Internet content
filtering products. If Mr. Edelman downloads our filtering software to conduct
his analysis, he will be required to enter into our standard license agreement.
The license agreement prohibits users from copying or decrypting our software
and from using or disclosing confidential information that belongs to us and
cannot be obtained through normal use of the software. Mr. Edelmans proposed
activities would violate these provisions of the license agreement or
applicable law, or both. He seeks a declaratory judgment that he cannot be
held liable for breach of certain provisions of the license agreement as a
result of his proposed activities. In addition, Mr. Edelman seeks a
declaration that he will not be prosecuted for violations of the Copyright Act
of 1976, the Digital Millennium Copyright Act, or laws protecting trade secrets
if he conducts his proposed analysis. Finally, Mr. Edelman seeks to enjoin us
from initiating litigation against him on the basis of his proposed activities.
We intend to defend the validity of our license agreement and to enforce the
provisions of this agreement to protect our proprietary rights. We also intend
to assert all of our legal rights against Mr. Edelman if he engages in future
activity that violates the agreement or our proprietary rights. To the extent
that this matter is resolved in Mr. Edelmans favor, however, it could have a
material adverse affect on our business, future results of operations,
financial position and cash flows. Even if Mr. Edelmans claims are not
successful, the litigation could result in substantial costs to the company and
divert managements time and attention away from business operations.

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 primarily from sales of Internet filtering
subscriptions. A smaller portion of our revenue also comes from installation
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. Contracts 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 revenue.

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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 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 deteriorates, 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 determined that we could 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 JUNE 30, 2002

Revenues

We generate our revenues primarily from subscriptions to our filtering,
Internet management, and content delivery services. A smaller portion of our
revenue also comes from installation fees, maintenance fees, and historically,
advertising.

Internet filtering and consulting services revenues increased by 55% to
$3.0 million for the quarter, compared to $1.9 million for the comparable
quarter in the prior fiscal year. This increase is due to our continued
growth in the education market, combined with additional sales to corporate
customers made by our growing network of resellers. In addition, our new
software plug-in filtering solutions have added to our revenue base for fiscal
2002, with software subscriptions accounting for 60% of sales during the
quarter. The increase in revenue was partially offset by a decline in revenue
recognized under SAB 101. The amount of SAB 101 revenue recognized during the
quarter was $116,000, down from $556,000 in the same quarter of the prior year.

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 has been eliminated as
a source of revenue.

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 28% to
$0.9 million for the quarter, compared to $1.2 million for the comparable
quarter in the prior fiscal year. The decrease is primarily due to reductions
in our staff and related personnel expenses that took place in fiscal 2001. 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 termination of our advertising-based
filtering model.

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Sales and marketing

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

Sales and marketing expenses decreased by 33% to $1.6 million for the
quarter, from $2.4 million for the comparable quarter in the prior fiscal year.
The decrease is due in part to our reduced direct sales staff and related
expenses, as we continue to shift a large portion of our sales efforts to an
indirect sales channel in which we attempt to 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 next quarter 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, insurance
costs, and an allocation of corporate facilities costs.

General and administrative expenses decreased by 41% to $0.9 million for
the quarter, from $1.4 million for the comparable quarter in the prior fiscal
year. This decrease is primarily due to reductions in our administrative staff
and related personnel costs that took place in fiscal 2001. 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 expect general and administrative expenses to remain materially consistent
with third 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 filtering products and enhancing existing products. Product
costs related to internal research and development have been expensed as
incurred.

Research and development expenses decreased by 62% to $0.5 million for the
quarter, from $1.3 million for the comparable period in the prior fiscal year.
This decrease is primarily the result of reductions in our staff that took
place in fiscal 2001, 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 expect research and development costs to remain materially
consistent with third 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 62% 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 capital leases.
Net interest income has decreased by 58% to $27,000, from $64,000 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.

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RESULTS OF OPERATIONS  NINE MONTHS ENDED JUNE 30, 2002

Revenues

Internet filtering and consulting services revenues increased by 45% to
$8.6 million for the nine-month period, compared to $5.9 million for the
comparable period in the prior fiscal year. Conversions from our
advertising-based filtering model to our subscription fee-based model during
the second half of fiscal 2001, combined with additional new sales to the
education market during the period, have significantly increased our base of
paying education customers. Sales to corporate customers made by our growing
network of resellers have also contributed to our increased revenue. In
addition, sales of our new software plug-in solutions have added to our revenue
for fiscal 2002. The increase in revenue was partially offset by a decline in
revenue recognized under SAB 101. The amount of SAB 101 revenue recognized
during the nine-month period was $657,000, down from $2,091,000 in the same
period of the prior year.

