**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K/A**

 

**Amendment No. 1**

** **

| **(Mark One)**                                        |                                                                                                |
|-------------------------------------------------------|-----------------------------------------------------------------------------------------------------|
| ý                                                | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE  SECURITIES EXCHANGE ACT OF 1934**           |
|                                                  |
| **For the fiscal year ended December 31,  2002** |
|                                                  |
| **OR**                                                |
|                                                  |
| o                                                     | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                  |
| **Commission File Number 0-20634**                    |

** **

**SAFENET,INC.**

(Exact name of registrant as specified in itscharter) 

 

| **Delaware**                                                     |   | **52-1287752**                      |
|------------------------------------------------------------------|--------|-------------------------------------|
| (State or other jurisdiction of   incorporation or organization) |   | (IRS Employer   Identification No.) |
|                                                             |   |                                |
| **8029 Corporate Drive   Baltimore, Maryland**                   |   | **21236**                           |
| (Address of principal executive offices)                         |   | (Zip Code)                          |

 

| Registrant’s telephone number, including  area code:  **(410) 931-7500**   |
|------------------------------------------------------------------------------------------------|
|                                                                                           |
| Securities registered under Section 12  (b) of the Exchange Act:  **NONE** |
|                                                                                           |
| Securities registered under Section 12  (g) of the Exchange Act:                     |
|                                                                                           |   |

 

| **Title of  each class**     |   | **Name of  each  exchange on which registered** |
|------------------------------|--------|-------------------------------------------------|
| Common Stock, $.01 par value |   | Nasdaq National Market                          |

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of thisForm 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the Registrant is an accelerated filer(as defined in Exchange Rule 12b-2). Yes ýNo o

 

The aggregate market value of the Common Stock issued and outstandingand held by non-affiliates of the Registrant, based upon the closing price forthe Common Stock on the Nasdaq National Market on June 30, 2002 wasapproximately $97,000,000. All executive officers and directors of theregistrant have been deemed, solely for the purpose of this calculation, to be“affiliates” of the registrant. This determination of the affiliate status isnot necessarily conclusive.

 

The number of shares of the registrant’s Common Stock outstanding as ofMarch 28, 2002 was 9,993,907.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Part III incorporates information by reference from the registrant’sproxy statement for the Annual Meeting of Shareholders, which proxy statementin definitive form will be filed no later than 120 days after the close ofthe registrant’s fiscal year ended December 31, 2002.

 

 

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**Explanatory Note**

 

This amendmentto SafeNet Inc.’s Annual Report on Form 10-K for the year ended December 31,2002, which was filed with the Securities and Exchange Commission on March 31,2003, is being filed to correct certain pro forma information regarding theacquisition of Cylink Corporation presented in footnote 16 to the Notes toConsolidated Financial Statements under Item 8—Financial Statements andSupplementary Data.  No further changeshave been made to the Form 10-K.  Inconnection with the filing of this amendment and pursuant to Rule 12b-15 underthe Securities Exchange Act of 1934, as amended, SafeNet, Inc. is includingcertain currently dated certifications and an updated consent of itsindependent auditors.  This amendmentcontinues to speak as of the date of the original filing of the Form 10-K andthe Company has not updated the disclosure in this amendment to speak to anylater date.

** **

**INFORMATION REGARDINGFORWARD-LOOKING STATEMENTS**

 

This Annual Report on Form 10-K, the exhibits hereto and theinformation incorporated by reference herein contain “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended. Forward-looking statements usually contain the words “estimate”,“anticipate”, “expect”, or similar expressions. All forward-looking statementsare inherently uncertain as they are based on various expectations andassumptions concerning future events and they are subject to numerous known andunknown risks and uncertainties. These uncertainties could cause actual resultsto differ materially from those expected for the reasons set forth below underRisk Factors. Readers are cautioned not to place undue reliance on theseforward-looking statements, which speak only as of the date hereof. SafeNet,Inc. undertakes no obligation to publicly release any revisions to “forwardlooking statements” to reflect events or circumstances after the date that thisreport is filed with the Securities and Exchange Commission or to reflect theoccurrence of anticipated events.

** **

**PART 1**

** **

**ITEM 1. BUSINESS**

** **

**COMPANY**

 

SafeNet, Inc. (“SafeNet” or the “Company”), was originally incorporatedin Maryland on April 7, 1983 under the name “Industrial ResourceEngineering, Inc.” SafeNet reincorporated under the name Information ResourceEngineering in Delaware by merging with its subsidiary in March 1989. TheCompany completed its initial offering in October of 1989 and a secondaryoffering in October of 1992. On November 1, 2000, the corporate name waschanged by a vote of the stockholders to SafeNet, Inc. SafeNet’s executiveoffices are located at 8029 Corporate Drive, Baltimore, MD 21236. The maintelephone line is (410) 931-7500 and website address is *www.safenet-inc.com*.

 

The Company has two reportable security business units: hardware,chips, software, and intellectual property designed and manufactured in theUnited States and Europe for sale to companies that will embed SafeNet’sproducts into their products for ultimate sale to end-users (“Embedded SecurityDivision”), and hardware, software, and network security systems designed andmanufactured in the United States for direct sales to end-users (“EnterpriseSecurity Division”).

 

In February 2003, SafeNet completed its acquisition of CylinkCorporation (“Cylink”), a California Corporation which developed, manufactured,marketed, and supported a comprehensive portfolio of hardware and softwaresecurity products for mission-critical private networks and businesscommunication over the Internet and private networks. Operations of Cylink wereintegrated into the Enterprise Security Division of SafeNet and function aspart of that business unit. This acquisition will have a significant impact onthe Company’s business operations going forward. As the transaction closedsubsequent to December 31, 2002, the Cylink acquisition has not beenconsidered in the Company’s discussion of its business as of and for the yearended December 31, 2002. However, due to its significance to the Company’sbusiness, a discussion of the Cylink acquisition and its anticipated impact isincluded at the end of Item 1. Business.

 

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Also in February 2003, SafeNet acquired substantially all the assets ofRaqia Networks, Inc. (“Raqia”), a development stage company, consistingprimarily of technology-related intangible assets. Total consideration paid bySafeNet was 389,640 shares of SafeNet common stock with an estimated value of$6.7 million plus $805,000 in cash. SafeNet had previously invested $1.0 millionin Raqia. The Company will obtain an independent valuation of the acquiredassets, in order to allocate the purchase price during the first quarter of2003.

 

In January 2002, SafeNet acquired Pijnenburg Securealink, Inc.(“Securealink”), a Delaware Corporation primarily engaged in the manufacture ofsecurity chips for e-commerce transactions through its European subsidiary.Securealink develops, markets and sells security chips and intellectualproperty, primarily in Europe and Asia. As a result of the acquisition, SafeNethas broadened its market with the addition of new technologies and a largerpresence in Europe. The operations of Securealink were integrated intoSafeNet’s Embedded Security division.

** **

**GENERAL**

** **

**Overview**

 

SafeNet delivers a widely deployed Virtual Private Network(VPN) technology for secure business communications over the Internet,offering both Original Equipment Manufacturer (OEM) technology andend-user products for VPN and e-commerce applications. SafeNet security solutionsoffer competitive advantages to SafeNet customers by lowering the cost ofdeploying and managing secure, reliable private networks, while enabling use ofVPNs over the Internet for trusted transactions with business partners,customers, and staff.

 

A VPN is a communications system that uses strong encryption andauthentication to create private “tunnels” through the Internet or othershared, public networks, allowing businesses to take advantage of the lowestcost network without exposing their business communications. VPN technology hasbeen a core competency of SafeNet for over a decade and remains a principalfocus of the Company.

 

Since it began business in 1983, SafeNet has been providing networksecurity solutions worldwide for financial, enterprise, telecommunications, andgovernment use. SafeNet’s SecureIP TechnologyTM has enjoyed broadmarket acceptance through both the enterprise and OEM VPN markets.Organizations that depend on robust security for all communications have beenenabled with SafeNet technology for years. Through customer engagements withorganizations such as the U.S. Department of Defense, the U.S. Department ofState, Internal Revenue Service, the U.S. Department of the Treasury, theFederal Reserve Bank, the U.S. Social Security Administration, and Citibank,SafeNet has gained over 19 years of direct experience developing, deploying,and managing network security systems for Fortune 500 companies and governmentorganizations around the world.

 

SafeNet has positioned its VPN technology as a provider of choice forleading Internet infrastructure manufacturers, semiconductor developers,service providers, and security vendors, licensing its de facto standard remoteaccess software to thirty-five leading OEM manufacturers including four of thesix leading VPN appliance manufacturers. Customers include Microsoft, CiscoSystems, Texas Instruments, ARM, Samsung, NETGEAR, NEC Corporation, Nokia,ZyXEL, Watchguard, Sonicwall and Netscreen. With SafeNet securing theinfrastructure of today’s e-business communications, the Company is opening newmarkets for interoperable, secure, and deployable VPN communications.

 

SafeNet has taken its vision—to offer a simple, cost-effective approachto Internet security—and become an innovator in the Internet security marketplace,using its expertise to identify and develop emerging security technologies. In1995, SafeNet introduced the first Internet VPN and has sought to educate themarket and develop leading-edge technology to bring VPNs into the mainstreamand make security on the Internet a reality for business.

 

VPNs have become one of the most sought after sectors in the networkingcommunications industry. The tremendous growth of the Internet and theapplications surrounding this pervasive public network has increased the needfor VPN products and technology around the world. SafeNet is continuing itstrend of 

 

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delivering security solutions for existing markets while remainingcompetitive by creating innovative products and technology for new and emergingmarkets, such as broadband and wireless technologies.

 

At the same time, after the incidents of September 11th, the needto provide the U.S. Government and infrastructure organizations with an evenhigher level of security has created yet another challenge for SafeNet. TheCompany has developed new technologies such as Federal Information ProcessingStandards (FIPS) certification and the Advanced Encryption Standard (AESalgorithm), aimed at supporting the nation’s homeland security efforts. Intoday’s corporate environment, it is imperative that organizations have optionsto protect their businesses through high assurance security technology and atthe same time follow the U.S. guidelines through its homeland securitydirectives.

** **

**SOFTWARE HIGHLIGHTS**

 

During this past fiscal year, SafeNet was awarded a contract to providea government-specific version of SafeNet’s new high assurance software,HighAssuranceTM Remote, making itavailable for any U.S. Government department, agency, or command to use forremote access and secure communications through a SafeNet-hosted websiteexclusively for government employees to download the software. SafeNetannounced the availability of this HighAssuranceTM Remote access VPNclient in November 2002. HighAssuranceTM Remote is based onSafeNet’s de facto standard VPN software product, SoftRemote, licensed tothirty-five leading OEM manufacturers.

 

SafeNet announced the availability of SoftRemotePDATM for the Pocket PC2002. Compatible with any portable, handheld device using Pocket PC 2002, suchas the Compaq iPAQ and Casio Cassiopeia®, SoftRemotePDA for the Pocket PC 2002secures end-to-end connections between Pocket PC handheld devices and the corporatenetwork.

 

NEC Solutions America licensed SafeNet’s leading VPN remote accessclient, SoftRemote®. NEC Solutions America will resell SoftRemote to itscustomers for wireless LAN (WLAN), 802.11, and handheld security applications.

 

The Company licensed a new version of SafeNet’s SoftRemote® VPNsoftware to Microsoft Corporation. This new version of SafeNet VPN clientsoftware will support the IETF standard L2TP/IPSec VPN protocol for users ofMicrosoft Windows 98, Windows Millennium Edition, and Windows NT Workstationdesktop operating systems.

 

During fiscal year 2002, the newest version of SafeNet’s de factostandard VPN client software SoftRemote® was introduced. SoftRemote 8.0, withMicrosoft® Windows® XP compatibility and support for Network AddressTranslation (NAT) Traversal, becomes the only VPN client on the market todaythat offers compatibility with all Microsoft Windows operating systems alongwith other advanced features and extensive interoperability.

** **

**SILICON HIGHLIGHTS**

 

During the Company’s fiscal year 2002, SafeNet introduced a newproduct, SafeXcel-1141. A next generation step from the SafeXcel-1140, theSafeXcel-1141, now offering DES, Triple DES, and AES algorithms, is a highlyintegrated VPN security co-processor optimized for a variety of products suchas routers, gateways, DSL/Cable modems, wireless access points, and firewalls.SafeNet believes the SafeXcel-1141 is poised for a leading position amongsecurity processors, because it provides the optimum price versus performancepoint for broadband and wireless applications. SnapGear, Inc., a leadingmanufacturer of VPN firewall appliances for the small to medium enterprisemarket, selected SafeNet’s Momentum Series SafeXcelTM-1141 chipfor its new VPN appliances. These appliances are intended for larger enterpriseuse with throughputs up to 10 Mbps.

 

ZyXEL Communications, the world’s leading xDSL Router Manufacturer(Gartner Dataquest, July 2001) selected the SafeXcel-1140 chip for its ZyWALL50 security gateway, used for the small-office-home-office (SOHO) market.

 

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During the fiscal year 2002, SafeNet introduced a new silicon product,the SafeXcelTM-1741. The SafeXcel-1741 offers high performance Triple DES andAES algorithms in a highly integrated VPN security co-processor. Ideal forbroadband applications including routers, gateways, DSL/cable modems, wirelessaccess points, and firewalls for remote or branch offices, the SafeXcel-1741improves performance up to 260 Mbps IPSec packet throughput for ESP packets(AES and SHA-1).

 

NETGEAR chose the Company’s SafeXcelTM-1741 securityco-processor to provide security to its new Wireless Firewall Router device—arouter device that establishes IPSec-based VPN tunnels over the wireless LANand multiple tunnels over the WAN connection, so that small businesses can havea completely secure and cost-effective network solution. During the same time,NEC Corporation also chose the SafeXcelTM-1741 to secure its FTTHconnections, deploying the chip in its IX2010 access router for corporatenetworks.

 

SafeNet also announced the availability of its VPN InterOp Toolkit,making SafeNet the only security vendor that can offer one complete securitysolution. The VPN InterOp Toolkit allows IPSec, Internet Key Exchange (IKE),and Public Key Infrastructure (PKI) functionality to be quickly integratedin networking appliances such as gateways, DSL/Cable modems, routers, wirelessaccess devices, storage devices, and SOHO boxes.

 

Early in fiscal year 2002, SafeNet announced the availability of theSafeXcel-810 chip for secure smart card readers. The SafeXcel-810 chip is anintegrated circuit (IC), which was originally developed by Securealink,designed for stand-alone smart card readers and keyboards with built-in readers.This chip has been selected by multiple customers who are actively integratingit into their own product lines.

** **

**INTELLECTUAL PROPERTYHIGHLIGHTS**

 

During SafeNet’s fiscal year 2002, the Company continued selling itstechnology to semiconductor manufacturers in the form of intellectual propertycalled EmbeddedIPTM. The resultof this development led to licensing contracts to leading companies includingARM Limited. ARM licensed the cryptographic acceleration offered by the SafeNetEIP-25 together with its ARM core to its technology partners for use in avariety of applications, including wireless chipsets and smart cards.

** **

**PARTNERSHIPHIGHLIGHTS AND ACQUISITIONS**

 

In January 2002, SafeNet acquired Securealink, which is engaged in themanufacture of security chips for e-commerce transactions through its Europeansubsidiary. Securealink develops, markets and sells security chips andintellectual property, primarily in Europe and Asia. As a result of theacquisition, SafeNet has broadened its market with the addition of newtechnologies and a larger presence in Europe.

 

During fiscal year 2002, SafeNet entered into a joint development andmarketing agreement with Raqia. Under the agreement, SafeNet also made aminority investment in Raqia. In February 2003, SafeNet acquired substantiallyall of the assets of Raqia, a development stage enterprise, for a purchaseprice of 389,640 shares of SafeNet common stock valued at approximately $6.7million and $805,000 in cash. SafeNet intends to integrate the assets purchasedfrom Raqia to create what SafeNet believes to be the industry’s most secure andcomprehensive systems-on-chip, co-processors, and accelerator cards.

 

SafeNet announced a strategic alliance with Phoenix Technologies Ltd.(Nasdaq: PTEC), a global leader in device-authenticated software products forconnected digital devices. Under the agreement, SafeNet and Phoenix will linktogether their market leading products to seek to create what SafeNet believesto be the industry’s most secure VPN software and services.

 

PalmSource, Inc. selected SafeNet as a VPN security partner in 2002.SafeNet and PalmSource have been collaborating in recent months on VPN securityfor wireless devices, including a license agreement for PalmSource todistribute an evaluation version of SoftRemotePDATM for the Palm OS® 5 platform to licensees. Licensees will then beable to license the VPN client from SafeNet for distribution with their PalmPowered products.

 

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SafeNet believes the acquisition of Cylink, which closed in February2003, strengthens SafeNet’s current activities, adds an impressive base of newgovernment customers, and further expands the scope of the Company’s productline. The Cylink organization is experienced in providing encryption appliancesto major government and financial organizations seeking to add strong securityto their products and looking for an easy, cost effective migration from costlyWAN technology to more cost effective VPN technology. Cylink is beingintegrated under the SafeNet brand and will continue to focus on its core areaof expertise in order to better serve SafeNet’s government and financialenterprise customers.

** **

**INDUSTRY BACKGROUND**

** **

**The VPN Market**

 

A VPN is a communications system using strong encryption that creates aprivate “tunnel” through the Internet and other communications systems,assuring authentication of users and privacy of information. This allowsbusinesses to use the lowest cost network without exposing their businesscommunications. A VPN can allow an organization’s employees to accesscompany-confidential information over an Intranet or Extranet, or allow tradingpartners access to a company Extranet for secure business-to-businesselectronic commerce applications. A leading market research firm predicts thatby the year 2008 the sales of VPN products and services will reach$1.8 billion.

 

VPNs also allow organizations to use public networks for theircommunications backbone. This is achieved by protecting the data traffic withdata communications security technology such as: encryption, messageauthentication, user authentication, and firewall technology. Because publicnetworks are much cheaper than private leased lines and dedicated frame relaynetworks, corporations can generally achieve substantial cost savings by usingVPNs while taking advantage of the global availability and access to theInternet.

 

With the increasing use of public and private communications networksand the ability of different types of computers to communicate with each other,data integrity and security have gained increased importance. Secure VPNs havethree key uses: secure remote access, secure site-to-site connections, andsecure Extranet connections.

 

SafeNet management believes that the market for security systems andproducts providing VPN solutions has grown over the last several years due toan increase in the use of the Internet for business communications andelectronic commerce applications such as work-at-home arrangements ortelecommuting, electronic mail, satellite offices connected to a central computer,electronic funds transfer, electronic data interchange with clients, suppliers,and business customers, and numerous other arrangements. The popularity andassociated usage of the Internet has increased the requirements for VPNtechnology and products to ensure secure “intra” and “inter” companycommunications.

 

VPNs are facilitating the growth of e-business and business-to-businessonline applications. Growth in this area has been significant and SafeNetmanagement believes it will continue to grow in the future.

** **

**PRODUCTS**

 

SafeNet’s VPN technology and product offerings include software andhardware products, dedicated solutions, and embedded technology for the OEMmarket.

** **

**SecureIP TechnologyTM**

 

SecureIP TechnologyTM****isthe core technology that is at the heart of all SafeNet solutions and products.Delivered in the form of computer chips, plug-in boards, software modules, andintellectual property, SecureIP TechnologyTM provides the buildingblocks for security implementation that enable organizations to use theInternet and other shared networks for secure communications. SecureIPTechnologyTM is sold in the following packages: 

 

**EmbeddedIPTM**

 

EmbeddedIPTMis the streamlined delivery of SafeNet SecureIP TechnologyTM foravailability to 

 

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OEMdevelopers, semiconductor developers, and technology integrators. EmbeddedIPTMis available for license in IP cores or blocks —whereby selected elements ofthe VPN encryption technology can be adapted in single or multipleimplementations. This allows OEMs to incorporate selective blocks in their ownASICs or processors to allow for very cost-effective, high throughput, lowpower-consuming designs. EmbeddedIP can be licensed in the followingimplementations:

 

•                      EncryptionEngines: DES/3DES, AES;

 

•                      HashEngines: SHA-1, MD5;

 

•                      PacketEngines: IPSec, MPPE;

 

•                      Public KeyAccelerators: RSA, DSA, and Diffie-Hellman;

 

•                      Entropybased True Random Number Generator (RNG).

** **

**SafeXcelTM**

 

SafeXcelTM****isSafeNet’s silicon product line for OEM developers looking for embedded,accelerated security. SafeXcel chips are separated into the Momentum Series (upto 100 Mbps), the Velocity Series (100 Mbps to 1 Gbps), and the Reliance Series(1 Gbps and higher). The SafeNet silicon product line includes high-performanceICs and privacy products for both IPSec and SSL encryption. Announced SafeXcelchips include the following: SafeXcel-1140, SafeXcel-1141, SafeXcel-1741,SafeXcel-2010, SafeXcel-2141, SafeXcel-ISES, SafeXcel-306, SafeXcel-317,SafeXcel-318, and SafeXcel-810.

 

**SafeXcelTMCards**

 

SafeXcelTM****Cardsare plug-in PCI boards that provide cryptographic throughput and accelerationfor operations such as encryption, hashing, public key computations, keynegotiation, signatures, and random number generation. Announced SafeXcel Cardsinclude SafeXcel 140-PCI, SafeXcel 141-PCI, SafeXcel 171-PCI, and SafeXcel241-PCI.

 

**SoftIPTM**

 

SoftIPTM****isthe SafeNet software product line that includes the remote access client,SoftRemote®, and the latest version, HighAssuranceTM****Remote. Other software productsinclude SoftRemoteLT for 802.11 applications, SoftRemotePDA for the Palm OS andSoftRemotePDA for the Pocket PC 2002 for handheld portable devices, andSoftRemote® Policy Manager, for complete deployment and managementof SoftRemote clients.

** **

**CGX Security Platform**

 

The CGX Security Platform is a next-generation, integrated, securityenvironment providing a single, easy solution for building encryption-basedsecurity systems. The CGX Security Platform, the embodiment of over19 years of encryption expertise, is a complete environment in which OEMscan build any type of encryption product. SafeNet believes Platform brings asignificant advantage to OEM developers by accelerating time to market,reducing development costs, and providing a system-level implementation ofencryption technology. With its flexibility, standalone software, and securityhardware, entire security systems can be easily developed.