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 has been eliminated as
a source of revenue.

Internet filtering services and customer support costs

Internet filtering services and customer support costs decreased by 39% to
$2.5 million for the nine-month period, compared to $4.2 million for the
comparable period in the prior fiscal year. The decrease is primarily due
reductions in our staff and related personnel expenses that took place in
fiscal 2001. In addition, we renegotiated key vendor contracts to obtain more
favorable terms. We expect Internet filtering services and customer support
costs to 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 termination of our advertising-based
filtering model.

Sales and marketing

Sales and marketing expenses decreased by 48% to $5.3 million for the
nine-month period, from $10.1 million for the comparable period in the prior
fiscal year. The decrease is due in part to our reduced direct sales staff and
related expenses, as we continue to shift a large portion of our sales efforts
to an indirect sales channel in which we attempt to 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 next quarter 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 $2.7 million for
the nine-month period, from $4.5 million for the comparable period in the prior
fiscal year. This decrease is primarily due to reductions in our administrative
staff and related personnel costs that took place in fiscal 2001. 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 expect general and administrative expenses to remain materially
consistent through the remainder of the fiscal year.

Research and development

Research and development expenses decreased by 59% to $1.4 million for the
nine-month period, from $3.4 million for the comparable period in the prior
fiscal year. This decrease is primarily the result of reductions in our staff
that took place in fiscal 2001, 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 expect research and development costs to
remain materially consistent through the remainder of the fiscal year.

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Depreciation and amortization

Depreciation and amortization expenses decreased by 59% to $1.5 million
for the nine-month period, from $3.7 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

Net interest income has decreased by 78% to $97,000 for the nine-month
period, from $445,000 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.

Impairment of acquired intangible assets

During fiscal 2001, we recorded a $1.4 million write-down on the carrying
value of intangible assets acquired as part of the fiscal 2000 acquisition of
N2H2 Pty Limited (formerly Iseek Pty Limited). These assets were assessed for
impairment due to operating results and forecasts from N2H2 Pty Limited being
less than expected. The impairment charges were calculated as the excess of the
fair value, as calculated by the present value of future cash flows from N2H2
Pty Limited, over the carrying value of the intangible assets.

Impairment of technology licenses

During fiscal 2001, we recorded a $0.5 million write-down on software
license agreements. At the time of signing these license agreements, we
intended to use this third-party software in the development of our products.
We recorded the write-down upon determining that the software would not be used
as part of our current or future product offerings. The impairment charge
represented the total net carrying value of the intangible assets.

Impairment 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 $2.8 million (including restricted cash of
$675,000) or 45% of total assets at June 30, 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 $3.6 million for the nine-month period ended June 30, 2002, compared
to $12.8 million for the comparable period of the prior fiscal year.

Investing activities consumed $106,000 during the nine-month period,
primarily as a result of additions to property and equipment. Additions to
property and equipment totaled $141,000 during the period, compared to
$1,389,000 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 $205,000 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.

At recent rates of cash consumption, our current cash balance is
insufficient to sustain our operations beyond six months from the end of the
third quarter. However, as a result of our campaign to convert school
customers from an advertising-based filtering model

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to our subscription fee-based model in the second half of fiscal 2001, we
anticipate that a disproportionately large number of our subscription renewals
will take place in the fourth fiscal quarter. Given this trend, we expect to
generate more cash than we spend in the next quarter. With the anticipated
level of fourth quarter renewals, combined with the success of our new software
solutions 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 we will achieve our
cash objectives for the fourth quarter, or 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  |  | $                      | 4,000,000 |        |  | $         | 1,219,000 |           |  | $       | 2,781,000 |  |  |  |  |       |  |  |  | 
|                         | Capital Leases   |  | $                      | 64,000    |        |  | $         | 64,000    |           |  |         |          |  |  |  |  |       |  |  |  | 
|Commercial Commitments:  |                  |  |                        |           |        |  |           |           |           |  |         |           |  |  |  |   |       |  |  |  
|                         | Letter of Credit |  | $                      | 665,000   |        |  |           |          |           |  | $       | 665,000   |  |  |  |  |       |  |  |  | 

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

We may need additional capital and may be unable to raise it on acceptable
terms.