** **

**SafeEnterpriseTM**

 

SafeEnterprise**TM**is SafeNet’s enterprise productline that integrates the full range of Internet security needs, such as accesscontrol, encryption, user authentication, message authentication, and policymanagement. SafeEnterprise is intended for large government and financialinstitutions that require a high level of strong and proven securitytechnology. During fiscal year 2002, SafeNet introduced a high assurancesecurity product line within the SafeEnterprise product category, whichincludes its HighAssurance Remote access client software, and the HighAssurance2000 Gateway, a rebranding of the NetHawk VPN Gateway 

 

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acquired through Cylink. The SafeEnterprise system consists of twoclient products (SafeNet Soft/SmartTMand SafeNet SoftRemote®) for remote access, a high performance gateway (SafeNetSpeedTM), and a centralizedsecurity management system, providing comprehensive security in an easy-to-use,scaleable solution (SafeNet Security Center). SafeNet Security Center includesthree levels of management systems and can also be utilized through a ManagedVPN Service program.

 

Along with these products, SafeNet added three encryptor productsthrough the Cylink acquisition, for leased line encryption. The SafeEnterpriseFrame Encryptor, the SafeEnterprise ATM Encryptor, and the SafeEnterprise LinkEncryptor are technology for enterprise-wide LAN-to-LAN, data sharing andclient-server applications. They combine the advantages of circuit and packetswitched services with low latency.

 

Finally, with the acquisition of Cylink, SafeNet has added PrivaCyManager, to be enhanced and rebranded SafeEnterprise Security Management Center(SMC), to its line of management tools. This management center will allow SafeNetcustomers to manage all aspects of their WAN and VPN networks and will allowfor easy migration from WAN to VPN technology.

** **

**PRODUCT DEVELOPMENT**

 

SafeNet conducts product development activities to increase the size ofits available market through broader product offerings and to reduce the costof its products, resulting in more competitive pricing and/or better operatingmargins.

 

The VPN market, in its growth period, will be continually looking forproducts that offer the strongest encryption and the fastest throughput. TheCompany will continue to devote resources to the latest VPN technology to meetthe increasing demands of the market.

** **

**PRODUCT DESIGNSTANDARDS**

 

VPN security technologies are utilized by SafeNet to provide securecommunication over public networks, including the Internet. This securitytechnology provides selective access to computer networks, prevents electroniceavesdropping or alteration during electronic data transmission, providesmessage authentication confirming that messages are received in unaltered form,and enables user authentication and digital signatures verifying the identityof the message sender and limiting computer access to authorized users. SafeNetoffers a choice of encryption algorithms to provide the level of networksecurity appropriate for each client application.

 

All of SafeNet’s network security systems and products comply with thefollowing general product design standards:

** **

**Standards Compliance**

 

SafeNet’s policy is to offer products based upon encryption algorithmsthat have been approved as industry and government standards, providingSafeNet’s clients assurance that they are using products that meet commercialreasonability tests. This includes FIPS certification as well as a move toCommon Criteria.

** **

**Network Compatibility**

 

SafeNet’s systems and products contain sufficient intelligence toaccommodate the specific communication protocols employed by complex computernetworks, including support for Frame Relay, Dial Asynchronous, leased line,X.25, Bisync and Internet protocol-based networks.

** **

**Interoperability**

 

SafeNet management believes the market opportunity for VPN technologyand products increases when vendors’ product offerings become interoperable.SafeNet’s commitment to the IPSec standard and multi-vendor interoperability isutilized in existing and planned product offerings.

** **

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**Ease of Use**

 

SafeNet believes that users of its products, while concerned that theirdata is secure, do not wish to be required to take specific actions to achievesecure status. Therefore, our products are designed to function without userinvolvement, thus offering an extremely high level of ease of use.

** **

**Ease of Managementand Administration**

 

SafeNet has extended its ease of use concept to the policy managementof its most widely deployed client, SafeNet SoftRemote®. The SoftRemote® PolicyManager is a Windows-based application that simplifies deployment of allversions of SafeNet SoftRemote® and enables centralized management of securitypolicies.

** **

**Price PerformanceCriteria**

 

SafeNet believes that in order for clients to invest in encryptiontechnology, its products must be implemented cost effectively. As such, ourdevelopment staff follows a design approach similar to that used with consumerelectronics products that are designed for low manufacturing cost.

** **

**Encryption Algorithms**

 

At present, SafeNet’s products employ a variety of encryptionalgorithms including the Advanced Encryption Standard (AES), U.S. GovernmentTriple Data Encryption Standard (“TDES”), Single DES, RSA Data Security Inc.Encryption Standard (“RSA”).

** **

**SALES AND MARKETING**

** **

**Sales**

 

SafeNet has continued to sell through both direct sales and indirectdistribution channels in order to expand worldwide sales coverage. In NorthAmerica, in addition to direct sales, the Company sells products primarilythrough Value Added Resellers (VAR) and Original Equipment Manufacturers.With the acquisition of Cylink, the VAR partner program expanded to includechannel partners in South America, Asia, Europe, the Middle East, and Africa.In Europe, SafeNet products are sold through a direct sales force, whichexpanded with the acquisition of Cylink to include an office in the UK andSingapore. Outside of such territories, SafeNet products are sold throughdistributors of communication or information security products. A global salesorganization provides support for these distribution channels. OEM salesefforts are sold through partners and direct sales.

 

As a result of the acquisition of Cylink, the Enterprise SecurityDivision expanded its sales concentration into financial and other commercialmarkets, while continuing to concentrate on U.S. Government and HomelandSecurity efforts. This was accomplished through the addition of severaldomestic offices in Virginia and New Jersey.

** **

**Marketing**

 

SafeNet continued its initiative of branding the company in Europe andAsia and strengthening its leadership position with a strong marketingpresence.

 

SafeNet began the year 2002 continuing as a leader in the VPN market.Through a presence at large tradeshow events like RSA Security Conference inSan Jose, California, and E-Gov in Washington, DC, SafeNet continued to showits strong security brand. With exhibitions at shows like CEBIT 2002 inHanover, Germany, SafeNet began to expand its brand awareness to the largeEuropean markets. During 2002, SafeNet increased it corporate web presence ande-commerce capabilities, which resulted in an over 150% increase in the websales of its software client.

 

Beginning in January 2002, SafeNet continued to broaden its brand withthe acquisition and rebranding of Securealink B.V. (“SafeNet, B.V.”), a fablesssemiconductor company in the Netherlands, and the opening of a new sales officein Switzerland, operating as SafeNet AG. Efforts were made to gain brandawareness 

 

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in Europe through leveraging the reputation and product offerings ofthe new Holland operations in Vught, the Netherlands.

 

SafeNet’s marketing program also continued lead generation andincreased coverage of SafeNet’s technology and products in leading tradepublications. The Company increased emphasis on developing awareness of theSafeNet brand through public relations efforts and joint marketing arrangementswith our strategic partners. SafeNet also increased its use of direct marketingprograms through email, direct mail, and web-based promotions. The Companyinstituted processes to ascertain the requirements of existing and prospectiveend-user and OEM customers. The Company’s success in embedding its technologyin leading networking vendors’ products has helped gain market awareness.SafeNet will continue its endeavor to co-brand SafeNet technology with industryleaders to increase market awareness.

** **

**CLIENT SUPPORT ANDPRODUCT WARRANTIES**

 

SafeNet provides support for clients through a staff of supportengineers knowledgeable in both SafeNet’s network security systems andproducts, and complex computer networks. In addition to supporting clients,this group of engineers performs system level quality assurance testing of newproducts and product enhancements. SafeNet provides client telephone support,including 24 hour a day “hot line” support. In addition, the Company offerson-site training, installation, and trouble-shooting services, generally on afee basis.

 

SafeNet provides limited warranties on its hardware products for oneyear upon delivery of the product. After warranty expiration, clients maypurchase an extended warranty support contract. This contract extends warrantyservice for an additional one-year period, providing repair or replacement ofdefective products and telephone support. SafeNet also offers support on a timeand materials basis.

** **

**MANUFACTURING ANDINVENTORY**

 

SafeNet’s inventory and current manufacturing operations are performedby a contract manufacturer, EIT, Inc., working under SafeNet’s direction. Theoutsource operations include engineering prototypes, pre-production runs, fullturnkey boxbuilds, and product drop shipments. SafeNet designs and develops allkey components of our products; printed circuit boards, software, and ourproprietary ASICs (Application Specific Integrated Circuit), which arefabricated by contract foundries. SafeNet also designs, specifies and monitorsall the testing required to meet our internal and external quality controlguidelines. SafeNet’s legacy products and product lines are handled by othercontract manufacturers with the appropriate product knowledge base. Outsourcingallows SafeNet to reduce fixed overhead and personnel costs and providesgreater flexibility to match product and market demands.

 

In January 2003, Cylink transferred substantially all of its inventoryand manufacturing operations to EIT, Inc.

** **

**COMPETITION**

 

The VPN market is highly competitive and subject to rapid technologicalchanges. SafeNet believes that competition in this market is likely tointensify as a result of increasing demand for Internet security technology andproducts. There are several companies in this field that have been establishedlonger than SafeNet, and have greater financial, research, service support, andmarketing resources than those of SafeNet. There are also a number of otherhardware and software data encryption methods and security technologies on themarket which compete with our products.

 

SafeNet management believes that the principal competitive factorsaffecting the VPN market include standards compliance, quality/reliability,technical features, network compatibility, ease of use, client service andsupport, distribution and price. Although SafeNet believes its technology andproducts currently compete favorably with respect to such factors, there can beno assurance that SafeNet can maintain its competitive position against currentand potential competitors.

 

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If the VPN market continues to develop, it will likely be characterizedby rapid advances in technology and new products that could render the existingtechnology upon which SafeNet’s technology and products are based lesscompetitive. However, the Company believes that its core technology will be thebasis for future product offerings in the years to come. This risk willincrease to the extent that our competitors include manufacturers of computerequipment and Internet appliances to which our products relate, since suchmanufacturers may be in a better position than SafeNet to develop securityproducts in anticipation of developments in their computer equipment.

** **

**PATENTS ANDINTELLECTUAL PROPERTIES**

 

Between 1996 and 2002, SafeNet was awarded seven United States Patentscovering cryptographic key management, kernel mode protection, key recoveryschemes, portable encrypting and authenticating network interface devices, suchas modems. The patents provide SafeNet with ownership rights to a technologythat SafeNet believes will be critical to the growth of computer networks, suchas the Internet. The patents cover our SafeXcel chips, CGX Security Platform,SafeNet Dial and the AX400. Additional domestic and foreign patentapplications, which cover the same products and technology, as well asadditional EmbeddedIP product offerings, are pending.

 

SafeNet has acquired the rights to license a United States Patent for aself-authenticating fingerprint identification card for certain computersecurity and financial applications. Under the license agreement, SafeNet paysto the licensor a royalty on each sale or license of products that contain thepatented technology.

 

The computer software source codes, which are essential elements ofSafeNet’s products, are the proprietary trade secrets of and are copyrighted bySafeNet. The protection of proprietary technology and information developed bythe Company will be limited to such protection as it may be able to securepursuant to trade secret or copyright laws or under any confidentialityagreements into which SafeNet may enter. SafeNet owns federally registeredtrademarks for the SafeNet name and for certain of its products; however, thereis no assurance as to the validity, enforceability, or lack of infringement ofsuch trademarks.

 

At present, SafeNet is a party to confidentiality agreements with itsofficers, directors, and employees. There can be no assurance that the scope ofany such protection SafeNet is able to secure will be adequate to protect itsproprietary information, or that SafeNet will have the financial resources toengage in litigation against parties who may infringe such proprietarytechnology or copyrights. In addition, there can be no assurance that otherswill not develop similar technology independent of SafeNet.