We may need to raise additional capital to grow our business and, if we
are unable to achieve profitability in the near term, to continue operations.
Additional financing may not be available to us on favorable terms, if at all.
The recent delisting of our common stock from the Nasdaq National Market, and
commencement of trading on the OTC-BB may also make it even more difficult for
us to obtain financing. Further, if we issue additional equity securities,
shareholders may experience significant dilution, and the new equity securities
may have rights, preferences or privileges senior to those of existing holders
of our common stock. If we cannot raise funds on acceptable terms, we may not
be able to develop or enhance our products and services, take advantage of
future opportunities or respond to competitive pressures or unanticipated
requirements. This could seriously harm our business. In addition, if we
cannot raise funds on acceptable terms and do not achieve profitability, we may
be forced to reduce or cease operations.

We have a history of losses and our future operating results are uncertain.

We have incurred net losses in each quarter since we incorporated in 1995.
We incurred net losses of $881,000 for 1997, $2.6 million for 1998, $7.7
million for 1999, $39.3 million for 2000, and $35.5 million for 2001. We
anticipate that we will incur a net loss in fiscal 2002. Operating expenses
will continue to consume a significant amount of our cash resources, although
at a reduced level.

We will need to significantly increase our revenues in order to achieve
profitability. Although our revenues have grown in recent quarters, we may not
be able to continue this growth or achieve or maintain profitability. We may
also fail to accurately estimate and assess increased operating expense
requirements as we grow. If we fail to achieve and maintain profitability, our
future capital raising efforts would be impaired and we may be unable to raise
the capital necessary to continue operations.

Our common stock is traded on the Over-the-Counter Bulletin board and, as a
result, it may be less liquid and subject to greater price fluctuations.

On March 20, 2002, we received notification from the Nasdaq National
Market that N2H2 had failed to meet Nasdaq listing requirements as set forth in
Marketplace Rule 4450(a)(3). Our common stock was delisted from Nasdaq
effective after the close of trading on March 20, 2002. Effective with the
opening of business on March 21, 2002, our common stock began trading on the
Over-The-Counter Bulletin Board, or OTC-BB, under the symbol NTWO. The
OTC-BB is not an exchange, and trading in stocks on the OTC-BB is often more
sporadic and lower in volume than that in shares on the national exchanges. We
cannot guarantee that our

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shares will ever be listed on the Nasdaq National Market, or any other
national stock exchange, in the future. As a result, it may be more difficult
to dispose of or to obtain adequate quotations as to the price of our common
stock.

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

Stocks trading on the OTC-BB are often subject to price fluctuations that
are unrelated, or disproportional, to the operating performance of the
companies. The price of our common stock has historically been volatile, even
before it was delisted from Nasdaq, since our initial public offering in August
1999. Our common stock reached a high of $33.13 per share on December 14, 1999
and traded as low as $0.12 per share on March 21, 2002. As a result of
fluctuations in the price of our common stock, you may be unable to sell your
shares at or above the price at which you purchased them. The trading price of
our common stock could be subject to fluctuations for a number of reasons,
including



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

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

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

During 2001, we terminated the advertising-based revenue model that we had
previously offered to schools. In connection with the termination of our
advertising based-revenue model, we have unilaterally terminated certain
advertising contracts. These advertising contracts may not allow unilateral
termination by either party. As a result, we may be subject to liabilities
associated with breach of contract claims. We have not received notice of any
breach of contract claims against us as a result of termination of these
advertising contracts. We may, however, be subject to future claims. To the
extent any such claim is brought, and resolved in favor of the other party, it
could materially affect our business, future results of operations, financial
position and cash flows. Even if none of these claims is successful, the
litigation could result in substantial costs to the company and divert
managements time and attention away from business operations.

Economic conditions could adversely affect our revenue growth and ability to
forecast revenue.