 

SafeNet believes that its products do not infringe the proprietaryrights of third parties. There can be no assurance, however, that third partieswill not assert infringement claims in the future.

** **

**EMPLOYEES**

 

As of March 3, 2003, SafeNet had 215 employees, of whom 17 areengaged in production and quality control, 25 in administration and financialcontrol, 112 in engineering, development, and client support, and 61 inmarketing and sales. SafeNet employs 165 employees in the United States, 39employees in the Netherlands, 8 employees in United Kingdom, and 3 employees inSingapore. Approximately 65 of those employees are from the acquisition ofCylink.

** **

**RISK FACTORS**

 

SafeNet operates in a rapidly changing environment that involvesnumerous risks, some of which are beyond our control. The following discussionhighlights some of the possible risks.

** **

**SafeNet has a Historyof Losses And May Incur Future Losses**

 

The Company has experienced substantial net losses in four of the lastfive years, including 2002. As of December 31, 2002, SafeNet had anaccumulated deficit of $20,225,000. Although our revenues are subject tofluctuation, SafeNet intends to maintain or increase our expenditures in allareas in order to execute the 

 

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Company’s business plan. As a result, the Company may incur substantialadditional losses. The likelihood of SafeNet’s success must be considered inlight of the problems, expenses and delays frequently encountered in connectionwith new technologies utilized with the transition to an Internet VPN businessand the competitive environment in which SafeNet operates. Investors should notconsider the Company’s historical results indicative of future revenue levelsor operating results. SafeNet can neither give assurance that it will operateprofitably in the future nor that the Company may sustain profitability if itis achieved.

** **

**Risk of IntegratingRecent Acquisitions or Other Future Acquisitions**

 

On February 6, 2003, SafeNet acquired Cylink, a manufacturer ofsecurity appliances and software for securing the Internet and private networkcommunications. SafeNet expects this acquisition to facilitate the Company’sgrowth in the enterprise systems aspects of the business through access to abroader range of government and commercial enterprise customer accounts, abroader and more complete product offering, and the fortified support ofSafeNet’s key government and financial customers.

 

Also, on February 27, 2003, SafeNet acquired substantially all theassets of Raqia, a development stage company, consisting primarily oftechnology-related intangible assets. In addition, the Company may from time totime pursue other acquisitions of businesses that it believes compliments orexpands its existing business, including acquisitions that could be material insize and scope.

 

The acquisitions of Cylink and Raqia and other future acquisitionsinvolve various risks, including: 

 

•        Difficulties in integrating theoperations, technologies, and products of the acquired company;

 

•        The risk of diverting management’sattention from normal daily operations of the business;

 

•        Potential difficulties in completing projectsassociated with in-process research and development;

 

•                       Risks ofentering markets in which SafeNet has no or limited direct prior experience andwhere competitors in such markets have stronger market positions;

 

•        Initial dependence on unfamiliar supplychains or relatively small supply partners;

 

•        Insufficient revenues to offsetincreased expenses associated with the acquisition;

 

•        The potential loss of key employees ofthe acquired company.

 

There can be no assurance that the Company’s acquisitions of Cylink andRaqia, or other businesses, will be successful and will not materiallyadversely affect SafeNet’s business, operating results, or financial condition.The acquisition of Cylink in particular will have a significant impact on theCompany’s business operations going forward and failure to integrate thisacquisition effectively could have a material adverse effect on the Company’sbusiness and operating results. SafeNet must also manage any growth resultingfrom such acquisitions effectively. Failure to manage such growth effectivelyand successfully integrate the acquired company’s operations could have amaterial adverse effect on SafeNet’s business and operating results.

** **

**Quarterly OperatingResults May Fluctuate and Future Revenues and Profitability Are Uncertain**

 

SafeNet has experienced significant fluctuations in its quarterlyoperating results and anticipates continued substantial fluctuations in itsfuture operating results. A number of factors have contributed to thesequarterly fluctuations including: 

 

•        Market acceptance and demand for SafeNetproducts;

 

•        Length of sales cycle including thesize, timing, cancellation, or delay of customer orders;

 

•        Introduction of new products and productenhancements by SafeNet or its competitors;

 

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•        Market acceptance of new productsintroduced by SafeNet or its competitors;

 

•        Budgeting cycles of customers;

 

•        The timing and execution of individualcontracts;

 

•        The product mix sold in a given quarter;

 

•        Changes in the percentage of revenuesattributable to OEM license fees and royalties;

 

•        Length of time required by OEM’s toembed SafeNet products into their products which generate royalties to theCompany;

 

•        The percentage of products sold throughthe SafeNet direct sales force and its indirect distribution channels;

 

•        Product development expenses;

 

•        Business combinations and assetacquisitions as well as business disposals

 

•        Competitive conditions in the industry;

 

•        Changes in general economic conditions.

 

The Company’s expenses are based, in part, on its expectationsregarding future revenues, and are largely fixed in nature, particularly in theshort-term. SafeNet may be unable to predict future revenues accurately or toadjust spending in a timely manner to compensate for any unexpected revenueshortfall. Accordingly, any significant shortfall of revenues in relation toexpectations could cause significant declines in quarterly operating results.

 

Due to all of the foregoing factors, SafeNet’s quarterly revenues andoperating results are difficult to forecast. Therefore, management believesthat period-to-period comparisons of the Company’s operating results will notnecessarily be meaningful, and investors should not rely upon them as anindication of future performance. Also, it is likely that operating resultswill fall below expectations and the expectations of securities analysts orinvestors in some future quarter. In such event, the market price of SafeNetcommon stock could be materially adversely affected.

** **

**Risks of Changes inTechnology and Industry Standards**

 

The network security industry is characterized by rapid changes,including evolving industry standards, frequent new product introductions,continuing advances in technology, and changes in customer requirements andpreferences. SafeNet expects technological developments to continue at a rapidpace in the computer and communications industries, and there can be noassurance that technological developments will not cause the Company’stechnology to be rendered obsolete or non-competitive.

 

Future SafeNet products may not keep pace with technological changesimplemented by competitors, developers of operating systems or networkingsystems, or persons seeking to breach network security. The introduction of newtechnologies could also require the Company to invest in research anddevelopment at much higher rates with no assurance of developing competitiveproducts. Changes in technologies or customer requirements may also cause thedevelopment cycle for new products to be significantly longer than theCompany’s historical product development cycle, resulting in higher developmentcosts or a loss in market share. SafeNet products may not satisfy evolvingpreferences of customers and prospects. Failure to develop and introduce newproducts and improve current products in a timely fashion could adverselyaffect the Company. Because of the complexity of SafeNet products, whichoperate on or utilize multiple platforms and communications protocols, theCompany has from time to time experienced delays in introducing new productsand product enhancements primarily due to development difficulties or shortagesof development personnel. There can be no assurance that the Company will notexperience longer delays 

 

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or other difficulties that could delay or prevent the successfuldevelopment, introduction, or marketing of new products or productenhancements.

** **

**The loss of acommercial customer that accounted for a significant portion of SafeNet’srevenues during 2002 could have a material adverse effect on SafeNet’s businessand results of operations.**

 

SafeNet has one commercial client that accounted for 41% of itsconsolidated revenues for the year ended December 31, 2002. A loss of thiscustomer or significant cutback in its orders for SafeNet’s products would havea material adverse effect on SafeNet’s business and results of operations. In2003, this customer announced the selection of a different vendor to supplysome of its next generation chip technology, for which SafeNet had previouslybeen the sole provider. SafeNet’s business continues to evolve in an effort toreduce to significant customer exposure through the introduction of new customersand more products. This customer continues to be a major revenue source forSafeNet.

** **

**Restrictions on theExport of Some SafeNet Products.**

 

Currently SafeNet sells products internationally and intends tocontinue to expand relationships with international distributors and resellers.International sales and operations could be subject to the following risks: 

 

•        The imposition of governmental controls;

 

•        Export license requirements;

 

•        Restrictions on the export of criticaltechnology;

 

•        Trade restrictions;

 

•        Changes in tariffs.

 

Some SafeNet network security products are cryptographic devices andare subject to the export restrictions administered by the Bureau of ExportControl, U.S. Department of Commerce. These restrictions permit the export ofencryption products based on country, algorithm, and class of end-user. Theyprohibit the export of encryption products to a number of countries and tobusiness entities that are not included in a range of end-users. There is noassurance, however, that the applicable regulations or policies concerning theexport of such technology will not become more restrictive. SafeNet foreigndistributors may also be required to secure licenses or formal permissionbefore encryption products can be imported.

** **

**Facing IntenseCompetition**

 

The security industry is relatively new, highly competitive, andsubject to rapid technological changes. SafeNet’s success will depend, in largepart, on its ability to establish and maintain an advantageous market position.The Company currently competes with companies that have substantially greaterfinancial resources, sales and marketing organizations, market penetration, andresearch and development capabilities, as well as broader product offerings andgreater market presence and name recognition. SafeNet management expects toface increasing competitive pressures from current competitors and new marketentrants. This competitive risk will increase to the extent that competitorsbegin to include software vendors, network providers, and manufacturers ofnetworking and computer equipment and communication devices. Thesemanufacturers and network providers may be in a better position to developsecurity products in anticipation of developments in their products andnetworks. Competitive factors in the VPN market include: 

 

•        Standards compliance;

 

•        Product quality and reliability;

 

•        Technical features;

 

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•        Product ease of use;

 

•        Network compatibility;

 

•        Client service and product support;

 

•        Distribution;

 

•        Price.

 

There can be no assurance that the Company can continue to competesuccessfully against new or existing competitors.

** **

**Market ConsolidationMay Create More Formidable Competitors**

 

There has been substantial consolidation in the information securityindustry, and SafeNet expects that there will be significant additionalconsolidation in the near future. As a result of that increasing consolidation,the Company expects that it will increasingly compete with larger firms that havebroader product offerings and greater financial resources. SafeNet managementbelieves that such competition may have a significant negative effect oncurrent and developing collaborative, marketing, distribution and resellingrelationships, product pricing and product development budget and capabilities.Any of those negative effects could significantly impair the Company’sfinancial condition and results of operations.

** **

**Risk of InadequateProtection for SafeNet Proprietary Technologies**

 

SafeNet’s success and ability to compete is dependent, in part, uponthe Company’s ability to maintain the proprietary nature of its technologies.SafeNet relies on a combination of patent, trade secret, copyright andtrademark law, and nondisclosure agreements to protect its proprietarytechnology. Although SafeNet holds several patents and has several pendingpatent applications that cover certain aspects of the Company’s technology,such patents, and patent applications do not protect some of SafeNet’s securityproducts. Current and future patent applications may not be granted.Additionally, current patents may not be broad enough to protect the coretechnology critical to SafeNet security products.

 

Confidentiality agreements and other methods on which SafeNet relies toprotect its trade secrets and proprietary information and rights may not beadequate to protect all proprietary rights. Litigation to defend and enforcethe Company’s intellectual property rights could result in substantial costsand diversion of resources and could have a material adverse effect onfinancial conditions and results of operations regardless of the final outcomeof such litigation. Despite SafeNet’s efforts to safeguard and maintain itsproprietary rights, it may not be successful in doing so or the steps taken bythe Company in this regard may not be adequate to deter misappropriation orindependent third-party development of SafeNet technology or prevent anunauthorized third party from copying or otherwise obtaining and using SafeNetproducts, technology, or other information that the Company regards asproprietary. SafeNet trade secrets or non-disclosure agreements may not providemeaningful protection of its proprietary information. Also, others mayindependently develop similar technologies or duplicate any technologydeveloped by SafeNet. The Company’s inability to protect its proprietary rightswould have a material adverse effect on its financial condition and results ofoperations.