Our revenue growth and potential for profitability depend on the overall
demand for filtering products, but are also impacted by general economic and
business conditions. A softening of demand for computer software caused by the
weakened economy, both domestic and international, has affected our sales and
may result in decreased revenues and growth rates. As a result of the economic
downturn, we may also experience difficulties in collecting outstanding
accounts receivable from our customers. In addition, the terrorist attacks on
the United States in 2001, and the armed conflict that has followed, have added
or exacerbated economic, political and other uncertainties, which could
adversely affect our sales and thus our revenue growth. The slowdown in the
domestic and international economies, as well as the effects of terrorist
activity and armed conflict, may cause customers and potential customers to

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delay their decisions about purchasing our software, to reduce the amount
they purchase or to cancel their orders, which could adversely affect our
business and operating results.

Our quarterly financial results fluctuate and may be affected by seasonal
variations.

Our quarterly operating results have fluctuated significantly in the past
and are likely continue to fluctuate in the future. Operating results vary
from quarter to quarter, depending on a number of factors, many of which are
outside our control, including:



| |  |  | the rate of market acceptance of new product introductions,                                                                                                                                                                       
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the variation in quarterly cash flows from subscription
payments, which is difficult to forecast because the sales cycle,
from initial evaluation to delivery of products or services, varies
substantially between customers, and
|
| |  |  | the tendency of our educational customers to budget and make
purchases on the basis of their fiscal year, which usually begins in
July.                                                                                           

Due to the combination of these and other factors, quarter to quarter
comparisons of operating results are not necessarily meaningful or indicative
of future performance. Further, it is possible that in some future quarter or
quarters our operating results will not meet or exceed the expectations of
public market analysts or investors. If that happens, or if adverse conditions
prevail or are perceived to prevail, either for our business or the market
generally, the market price of our common stock could be seriously harmed.

Our success depends on continued market acceptance and operation of our
Internet filtering services.

If we are unable to continue to solve our customers Internet content
filtering problems, we will experience diminished revenues and our business
could fail. We currently receive, and expect to continue to receive, most of
our revenues from our Internet filtering services or products. Our future
financial performance will depend, in part, upon the successful development,
introduction, and customer acceptance of new and enhanced versions of our
Internet filtering products and the services. We cannot be certain that we
will be successful in upgrading and continuing to sell our Internet filtering
products and services, or that any new products or services that we may develop
or acquire, will achieve market acceptance. Any failure to upgrade our
services or products or to maintain our market acceptance could seriously harm
our business, financial condition, and results of operations.

We may fail to filter all potentially objectionable content.

We may not succeed in filtering Internet content to meet our customers
expectations. We rely upon a combination of automated filtering technology and
human review to categorize Web site content for use by our filtering services
and products. The total number of Web sites and partial Web sites is growing
rapidly. A partial Web site is a graphic image, text or other visual appearing
as a part of a full Webscreen display. We cannot be sure that our filtering
technologies will successfully block all potentially objectionable Internet
content for our clients. Our categorized database also may not contain
substantially all of the material available on the Internet fitting into any
one of our content categories. In addition, our customers may not agree with
our categorization determinations. Our failure to effectively categorize and
filter Internet content according to our customers expectations could result
in lost revenues and generate negative publicity that would impair the growth
of our business and our efforts to increase positive associations with our
brand.

Our filtering services have been accused of overbreadth by free speech groups.

In a recent federal court case, a federal appeals court held that certain
provisions of the Childrens Internet Protection Act resulted in an
unconstitutional restriction of freedom of speech. These provisions required
public libraries receiving federal funds to install Internet
filtering programs like N2H2s on all of their computer terminals. The basis
for this ruling is, in part, that such programs are overbroad in the types of
speech that they filter out. This ruling is currently on appeal to the United
States Supreme Court. To the extent that this decision is upheld, it will
negatively impact our ability to market our products to libraries without modification, which could be time-consuming and costly.

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We may be subject to claims that our license agreements and other intellectual
property rights should not be binding on certain users.

An individual represented by the American Civil Liberties Union has
recently filed a lawsuit against us in federal court. The plaintiff is
purportedly a computer researcher who seeks to conduct a quantitative analysis
of the accuracy and comprehensiveness of our Internet content filtering
products for purposes of determining whether these products exclude some speech
on the Internet that is constitutionally protected. His activities in
conducting this analysis would violate our standard license agreement and our
intellectual property rights. The plaintiff alleges that the threat that we
will enforce these our license agreement and our other rights has deterred him
from this activity, which he alleges is protected under the fair use doctrine
of copyright law and other legal doctrines. He seeks a declaration to prohibit
us from enforcing the license agreement against him based on his use of our
software in his research activities. To the extent that this claim is resolved
in the plaintiffs favor, it could materially affect our ability to enforce our
license agreements and other intellectual property rights against certain users
of our software filtering products. In addition, it could contribute to an
increase in the number of people who seek to use our software in ways that we
believe violate our proprietary rights. This would have a material negative
impact on our business, future results of operations, financial position and
cash flows. Even if the particular claim described above is resolved in our
favor, the litigation could result in substantial costs to the company and
divert managements time and attention away from business operations.

We may fail to compete successfully with other providers of Internet filtering
services.

The market for our services and products is intensely competitive and
rapidly changing. Many of our competitors are larger than us and have
substantially greater resources than we do. Our primary competition comes from
Pure Artificial Intelligence, Universal Resource Locator, and packet filtering
software applications. Although we believe that there is a qualitative
difference among the offerings, some of our competitors filtering products are
significantly less expensive than ours. This lower cost, along with other
factors, may lead to greater market acceptance of our competitors products and
services than for ours. Increased competition could force us to reduce our
prices or the quality of our offerings. It could also reduce our market share
and impact the profitability of our business. Although we believe the Internet
provides opportunities for more than one provider of content filtering products
similar to ours, one or more of our competitors may eventually dominate the
sector.

We must establish and maintain reseller networks in order to sell into the
corporate and government markets.

During 2001, we significantly reduced our direct sales staff and began to
develop our reseller channel for selling products and services to corporations
and government entities. In order to establish market share in these markets
and increase revenue, we will need to substantially increase the distribution
of our products and services. If we fail to sufficiently build our reseller
distribution channel, or if our resellers fail to effectively promote our
products and services, our business will be seriously harmed through decreased
growth opportunities.

We will need to establish and maintain strategic relationships.

We pursue strategic alliances with other industry leaders in areas where
collaboration can produce industry advancement and acceleration of new markets.
The objectives and goals for a strategic alliance can include one or more of
the following: technology exchange, product development, joint sales and
marketing, and new market creation. We depend on strategic relationships to
offer services and products to a larger customer base than can be reached
through our direct sales efforts. We cannot be certain that we will be able to
maintain and expand our strategic relationships or enter into new strategic
relationships or that these new relationships will be on commercially
reasonable terms.

If we are unable to maintain and expand our existing strategic
relationships or enter into new strategic relationships, we will need to use
substantially more resources to develop, distribute, sell, and market our
services and products than planned. We would also lose the customer
introductions and co-marketing benefits that we anticipate from such strategic
relationships. Our success will depend both on the success of the other
parties to these relationships and on their ability to market our services and
products successfully. Most of these companies have multiple strategic
relationships, and we cannot assure you that they will regard their
relationships with us as significant for their own businesses. If any of these
firms fail to effectively promote our services or products, our business would
be seriously harmed through decreased growth opportunities.

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Our success depends on our ability to attract and retain qualified and
experienced employees.

We face a significant risk from a loss of any member of our senior
management team or any key employee, particularly if the departing employee
joins or forms a competitor. These risks relate mainly to:



| |  |  | the loss of the key employees skills and talent,                                                      
| | - |  | -------------------------------------------------------------------------------------------------------
|
| |  |  | the resulting loss of existing or potential customers, or                                              
|
| |  |  | the unauthorized disclosure or use of our technical knowledge, practices, procedures or customer lists.

Loss of a key employee could seriously harm our business, financial
condition, and results of operations. We cannot assure you that in such an
event we would be able to recruit personnel to replace our senior management in
a timely manner and on acceptable terms.

We expect there will continue to be competition for experienced
engineering, sales, and consulting personnel, particularly in the Internet
market. Many of the companies we compete against for experienced personnel
have greater resources than us. We cannot assure you that we will be
successful in attracting and retaining qualified personnel. As a result, our
growth could be limited due to our lack of capacity to provide our services.
We could also experience deterioration in service levels or decreased customer
satisfaction. Either of these occurrences could seriously harm our business,
financial condition, and results of operations through increased costs of doing
business and decreased demand for our services.

Expansion of our international operations exposes us to a number of risks.