 

Further, as the number of network security products in the industryincreases and the functionality of these products further overlaps, SafeNet maybecome subject to claims of infringement or misappropriation of theintellectual property or proprietary rights of others. Third parties couldassert infringement or misappropriation claims against the Company in thefuture with respect to current or future products. SafeNet may also be subjectto additional risks as the Company enters into transactions in countries whereintellectual property laws are not well developed or are poorly enforced. Legalprotections of its rights may be ineffective in such countries, and technologydeveloped in such countries may not be protected in jurisdictions whereprotection is ordinarily available. Any claims or litigation, with or withoutmerit, could be costly and could result in a diversion of management’sattention, which could have a material adverse effect on its financialcondition and results of operations. Adverse determinations in such claims or 

 

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litigation could also have a material adverse effect on the Company’sfinancial condition and results of operations.

** **

**Risks Relating toEvolving Distribution Channels**

 

SafeNet relies on both our direct sales force and an indirect channeldistribution strategy for the sale and marketing of its products. The Company’ssales and marketing organization may be unable to successfully compete againstthe more extensive and well-funded sales and marketing operations of certain ofits current and future competitors. SafeNet may also be unable to continue toattract integrators and resellers that can market its legacy productseffectively and provide timely and cost-effective customer support and service.Additionally, the Company’s distributors, integrators, and resellers may carrycompeting lines of network security solutions. The loss of important salespersonnel, distributors, integrators, or resellers could adversely affectSafeNet.

** **

**Risk of ProductDevelopment Delays**

 

SafeNet may experience schedule overruns in product developmenttriggered by factors such as insufficient staffing or the unavailability ofdevelopment-related software, hardware, or technologies. Further, whendeveloping new network security products, development schedules may be alteredas a result of the discovery of software bugs, performance problems or changesto the product specification in response to customer requirements, technologymarket developments or self-initiated changes. All of these factors can cause aproduct to enter the market behind schedule, which may adversely affect marketacceptance of the product or place it at a disadvantage to a competitor’sproduct that has already gained market share or market acceptance during thedelay.

** **

**Product LiabilityRisk**

 

The sale and installation of SafeNet’s network security systems andproducts within the computer networks of its customers and the operation of itsSafeNet facility entails a risk of product failure, product liability or otherclaims. An actual or perceived breach of network or computer security,regardless of whether such breach is attributable to the Company’s products,could adversely affect its reputation and financial condition or results ofoperations. The complex nature of SafeNet products can make the detection oferrors or failures difficult when products are introduced. If errors orfailures are subsequently discovered, this may result in delays and lostrevenues during the correction process. A malfunction or the inadequate designof SafeNet products could result in product liability claims. Managementattempts to reduce the risk of such losses through warranty disclaimers andliability limitation clauses. However, SafeNet may not have obtained adequatecontractual protection in all instances or where otherwise required underagreements it has entered into with others.

 

SafeNet currently maintains product liability insurance. However, theinsurance coverage may not be adequate and any product liability claim fordamages resulting from security breaches could be substantial. In the event ofproduct liability litigation, insufficient insurance coverage could have amaterial adverse effect on SafeNet’s financial condition and results ofoperations. Further, certain customers and potential customers may requireminimum product liability insurance coverage as a condition precedent topurchasing SafeNet products. Failure to satisfy such insurance requirementscould impede the Company’s ability to achieve product sales, which would have amaterial adverse effect on its financial condition and results of operations.There is no assurance that such insurance will be available at a reasonablecost or will be sufficient to cover all possible liabilities.

** **

**Dependence upon ThirdParty Suppliers and Contractors**

 

SafeNet relies upon third party contractors for the manufacture ofcomponents and sub-assemblies for SafeNet products. There is no assurance thatthe Company will be able to obtain and/or maintain satisfactory contractualrelations with qualified vendors or suppliers. The unavailability of such thirdparties may substantially decrease SafeNet’s control of the cost, quality andtimeliness of the manufacturing process. At present, the Company is not a partyto any exclusive supply contracts with third party contractors for its legacyproducts. All purchases of components or parts for SafeNet products are 

 

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accomplished by the use of purchase orders issued in the ordinarycourse of business. While SafeNet has not experienced any significant supplyproblems in the past, and there have been no materially late deliveries ofcomponents or parts, it is possible that in the future the Company mayencounter shortages in parts, components, or other elements vital to themanufacture, production, and sale of SafeNet products. The Company’s businesswould suffer if the supply of such components were interrupted.

** **

**Dependence upon KeyPersonnel**

 

The network security industry is highly specialized and the competitionfor qualified employees is intense. SafeNet expects this to remain so for thenear future. The Company believes its success depends significantly upon anumber of key technical and management employees, and upon its ability toretain and hire additional key personnel. The loss of the services of keypersonnel or the inability to attract additional qualified personnel couldmaterially and adversely affect results of operations and product developmentefforts. SafeNet may be unable to achieve its revenue and operating performanceobjectives unless it can attract and retain technically qualified and highlyskilled engineers, sales, technical, marketing, and management personnel. Suchpersonnel are particularly important to research and development efforts, whereSafeNet employs a large number of technical personnel holding advanced degrees.Further, additions of new and departures of existing personnel, particularly inkey positions, can be disruptive and can result in further departures ofSafeNet personnel, which could in turn harm the business and results ofoperation.

 

In 2002, SafeNet entered into a five-year employment agreement withAnthony A. Caputo, its Chairman, Chief Executive Officer, and President.However, the Company has not historically provided such types of employmentagreements other employees. This may adversely affect the Company’s ability toattract and retain the necessary technical, management, and other keypersonnel.

** **

**SafeNet’s stock pricehas been and could continue to be volatile.**

 

Market prices for SafeNet’s common stock and the securities of othernetwork security companies have been volatile. Factors such as announcements oftechnological innovations or new products by SafeNet or by its competitors andmarket conditions for network security company and other technology stocks ingeneral can have a significant impact on the market for SafeNet’s common stock,which could reduce SafeNet’s stock price regardless of its operatingperformance.

 

SafeNet periodically reviews and considers possible acquisitions ofcompanies that it believes will contribute to its long-term objectives. Inaddition, depending on market conditions, liquidity requirements and otherfactors, SafeNet considers, from time to time, accessing the capital markets.Such events may also affect the market prices for SafeNet’s common stock andreduce such prices regardless of operating performance.

** **

**Anti-takeoverprovisions in SafeNet’s charter documents and Delaware law could prevent ordelay a change in control.**

 

SafeNet’s certificate of incorporation and bylaws may discourage, delayor prevent a merger or acquisition that a stockholder may consider favorable byauthorizing the issuance of “blank check” preferred stock. In addition, certainprovisions of Delaware law may also discourage, delay or prevent a third partyfrom acquiring or merging with SafeNet, even if such action were beneficial tosome, or even a majority, of SafeNet’s stockholders.

** **

**SafeNet Does Not PayDividends**

 

The Company has never paid nor declared any cash or other dividends onits common stock since its inception and does not presently anticipate thatdividends will be paid on its common stock in the foreseeable future.

** **

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**SIGNIFICANT BUSINESSACQUISITION SUBSEQUENT TO DECEMBER 31, 2002**

 

In February 2003, SafeNet completed its acquisition of Cylink.Operations of Cylink were integrated into the Enterprise Security Division ofSafeNet and function as part of that business unit. This acquisition will havea significant impact on the Company’s business operations going forward.

 

Cylink developed, manufactured, marketed and supported a comprehensiveportfolio of hardware and software security products for mission-criticalprivate networks and business communications over the Internet. Cylink’ssolutions enabled its customers to merge their operations and transactions ontoexisting networks, maximize network use, reduce the costs of operations andexpand their businesses. Cylink’s customers included leading Fortune 500companies, multinational corporations, financial institutions and numerousagencies within the United States Government.

 

Cylink’s solutions offered competitive advantages to its customers bylowering the cost of deploying and managing secure, reliable private networks,while enabling its customers’ use of the Internet for trusted transactions withtheir business partners. Cylink offered “drop-in” hardware encryption productsthat are easily deployed within its customers’ existing high-speed data networksknown as Local Area Networks, LANs, and Wide Area Networks, WANs, includingVPNs, that use the Internet.

 

Cylink’s products were centrally managed by a proprietary softwaremanagement system. This system allowed Cylink’s customers’ network security managersto remotely configure and operate all of Cylink’s products without risk oftampering by other network operations personnel. In addition, Cylink’s publickey-based solutions included the NetHawk, which creates a secure VPN fortransmitting high-value information. Cylink also offered a unified managementplatform for all of its security appliances to authenticate these devices,configure their use and centrally manage their operation. Such solutionsincluded Cylink’s public key infrastructure, or PKI, for managing the digitalidentities and privileges of all correspondents on the customer’s network.Cylink’s products created trust in its customers’ networks by securing theaccess, privacy and integrity of its customers’ important information when suchinformation is transmitted over their LANs, WANs, and the Internet.

 

These products, along Cylink’s commitment and focus to customer serviceand support, will be integrated as a part of SafeNet’s industry leading productofferings as well as world class standards of customer service and support.These products will work to build and improve SafeNet’s base product mix aswell as improve certain technology and software offerings from the SafeNetproduct family. SafeNet believes that these products provide SafeNet a bridgeto the next generation of security solutions. Specifically, Cylink’s Nethawktechnology is a critical piece of SafeNet’s High Assurance Gateway technologyline. Cylink’s PrivaCy Manager is a critical piece of SafeNet’s SecurityManagement Center technology product package bridging WAN and relatedtechnology infrastructures to the VPN and Internet environment with minimalcosts and maximum benefits.

 

See Note 16 in the Notes to the Consolidated Financial Statements forfurther discussion.

** **

**PART II**

** **

**ITEM 2 – PROPERTIES**

 

SafeNet maintains its leased corporate and administrative facilities at8029 Corporate Drive, Baltimore, Maryland. The building, constructed in 1988,has approximately 25,000 square feet and is also used for SafeNet’s executiveheadquarters, United States production, and SafeNet Trusted Services facility.The lease, which expires in December 2003, provides for annual increases inrentals during each year of the lease and will require the Company to payapproximately $115,000 in 2003.

 

Cylink leases approximately 47,000 square feet in Santa Clara,California. The lease, which expires in August 2009, requires annual rental of$1,346,000. SafeNet also holds the lease to the former Cylink ATM Center,comprising approximately 10,000 square feet in Raleigh, North Carolina, whichexpires in June 2003. We also lease facilities for sales offices in New Jersey,Virginia, North Carolina, Belgium, the United Kingdom and Singapore. We believethat our current facilities are well maintained and are adequate for theforeseeable future.

 

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SafeNet leases approximately 20,000 square feet related to itsabandoned administrative and production facilities in Regensdorf, Switzerland.The lease, which expires on December 31, 2003, calls for an annual rentalof approximately $348,000.

 

SafeNet BV leases approximately 13,700 square feet for its operationsin Vught, The Netherlands. The lease, which expires on March 31, 2007,requires annual rental of approximately $180,000.

 

SafeNet also leases office space in Danvers, Massachusetts with annualrent of approximately $99,000.

** **

**ITEM 3 – LEGALPROCEEDINGS**

 

SafeNet is not aware of any material litigation or proceeding, pendingor threatened, to which it is or may become a party.