We currently have very limited international operations. As a key
component of our business strategy, we intend to continue to try and increase
our international sales. For that purpose we hired a European operations
director in June 1999, created N2H2 Limited (a wholly owned subsidiary formed
under the laws of the United Kingdom) in August 1999, and acquired N2H2 Pty
Limited (formerly Iseek Pty Limited, a company formed under the laws of
Australia) in February 2000. Our ability to expand our international
operations is subject to a number of risks, including:



| |  |  | our ability to customize services for local markets and foreign languages,                                               
| | - |  | -------------------------------------------------------------------------------------------------------------------------
|
| |  |  | laws and business practices favoring local competitors,                                                                  
|
| |  |  | our dependence on local staff and vendors,                                                                               
|
| |  |  | compliance with multiple, conflicting and changing governmental
laws and regulations, including tax laws and regulations,
|
| |  |  | longer sales cycles,                                                                                                     
|
| |  |  | possible delays or greater difficulty in accounts receivable collection,                                                 
|
| |  |  | import and export restrictions and tariffs, and                                                                          
|
| |  |  | uncertainties regarding transactions in foreign currencies.                                                              

If we are unable to successfully manage the risks associated with our
international operations, our international sales growth will be limited and
our results of operations will be seriously harmed. Currently, we do not
engage in or intend to engage in hedging.

Our services may have limited interoperability and may not keep pace with rapid
technological changes.

We may fail to develop filtering services compatible with future operating
systems, and we may not keep pace with technological advances. Our Internet
services are designed to operate with a variety of hardware and software used
by our customers. Our school

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customers may use older operating systems, however, requiring us to
maintain multiple service platforms at increased cost to us. In addition, we
must continuously modify and enhance our services to keep pace with changes in
hardware, software, communication, browser and database technology.
Uncertainties about the timing and nature of vendors new product announcements
or their introduction or modification of operating systems would require
increased research and development expenses. The failure of our services to
operate effectively across existing and future versions of hardware and
software used by customers would limit or reduce the market for our services,
result in customer dissatisfaction and seriously harm our business, financial
condition and results of operations.

We have limited protection of our intellectual property and proprietary
technology.

We may fail to adequately protect our intellectual property and
proprietary technology. Intellectual property is critical to our success, and
we rely upon trademark, copyright and trade secret laws in the United States
and other jurisdictions to protect our proprietary technology and brands.
N2H2, BESS and SEARCHOPOLIS are U.S. registered service marks. We have also
applied in the U.S. to register the N2H2 and Bess logos, and DELIVERING THE
WEB YOU WANT, and have filed foreign applications for many of these marks.
These trademark applications may not be granted. In addition, any of our
trademarks may be challenged by others or invalidated through administrative
process or litigation. None of our technology is patented. Our proprietary
search technology is protected by United States trade secret and copyright
laws. We own and operate the servers that provide our filtering services. We
protect our proprietary rights through the use of intellectual property
agreements with employees and consultants covering confidentiality,
nondisclosure, and assignment of invention matters. Some of our former
employees and consultants who may have had access to our proprietary
information have not entered into these intellectual property agreements,
although we believe that all intellectual property that is material to our
business is covered by signed agreements. If we are wrong in this assessment,
former employees could use our proprietary technology without our having an
effective remedy, and our business would be seriously harmed.

We are subject to risks of infringement.

Trademark, copyright and trade secret protection may not be available to
us in every country in which our services are available. The laws of some
foreign countries may not be as protective of intellectual property rights as
United States laws, and mechanisms for enforcement of intellectual property
rights may be inadequate. Despite our efforts to protect our proprietary
rights, unauthorized parties may obtain, copy and use our proprietary
technology. We expect that it will become more difficult to monitor use of our
services as we increase our international presence. We cannot assure you that
our means of protecting our proprietary technology and brands will be adequate
or that our competitors will not independently develop similar technology.

Many of our products are dependent on third-party software or hardware.

Many of our products are dependent on third-party software or hardware
providers, including our products that run on Microsoft ISA, Microsoft Proxy
II, Volera Excelerator (formerly Novell ICS), and Check Point. If any of these
companies (i) cancels the product on which our products are dependent, (ii)
changes the design of its product such that it becomes incompatible with our
products, or (iii) delays the launch of new versions of their product, it may
have a negative impact on our sales.

We may become involved in intellectual property disputes and cannot predict the
likelihood or impact of unfavorable outcome.

We expect that as competition in the market for Internet filtering
increases and as the number of patents relating to these products continues to
increase, the potential for intellectual property claims against us may also
increase. Allegations of infringement against us, if made, would likely result
in significant expense to us and divert the efforts of our management and
development personnel, even if we ultimately prevail. In the event of an
adverse result, we could be required to do one or more of the following:



| |  |  | pay substantial damages, including treble damages,                                                           
| | - |  | -------------------------------------------------------------------------------------------------------------
|
| |  |  | permanently cease use of any technology determined to be infringing,                                         
|
| |  |  | obtain a license for the technology
or expend significant resources to develop non-infringing technology, and
|
| |  |  | attempt to redesign our filtering
services to avoid the infringement or to develop non-infringing technology.

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Any limitation on our ability to market our services or products or any
incurrence of substantial costs and delays associated with redesigning our
services or products would seriously harm our business, financial condition,
and results of operations.

Our services create risks of potential negative publicity and legal liability.

Because customers rely on our services for providing a content safe
Internet environment, any significant defects or errors in our services or
products may result in negative publicity or legal claims. This negative
publicity or any such legal claims could seriously harm our business, financial
condition and results of operations. In addition, our ability to maintain a
log of Internet data retrieval requests and the workstations from which they
originated may result in negative publicity or claims based on potential
privacy violations. Although our agreements with customers typically contain
provisions designed to limit our exposure to potential legal liability, these
limitation of liability provisions may not be completely effective. We have
not experienced any liability claims to date, but we cannot assure you that we
will not face this type of claim in the future. We maintain errors and
omissions insurance, but we cannot assure you that this insurance coverage will
adequately cover us for any claims.

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

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

In November 2001, we entered into an Internet hosting agreement with a
third party hosting provider, which will maintain some of our servers through
November 2002, with automatic one year renewals. Our operations depend on
their ability to protect our systems against damage from fire, earthquake,
power loss, flood, telecommunications failures, vandalism and other malicious
acts, and similar unexpected adverse events. Any major disruption in our
services could diminish revenues, decrease customer and user confidence in our
services and/or stunt the growth of our business.

We may not be able to distribute our services abroad due to United States
export laws.

The encryption technology contained in our services and products is
subject to United States export controls. Such export controls limit our
ability to distribute certain encrypted services and products outside of the
United States. While we take precautions against unlawful exportation, such
exportation inadvertently may have occurred in the past or may occur from time
to time in the future, subjecting us to potential liability. Future
legislation or regulation may further limit the encryption technology that we
can include in our services and products. In addition, foreign governments
have import and domestic use laws and regulations that restrict the types of
permitted encryption software distributed in their countries. Such regulations
could alter the design, production, distribution, and use of our services and
products.

The future use of the Internet in education is uncertain.

The success of our services and products in the education market will
depend, in large part, on the continued broad use and acceptance of the
Internet as a source of information in educational settings. Schools, teachers
and parents may cease to consider the Internet a viable research tool due to
concerns over the potential exposure of students to unsuitable material, even
with filtering services such as ours, or because of inadequate development of
telecommunications and networking systems. The Internet could lose its
viability due to delays in the development or adoption of new standards and
protocols to handle increased levels of Internet activity or due to increased
governmental regulation. Cutbacks in technology funding could also limit use
of the Internet in schools. If the necessary Internet infrastructure and
complementary products are not developed on a timely basis, or if school use of
the Internet experiences a significant decline, we may not be successful in
growing our business and our financial condition and results of operations
would be seriously harmed.

Government regulation and legal uncertainties could increase the cost of, or
limit a companies ability to, do business on the Internet.

Currently, few laws or regulations specifically govern communications or
commerce on the Internet. In the future, laws and regulations may be adopted
regarding user privacy, pricing, and the characteristics and quality of
products and services. For example,

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the Telecommunications Act of 1996 sought to prohibit transmitting various
types of information and content over the Internet. Several telecommunications
companies have petitioned the Federal Communications Commission to regulate
Internet service providers and online service providers in a manner similar to
long distance telephone carriers and to impose access fees on those companies.
This could increase the cost of transmitting data over the Internet.

Our ability to manage growth is unproven.

Potential growth is likely to place a significant strain on our
managerial, operational, financial, and other resources. Our future success
will depend, in part, upon the ability of our senior management to manage
growth effectively.

The concentrated ownership of our common stock could delay or prevent a
change of control, which could cause a decline in the market price of our
common stock.