 

In 1998, Cylink filed amended Quarterly Reports on Form 10-Q forthe first and third quarters of 1998 and an amended Annual Report onForm 10-K for the 1997 fiscal year, reflecting restated financial resultsfor those quarters, and for the fourth quarter of 1997. BetweenNovember 6, 1998 and December 14, 1998 several securities classaction complaints were filed against Cylink and certain of its current andformer Directors and officers in federal courts in California. These complaintsalleged, among other things, that Cylink’s previously issued financialstatements were materially false and misleading and that the defendants knew orshould have known that these financial statements caused Cylink’s common stockprice to rise artificially. The actions variously alleged violations ofSection 10(b) of the Securities Exchange Act of 1934, as amended, and SECRule 10b-5 promulgated thereunder, and Section 20 of the ExchangeAct. The securities class action lawsuits were ordered consolidated into a singleaction pending in the United States District Court for the Northern District ofCalifornia, captioned In Re Cylink Securities Litigation, No. C98-4292(VRW). On October 16, 2002, Cylink entered into an agreement with allplaintiffs in the securities class action lawsuit to settle all claims in theclass action for $6.2 million. The settlement amount will be paid entirelyfrom insurance proceeds under insurance policies held by Cylink. The settlementagreement is subject to approval by the United States District Court for theNorthern District of California. The court preliminarily approved thesettlement agreement on November 12, 2002. A motion by the plantiffs wasfiled on Feb 24, 2003 and was heard on March 6, 2003. The court requestedadditional information from Cylink’s litigation expert. The information wasprovided to the court on March 20, 2003.

** **

**ITEM 4 – SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

A Special Meeting of Stockholders was held on February 5, 2003, toconsider and vote upon the merger of Cylink with a wholly-owned subsidiary ofSafeNet pursuant to an agreement and plan of reorganization datedOctober 30, 2002, the issuance of shares of SafeNet common stock pursuantto the merger and related transactions (collectively, the “Merger Proposal”).At the meeting, the stockholders approved the Merger Proposal. There were4,941,305 shares cast in favor of the Merger Proposal, 65,137 shares castagainst the Merger Proposal, and 6,817 shares abstained.

** **

**ITEM 5 – MARKET FORCOMMON EQUITY AND RELATED MATTERS**

 

SafeNet’s Common Stock is listed on the Nasdaq National Market underthe symbol SFNT. The following table sets forth the quarterly range of pershare high and low bid prices for SafeNet’s Common Stock as reported by theNasdaq National Market for the periods indicated.

 

|           |   | **High** |   | **Low** |   |
|----------------|--------|----------|--------|---------|--------|
| **2002:**      |   |     |   |    |   |
| Fourth Quarter |   | $        | 29.10  |    | $      | 13.05 |   |
| Third Quarter  |   | 21.65    |   | 13.32   |   |
| Second Quarter |   | 16.50    |   | 10.37   |   |
| First Quarter  |   | 19.41    |   | 9.70    |   |
| **2001:**      |   |     |   |    |   |
| Fourth Quarter |   | 19.71    |   | 5.81    |   |
| Third Quarter  |   | 10.10    |   | 5.81    |   |
| Second Quarter |   | 17.55    |   | 7.10    |   |
| First Quarter  |   | 64.69    |   | 10.75   |   |
|                |        |          |        |         |        |  |  |

 

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On March 28, 2003, the last reported per share sale price of SafeNet’sCommon Stock on the Nasdaq National Market was $20.89. As of that date, therewere approximately 217 holders of record of the Common Stock and approximately4,000 beneficial holders of the Common Stock. We have not paid dividends on ourCommon Stock and intend for the near future to retain earnings, if any, tofinance the expansion and development of our business.

** **

**ITEM 6 – SELECTEDFINANCIAL DATA**

 

The selected financial data set forth below as of and for each of thefive years ended December 31, 2002 is derived from our audited financialstatements. The selected financial data is qualified by and should be read inconjunction with the Consolidated Financial Statements and Management’sDiscussion and Analysis of Financial Condition and Results of Operationsincluded elsewhere herein.

 

The accompanying financial data has been restated to reflect the netassets of the disposed operations of GretaCoder Data Systems (GDS) ascurrent assets, non-current assets, and current liabilities of discontinuedoperations. The following data should be read in conjunction with Note 3 to theConsolidated Financial Statements. 

 

|                                                          |   | **Year Ended  December 31,** |   |
|---------------------------------------------------------------|--------|------------------------------|--------|
| **(Amounts in thousands, except per share data)**             |   | **2002**                     |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                          |   |                         |   |   |   |   |   |   |   |   |   |
| Revenues                                                      |   | $                            | 32,235 |   | $ | 16,462 |   | $ | 25,278 |   | $ | 10,565 |   | $ | 11,624 |   |
| Cost of revenues                                              |   | 8,963                        |   | 4,525 |   | 5,834 |   | 4,352 |   | 5,527 |   |
|                                                          |   |                         |   |   |   |   |   |   |   |   |   |
| Gross profit                                                  |   | 23,272                       |   | 11,937 |   | 19,444 |   | 6,213 |   | 6,097 |   |
|                                                          |   |                         |   |   |   |   |   |   |   |   |   |
| Research and development expenses                             |   | 8,504                        |   | 6,118 |   | 6,342 |   | 4,580 |   | 3,446 |   |
| Sales and marketing expenses                                  |   | 7,341                        |   | 5,061 |   | 4,756 |   | 5,251 |   | 5,889 |   |
| General and administrative expenses                           |   | 4,108                        |   | 2,203 |   | 2,681 |   | 2,227 |   | 2,292 |   |
| Write-off in in-process research and  development             |   | 3,375                        |   | — |   | — |   | — |   | — |   |
| Amortization of intangibles                                   |   | 1,488                        |   | — |   | — |   | — |   | — |   |
| (Recovery of) reserve for Cyberguard  advance                 |   | —                       |   | — |   | (275 | ) | (375 | ) | 772 |   |
|                                                          |   |                         |   |   |   |   |   |   |   |   |   |
| Total operating expenses                                      |   | 24,816                       |   | 13,382 |   | 13,504 |   | 11,683 |   | 12,399 |   |
|                                                          |   |                         |   |   |   |   |   |   |   |   |   |
| Operating (loss) income                                  |   | (1,544                       | )      | (1,445 | ) | 5,940 |   | (5,470 | ) | (6,302 | ) |
| Investment income and other expenses, net                     |   | 669                          |   | 1,336 |   | 1,320 |   | 95 |   | 232 |   |
|                                                          |   |                         |   |   |   |   |   |   |   |   |   |
| (Loss) income from continuing operations  before income taxes |   | (875                         | )      | (109 | ) | 7,260 |   | (5,375 | ) | (6,070 | ) |
| Income tax benefit, net                                       |   | (90                          | )      | — |   | — |   | — |   | — |   |
|                                                          |   |                         |   |   |   |   |   |   |   |   |   |
| (Loss) income from continuing operations                      |   | $                            | (785   | ) | $ | (109 | ) | $ | 7,260 |   | $ | (5,375 | ) | $ | (6,070 | ) |
|                                                          |   |                         |   |   |   |   |   |   |   |   |   |
| (Loss) income from continuing operations  per common share    |   |                         |   |   |   |   |   |   |   |   |   |
| Basic                                                         |   | $                            | (0.10  | ) | $ | (0.01 | ) | $ | 1.08 |   | $ | (0.98 | ) | $ | (1.12 | ) |
|                                                          |   |                         |   |   |   |   |   |   |   |   |   |
| Diluted                                                       |   | $                            | (0.10  | ) | $ | (0.01 | ) | $ | 1.01 |   | $ | (0.98 | ) | $ | (1.12 | ) |
|                                                          |   |                         |   |   |   |   |   |   |   |   |   |
| Shares used in computation                                    |   |                         |   |   |   |   |   |   |   |   |   |
| Basic                                                         |   | 7,730                        |   | 7,057 |   | 6,751 |   | 5,504 |   | 5,409 |   |
|                                                          |   |                         |   |   |   |   |   |   |   |   |   |
| Diluted                                                       |   | 7,730                        |   | 7,057 |   | 7,195 |   | 5,504 |   | 5,409 |   |

 

20

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|                      |   | **At  December 31,** |   |
|---------------------------|--------|----------------------|--------|
|                      |   | **2002**             |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                      |   |                 |   |   |   |   |   |   |   |   |   |
| Balance Sheet Data:       |   |                 |   |   |   |   |   |   |   |   |   |
| Working capital           |   | $                    | 31,987 |   | $ | 32,385 |   | $ | 33,695 |   | $ | 23,035 |   | $ | 11,081 |   |
| Intangible assets         |   | 13,900               |   | 727 |   | 1,516 |   | 2,107 |   | 1,527 |   |
| Total assets              |   | 55,319               |   | 39,877 |   | 43,106 |   | 31,896 |   | 18,940 |   |
| Stockholders’ equity |   | 48,378               |   | 35,459 |   | 37,723 |   | 27,636 |   | 15,400 |   |
|                           |        |                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

** **

**QUARTERLY RESULTS OFOPERATIONS**

 

The following is a summary of the quarterly results of operations forthe years ended December 3l, 2002 and 2001. All periods’ results have beenrestated to separately disclose discontinued operations.

 

(Unaudited – Amounts in thousands, except per share data): 

 
|                                       |   | **2002  Quarter Ended** |   |
|--------------------------------------------|--------|-------------------------|--------|
|                                       |   | **March 31**            |   | **June 30** |   | **Sept. 30** |   | **Dec. 31** |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| Revenues                                   |   | $                       | 6,154  |   | $ | 7,428 |   | $ | 8,827 |   | $ | 9,826 |   |
| Cost of revenues                           |   | 1,953                   |   | 2,061 |   | 2,580 |   | 2,369 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| Gross profit                               |   | 4,201                   |   | 5,367 |   | 6,247 |   | 7,457 |   |
| Operating (loss) income               |   | (4,016                  | )      | 222 |   | 754 |   | 1,496 |   |
| (Loss) income from continuing operations   |   | (3,742                  | )      | 246 |   | 877 |   | 1,834 |   |
| (Loss) income from discontinued operations |   | (3,784                  | )      | (398 | ) | 116 |   | 112 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| Net (loss) income                     |   | $                       | (7,526 | ) | $ | (152 | ) | $ | 993 |   | $ | 1,946 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| (Loss) Earnings Per Share, Basic:          |   |                    |   |   |   |   |   |   |   |
| (Loss) income from continuing operations   |   | $                       | (0.49  | ) | $ | 0.03 |   | $ | 0.12 |   | $ | 0.24 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| (Loss) income from discontinued operations |   | $                       | (0.49  | ) | $ | (0.05 | ) | $ | 0.01 |   | $ | 0.01 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| Net (loss) income                     |   | $                       | (0.98  | ) | $ | (0.02 | ) | $ | 0.13 |   | $ | 0.25 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| (Loss) Earnings Per Share, Diluted:        |   |                    |   |   |   |   |   |   |   |
| (Loss) income from continuing operations   |   | $                       | (0.49  | ) | $ | 0.03 |   | $ | 0.11 |   | $ | 0.22 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| (Loss) income from discontinued operations |   | $                       | (0.49  | ) | $ | (0.05 | ) | $ | 0.01 |   | $ | 0.01 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| Net (loss) income                     |   | $                       | (0.98  | ) | $ | (0.02 | ) | $ | 0.12 |   | $ | 0.23 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| Shares used in computation                 |   |                    |   |   |   |   |   |   |   |
| Basic                                      |   | 7,677                   |   | 7,689 |   | 7,736 |   | 7,824 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| Diluted                                    |   | 7,677                   |   | 7,932 |   | 8,062 |   | 8,625 |   |

 

21

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|                                       |   | **2001  Quarter Ended** |   |
|--------------------------------------------|--------|-------------------------|--------|
|                                       |   | **March 31**            |   | **June 30** |   | **Sept. 30** |   | **Dec. 31** |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| Revenues                                   |   | $                       | 5,641  |   | $ | 3,134 |   | $ | 3,602 |   | $ | 4,085 |   |
| Cost of revenues                           |   | 1,489                   |   | 1,444 |   | 874 |   | 718 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| Gross profit                               |   | 4,152                   |   | 1,690 |   | 2,728 |   | 3,367 |   |
| Operating (loss) income               |   | 648                     |   | (1,845 | ) | (448 | ) | 200 |   |
| (Loss) income from continuing operations   |   | 1,066                   |   | (1,497 | ) | (167 | ) | 489 |   |
| (Loss) income from discontinued operations |   | (635                    | )      | (1,278 | ) | (550 | ) | (990 | ) |
|                                       |   |                    |   |   |   |   |   |   |   |
| Net (loss) income                     |   | $                       | 431    |   | $ | (2,775 | ) | $ | (717 | ) | $ | (501 | ) |
|                                       |   |                    |   |   |   |   |   |   |   |
| (Loss) Earnings Per Share, Basic:          |   |                    |   |   |   |   |   |   |   |
| (Loss) income from continuing operations   |   | $                       | 0.15   |   | $ | (0.21 | ) | $ | (0.02 | ) | $ | 0.07 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| (Loss) income from discontinued operations |   | $                       | (0.09  | ) | $ | (0.18 | ) | $ | (0.08 | ) | $ | (0.13 | ) |
|                                       |   |                    |   |   |   |   |   |   |   |
| Net (loss) income                     |   | $                       | 0.06   |   | $ | (0.39 | ) | $ | (0.10 | ) | $ | (0.06 | ) |
|                                       |   |                    |   |   |   |   |   |   |   |
| (Loss) Earnings Per Share, Diluted:        |   |                    |   |   |   |   |   |   |   |
| (Loss) income from continuing operations   |   | $                       | 0.15   |   | $ | (0.21 | ) | $ | (0.02 | ) | $ | 0.07 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| (Loss) income from discontinued operations |   | $                       | (0.09  | ) | $ | (0.18 | ) | $ | (0.08 | ) | $ | (0.14 | ) |
|                                       |   |                    |   |   |   |   |   |   |   |
| Net (loss) income                     |   | $                       | 0.06   |   | $ | (0.39 | ) | $ | (0.10 | ) | $ | (0.07 | ) |
|                                       |   |                    |   |   |   |   |   |   |   |
| Shares used in computation                 |   |                    |   |   |   |   |   |   |   |
| Basic                                      |   | 6,999                   |   | 7,059 |   | 7,079 |   | 7,092 |   |
|                                       |   |                    |   |   |   |   |   |   |   |
| Diluted                                    |   | 7,465                   |   | 7,059 |   | 7,079 |   | 7,092 |   |

 

22

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During the quarter ended March 31, 2002, the Company recorded acharge of $3,375,000 related to the write-off of in process research anddevelopment assets acquired in connection with the purchase of Securealink onJanuary 2, 2002. During that quarter, the Company also recorded a chargeof $3,506,000 related to the loss on the disposal of the GDS business.

** **

**ITEM 7 – MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Except for historical information contained herein, the statements inthis Item are forward-looking statements that are made pursuant to the safeharbor provisions of the Private Securities Litigation Reform Act of 1995.Forward-looking statements involve known and unknown risks and uncertainties,which may cause SafeNet’s actual results in future periods to differ materiallyfrom forecasted results. Those risks include, among others, risks associatedwith the receipt and timing of future customer orders, price pressures,achieving technical and product development milestones, the ability tonegotiate favorable strategic OEM agreements, sufficient cash flow to supportSafeNet’s liquidity requirements, other competitive factors leading to adecrease in anticipated revenues and gross profit margins and productdevelopment expenses.

** **

**OVERVIEW**

 

SafeNet designs, manufactures and markets enterprise network securitysolutions using encryption technology. Our products are used in electroniccommerce applications by financial institutions, government agencies and largecorporations to secure data transmissions on private and public computernetworks, such as the Internet.

 

In January 2002, we acquired Securealink. Securealink develops, marketsand sells security chips and intellectual property, primarily in Europe andAsia.

 

In February 2002, management decided to discontinue our Swissoperations at GDS, which was formerly our European operations segment (see note3 to the audited financial statements). The operating results of thediscontinued businesses has been reported in the discontinued operationssection of the consolidated statement of operations. The following comparisonsof operating results focuses on the continuing operations of the Company.

 

SafeNet’s historical operating results have been dependent on a varietyof factors including, but not limited to, the length of the sales cycle, thetiming of orders from and shipments to clients, product development expensesand the timing of development and introduction of new products. Our expenselevels are based, in part, on expectations of future revenues. The size andtiming of our historical revenues have varied substantially from quarter toquarter and year to year. Accordingly, the results of a particular period, orperiod-to-period comparisons of recorded sales and profits may not beindicative of future operating results.

 

While management is committed to the long-term profitability ofSafeNet, the recent growth of the computer security industry has made itimportant that market share be obtained. We have undertaken various strategiesin order to increase our revenues and improve our future operating results,including new product offerings such as our SafeNet EmbeddedIP and SafeNet SoftRemote. Management believes that growth in the market for products that providesecure remote access to computer networks requires SafeNet to increase itsinvestment in development, sales and marketing activities to allow SafeNet totake advantage of this market opportunity and to achieve long-termprofitability, thereby maximizing shareholder value. However, there can be noassurance that these strategies will be successful.

** **

23

----

 

**RESULTS OF OPERATIONSOF SAFENET**

 

The following table sets forth certain Consolidated Statement ofOperations data of SafeNet as a percentage of revenues for the years endedDecember 31. 

 

|                                                          |   | **2002** |   | **2001** |   | **2000** |   |
|---------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Revenues                                                      |   | 100      | %      | 100      | %      | 100      | %      |
| Cost of revenues                                              |   | 28       |   | 27       |   | 23       |   |
|                                                          |   |     |   |     |   |     |   |
| Gross profit                                                  |   | 72       |   | 73       |   | 77       |   |
|                                                          |   |     |   |     |   |     |   |
| Research and development expenses                             |   | 26       |   | 37       |   | 25       |   |
| Sales and marketing expenses                                  |   | 23       |   | 31       |   | 19       |   |
| General and administrative expenses                           |   | 13       |   | 13       |   | 11       |   |
| Write-off in in-process research and  development             |   | 10       |   | —   |   | —   |   |
| Amortization of intangibles                                   |   | 5        |   | —   |   | —   |   |
| Recovery of CyberGuard advance                                |   | —   |   | —   |   | (1       | )      |
|                                                          |   |     |   |     |   |     |   |
| Total operating expenses                                      |   | 77       |   | 81       |   | 54       |   |
|                                                          |   |     |   |     |   |     |   |
| Operating (loss) income                                  |   | (5       | )      | (8       | )      | 23       |   |
| Investment income and other expenses, net                     |   | 2        |   | 8        |   | 5        |   |
|                                                          |   |     |   |     |   |     |   |
| (Loss) income from continuing operations  before income taxes |   | (3       | )      | —   |   | 28       |   |
| Income tax benefit                                            |   | (0       | )      | —   |   | —   |   |
|                                                          |   |     |   |     |   |     |   |
| (Loss) income from continuing operations                      |   | (3       | )%     | —   | %      | 28       | %      |

 

The Company has two reportable segments: products, chips and software designedand manufactured for sale to companies that will embed the Company’s productsinto their products for ultimate sale to end-users (“Embedded SecurityDivision”), and network security products designed and manufactured for directsales to end-users and remote access software sold to OEM’s (“EnterpriseSecurity Division”). The segments are strategic business units that offerdifferent products. The segments are managed separately because each segmentrequires different technology and marketing strategies (see note 13 to theaudited consolidated financial statements).

 

The acquisition of Cylink in February 2003, is expected to have asignificant impact on the Company’s results of operations and financialcondition. Since the transaction closed subsequent to December 31, 2002,the Cylink acquisition has not been considered in the Company’s discussion ofits results of operations and financial condition as of and for the year endedDecember 31, 2002. However, due to its significance to the Company’sbusiness, a discussion of the Cylink acquisition and its anticipated impact isincluded at the end of Item 7: Management’s Discussion and Analysis.

** **

**Year endedDecember 31, 2002 Compared to Year ended December 31, 2001**

 

Revenues increased 96%, or $15,773,000, to $32,235,000 for the periodended December 31, 2002, from $16,462,000 in 2001. The Embedded SecurityDivision revenues increased 234% or $12,815,000 due to the full year presenceof the Securealink acquisition for 2002 as well as increased revenue from ourlargest commercial customer. The Enterprise Security Division segment increased27% or $2,958,000 due to revenues earned under additional long-term governmentcontracts. These contracts are the result of the government’s approach tointernet and communication security in light of the Homeland SecurityInitiative.

 

Gross margin remained consistent, 72% for the period endedDecember 31, 2002, from 73% in 2001. Gross margins in the EmbeddedSecurity Division decreased to 72% in 2002 from 77% in 2001, due to the changein product mix with the addition of Securealink delivering lower marginproducts. Enterprise Security 

 

24

----

 

Division margins increased to 74% in 2002 from 71% in 2001 based onincreased customer base of higher margin customers as well changes in productmix with higher volumes in higher margin products such as license revenue.

 

Research and development expenses increased 39%, or $2,386,000 to$8,504,000 for the period ended December 31, 2002, from $6,118,000 in2001. The increase is primarily related to the addition of the Securealinkbusiness, with the main cost of that business being research and developmentcosts. Research and development expenses for the Embedded Security Divisionwere focused on the next generation products (chips), designed to be a verycost-effective, high throughput, low power-consuming chips in the tradition ofSafeNet’s other silicon products. Research and development expenses for theEnterprise Security Division were focused on SafeNet’s High Assurance productline, including gateways, software, and other appliances. Some of theseproducts were made available in 2002 with the remaining products coming tomarket in 2003.

 

Sales and marketing expenses increased 45%, or $2,280,000 to $7,341,000for the period ended December 31, 2002, from $5,061,000 in 2001. Theadditional expense reflects increased headcount, higher commissions from higherrevenues, as well as additional promotional dollars spent on the branding ofthe Securealink products and name. As a percentage of revenues, the expenseswere 23% and 31% in 2002 and 2001, respectively.

 

General and administrative expenses increased 86%, or $1,905,000, to$4,108,000 for the period ended December 31, 2002, from $2,203,000 in 2001.The increase is due to the additional office space obtained with theSecurealink acquisition, additional corporate employees, increased bonusexpenses, and additional professional fees incurred related to new corporategovernance requirements. As a percentage of revenues, the expenses were 13% in2002 and 2001.