Our directors, executive officers and their affiliated entities
beneficially own a large percentage of our outstanding common stock. As a
result, these shareholders may, as a practical matter, be able to exert
significant influence over all matters requiring shareholder approval,
including the election of directors and approval of significant corporate
transactions such as acquisitions, and to block unsolicited tender offers. This
concentration of ownership may delay, deter or prevent a third party from
acquiring control over us at a premium over the then-current market price of
our common stock, which could result in a decrease in our stock price.

Our articles of incorporation and bylaws, our shareholder rights plan and
Washington law contain provisions that could discourage a takeover.

Some provisions of our Restated Articles of Incorporation and Amended
Bylaws, our shareholder rights plan and Washington law, make it more difficult
for a third party to acquire us, even if doing so would be beneficial to our
shareholders.




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 June 30, 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

On July 25, 2002, Benjamin Edelman filed suit against us in the U.S.
District Court for the District of Massachusetts. Mr. Edelman is purportedly a
computer researcher who seeks to conduct a quantitative analysis of the
accuracy and comprehensiveness of our Bess and Sentian Internet content
filtering products. If Mr. Edelman downloads our filtering software to conduct
his analysis, he will be required to enter into our standard license agreement.
The license agreement prohibits users from copying or decrypting our software
and from using or disclosing confidential information that belongs to us and
cannot be obtained through normal use of the software. Mr. Edelmans proposed
activities would violate these provisions of the license agreement or
applicable law, or both. He seeks a declaratory judgment that he cannot be
held liable for breach of certain provisions of the license agreement as a
result of his proposed activities. In addition, Mr. Edelman seeks a
declaration that he will not be prosecuted for violations of the Copyright Act
of 1976, the Digital Millennium Copyright Act, or laws protecting trade secrets
if he conducts his proposed analysis. Finally, Mr. Edelman seeks to enjoin us
from initiating litigation against him on the basis of his proposed activities.
We intend to defend the validity of our license agreement and to enforce the
provisions of this agreement to protect our proprietary rights. We also intend
to assert all of our legal rights against Mr. Edelman if he engages in future
activity that violates the agreement or our proprietary rights. To the extent
that this matter is resolved in Mr. Edelmans favor, however, it could have a
material adverse affect on our business, future results of operations,
financial position and cash flows. Even if Mr. Edelmans claims are not
successful, the litigation could result in substantial costs to the company and
divert managements time and attention away from business operations.




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 nine-months ended June 30,
2002, the Company used $3.6 million to fund its operating loss, leaving
remaining net proceeds of $2.6 million.




ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not Applicable.




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

Not Applicable.




ITEM 5. OTHER INFORMATION

Not Applicable.




ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

a) Exhibits:

|     |  |                                                                                                                                                                                                                                         
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    
|4.1  |  | Rights Agreement dated May 24, 2002 between N2H2, Inc. and Mellon Investor
Services LLC, as Rights Agent, incorporated into this Form 10-Q by reference
to Exhibit 4.2 to N2H2s Registration Statement on Form 8-A, filed June 3,
2002.
|    
|10.1 |  | Employment Agreement dated August 2, 2002 between Philip Welt, President and
Chief Executive Officer, and the registrant                                                                                                                
|    
|10.2 |  | Stock Option Agreement dated August 2, 2002 between Philip Welt, President and
Chief Executive Officer, and the registrant                                                                                                              
|    
|99.1 |  | Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                                         
|    
|99.2 |  | Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                                         

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b) Reports on Form 8-K.

| |                                                                                                  
| | -------------------------------------------------------------------------------------------------
| | The Company filed a Form 8-K on June 3, 2002 regarding the adoption
of a shareholder rights plan.




SIGNATURES

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

|                       |                                                                                    |                   
|---------------------- | ---------------------------------------------------------------------------------- | ------------------
|                       | N2H2, INC.                                                                        
|                      
|Dated: August 13, 2002 | By:                                                                                | /s/ Howard P. Welt
|                       | Howard P. Welt
President and Chief Executive Officer
(principal executive officer)

|                       |                                                                                                                              |                  
|---------------------- | ---------------------------------------------------------------------------------------------------------------------------- | -----------------
|                       | N2H2, INC.                                                                                                                  
|                      
|Dated: August 13, 2002 | By:                                                                                                                          | /s/ J. Paul Quinn
|                       | J. Paul Quinn
Vice President  Chief Financial Officer,
Secretary and Treasurer
(principal financial and accounting officer)

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