 

The write-off of acquired in-process research and development assets,which totaled $3,375,000 for the year ended December 31, 2002, relates tothe January 2002 acquisition of Securealink. This represents the estimated fairvalue of the in-process research and development projects that had not yetreached technological feasibility at the acquisition date, and had noalternative future use. Accordingly, this amount was immediately expensed at theacquisition date. The value assigned to the acquired in-process technologyrelates entirely to the development of a new application specific integratedcircuit. The estimated fair value of this project was determined by the use ofa discounted cash flow model, using a discount rate that took into account thestage of completion and the risks surrounding the successful development andcommercialization of the technology. Subsequent to the acquisition, the Companyincurred approximately $750,000 in additional research and development chargesto complete the development of the technology, which was licensed to a customerduring fiscal year 2002.

 

Amortization of intangible assets, which totaled $1,488,000 for theyear ended December 31, 2002, also relates to the January 2002 acquisitionof Securealink. Intangible assets, which consist primarily of developedtechnology and patents, are amortized over estimated useful lives ranging fromone to five years.

 

Investment income and other expenses decreased by $667,000, to $669,000for the period ended December 31, 2002, from $1,336,000 in 2001.Investment income and other expenses decreased primarily due to lower interestrates throughout 2002 as compared to 2001.

 

For the year ended December 31, 2002, the Company incurredoperating losses, however, the Company also experienced an income tax benefitrelated to the amortization of acquired intangibles from the Securealinkacquisition. For the year ended December 31, 2001, the Company incurredoperating losses and therefore, did not record income tax expense. TheCompany’s income tax benefit related to these losses has been offset by avaluation allowance for the full amount of the net deferred tax assets sincethe Company’s ability to use the remaining net operating loss carryforward isdependent upon future taxable income.

 

The Company had a loss from continuing operations of $785,000 for theyear ended December 31, 2002 compared to a loss from continuing operationsof $109,000 for the same period in 2001. The loss from 

 

25

----

 

continuing operations per common share was $0.10 in 2002 compared toloss from continuing per common share of $0.01 in 2001.

** **

**Year endedDecember 31, 2001 Compared to Year ended December 31, 2000**

 

Revenues decreased 35%, or $8,816,000, to $16,462,000 for the periodended December 31, 2001, from $25,278,000 in 2000. The Embedded SecurityDivision revenues decreased 15% or $941,000 due to the adverse impact of theeconomic slowdown on customers, causing them to delay purchases of softwarelicenses and upgrades, and accelerator boards. The Enterprise Security Divisionsegment decreased 42% or $7,875,000 primarily due to delayed purchases ofSafeNet’s VPN products from government customers in the wake of the September 11thtragedy.

 

Gross margin decreased to 73% for the period ended December 31,2001, from 77% in 2000. The Company recorded additional inventory reservesrelated primarily to legacy products with diminishing future demand. Theseadditional reserves aggregated $173,000 in the second quarter of 2001 andnegatively impacted gross margins by 1%. For the year, the additional inventoryreserves affected the Embedded and Enterprise segments by $58,000, and$115,000, respectively, impacting gross margins by 0%, and 1%, respectively.Gross margins in the Embedded Security Division increased to 77% in 2001 from68% in 2000, due to increased royalty revenues earned on chip sales and licensefees associated with intellectual property sales. Enterprise Security Division’margins decreased to 71% from 80% based primarily on the change in product mixto include a lesser amount of higher margin software sales.

 

Research and development expenses decreased 4%, or $224,000 to$6,118,000 for the period ended December 31, 2001, from $6,342,000 in2000. The decrease is primary related to lower external development costs ofchip fabrication.

 

Sales and marketing expenses increased 6%, or $305,000 to $5,061,000for the period ended December 31, 2001, from $4,756,000 in 2000. Theadditional expense reflects management’s focus on increasing sales andmarketing resources in new markets. Additional expenses include the costsassociated with new employees and expanded marketing programs such as theSafeNet Secure Tour and two trade shows. As a percentage of revenues, theexpenses were 31% and 19% in 2001 and 2000, respectively.

 

General and administrative expenses decreased 18%, or $478,000, to$2,203,000 for the period ended December 31, 2001, from $2,681,000 in2000. The decrease is due to cost saving measures including staff reductions,reductions in performance-based compensation, travel expenses, and professionalfees. As a percentage of revenues, the expenses were 13% and 11% of revenues in2001 and 2000, respectively.

 

Interest income and other expenses increased by $16,000, to $1,336,000for the period ended December 31, 2001, from $1,320,000 in 2000. Interestincome remained steady despite declining interest rates in 2001 due to largeraverage cash and short-term investment holdings throughout 2001 compared to2000.

 

For the year ended December 31, 2001, the Company has incurredoperating losses and therefore, did not record income tax expense. TheCompany’s income tax benefit related to these losses has been offset by a valuationallowance for the full amount of the net deferred tax assets since theCompany’s ability to use the remaining net operating loss carryforward isdependent upon future taxable income. For the year ended December 31,2000, the Company did not recognize income tax expense due to the reversal ofthe valuation allowance on net operating loss carryforwards available to offsetearnings.

 

The Company had a loss from continuing operations of $109,000 for theyear ended December 31, 2001 compared to income from continuing operationsof $7,260,000 for the same period in 2000. The loss from continuing operationsper common share was $0.01 in 2001 compared to diluted income from continuingper common share of $1.01 in 2000.

** **

26

----

 

**Liquidity and CapitalResources**

 

SafeNet believes that its current cash resources will be sufficient tomeet its needs for the next year. As of December 31, 2002, SafeNet hadworking capital of $31,987,000 including cash and short-term investments of$32,162,000.

 

In January 2002, as partial consideration for the acquisition ofSecurealink, SafeNet paid $2,000,000 in cash and issued contingent convertiblepromissory notes, which were paid in May 2002, in the aggregate amount of$1,618,000.

 

Additionally, after closing of the acquisition in January 2002, SafeNetadvanced to Securealink approximately $1,484,000 in order to repaySecurealink’s line of credit.

 

As discussed in Note 3 to the consolidated financial statements, inFebruary 2002, SafeNet management decided to discontinue operations at GDSbased on the amount of GDS operating and cash losses during 2000 and 2001 aswell as a significant downturn in future business prospects. GDS suffered cashlosses of $2,284,000 and $756,000 during the years ended December 31, 2001and 2000, respectively. Management’s decision to discontinue operations at GDSpositively impacted cash flows in 2002.

 

In 2002, cash and short-term investments increased $1,478,000. Theincrease was mainly attributable to cash provided by operating activities of$5,933,000. Cash used in investing activities during 2002 included investmentsin computer software development costs and equipment totaling $833,000 and cashpaid for Securealink was $3,769,000, net of cash required. Cash provided byfinancing activities in 2002 included $2,187,000 from the exercise of stockoptions.

 

SafeNet has expended and will continue to expend portions of itsoperating cash for acquisition and integration costs related to acquisitions.The Cylink acquisition expended $386,000 for acquisition costs in 2002 and$255,000 for integration costs in 2002. We expect the cash outflow to besignificant in 2003 as we integrate Cylink throughout the majority of 2003.Actual cash outflows for the Cylink integration and acquisition for 2003through February 2003 were $1,126,000. The Raqia acquisition will also requirecash outflows, including $1,305,000 through February 2003. There will also beadditional investments made into the acquired technology from the Raqiaacquisition in 2003. We estimated the integration costs for Cylink and Raqiaduring 2003 to be $4,000,000 and $250,000, respectively. We estimate theacquisition costs for Cylink and Raqia during 2003 to be $4,600,000 and$200,000, respectively. SafeNet believes that its current cash resources willbe sufficient to meet its needs for the next year.

** **

**Inflation andSeasonality**

 

SafeNet does not believe that inflation will significantly impact itsbusiness. We do not believe our business is seasonal. However, because wegenerally recognize product revenues upon shipment and software revenues uponestablishing fair value of undelivered elements, recognition may be irregularand uneven, thereby disparately impacting quarterly operating results andbalance sheet comparisons.

** **

**Effect of RecentAccounting Pronouncements**

 

In June 2002, the Financial Accounting Standards Board issued StatementNo. 146, *Accountingfor Costs Associated with Exit or Disposal Activities*, whichaddresses accounting and reporting for costs associated with exit or disposalactivities and nullifies EITF Issue No. 94-3, *Liability Recognition for CertainEmployee Termination Benefits and Other Costs to Exit an Activity (includingCertain Costs Incurred in a Restructuring).*Statement No. 146 requiresthat a liability for a cost associated with an exit or disposal activity berecognized at fair value when the liability is incurred rather than at the dateof a commitment to an exit plan. Costs covered by Statement No. 146include one-time termination benefits and certain contract termination costs,including operating lease termination costs that are associated with an exit ordisposal activity. The provisions of this Statement are effective for exit ordisposal activities that are initiated after December 31, 2002.

 

27

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**Critical AccountingPolicies**

 

The Company’s accounting policies are more fully described in Note 2 ofthe Notes to Consolidated Financial Statements. As discussed in this note, thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsabout future events that affect the amounts reported in the financialstatements and accompanying notes. Future events and their effects cannot bedetermined with absolute certainty; therefore, the determination of estimatesrequires the exercise of judgment. Actual results inevitably will differ fromthose estimates, and such differences may be material to the financialstatements.

 

SafeNet believes the following critical accounting policies affect itsmore significant judgments and estimates used in the preparation of itsconsolidated financial statements. SafeNet Senior Management has discussed eachof these critical accounting policies with the Company’s audit committee.

* *

*Allowance fordoubtful accounts*

 

SafeNet maintains an allowance for doubtful accounts for estimatedlosses resulting from the inability of its customers to make required payments.The Company calculates its allowance based on a specific analysis of past duebalances and also considers historical trends of write-offs. If the financialcondition of SafeNet’s customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired.

* *

*Inventory*

 

SafeNet provides for its estimated inventory obsolescence orunmarketable inventory equal to the difference between the cost of theinventory and the estimated market value based upon assumptions about futuredemand and market conditions. The Company utilizes projected sales by productto determine the net realizable value of the inventory. If actual marketconditions are less favorable than those projected by management, additionalinventory write-downs may be required.

* *

*Software DevelopmentCosts*

 

SafeNet calculates amortization of its capitalized software developmentcosts based on the greater of the amount computed using the ratio that currentgross revenues for a product bear to the total of current and anticipatedfuture gross revenues for that product or the straight-line method over theremaining estimated economic life of the product including the period beingreported on. In addition, SafeNet assesses the recoverability of softwaredevelopment costs by comparing the unamortized balance to the net realizablevalue of the asset and writes off the amount by which the unamortizedcapitalized costs exceed the net realizable value.

 

These calculations require management to make assumptions about futuredemand for its products, future revenues to be generated from the sale of itsproducts, as well as the estimated useful lives of developed technology. Ifactual market conditions or product demand is different from those assumptions,or if changes in technology limit the useful life of SafeNet’s core technology,additional amortization or write-downs may be required.

* *

*Goodwill and OtherIntangible Assets*

 

SafeNet accounts for acquired businesses using the purchase method ofaccounting. A portion of the purchase prices for these businesses is allocatedto identifiable tangible and intangible assets and assumed liabilities based onestimated fair values at the dates of acquisitions. Any excess purchase priceis allocated to goodwill.

 

The identified intangible assets include patents, developed technology,purchase orders, contract backlog and acquired in-process research anddevelopment assets. Research and development assets are written off at the dateof acquisition in accordance with Financial Accounting Standards Board (“FASB”)Interpretation No. 4, *Applicability of FASB Statement No. 2 toBusiness Combinations Accounted for by the Purchase Method*. The fairvalues were determined by management, generally based upon information suppliedby the management of the acquired entities and valuations prepared byindependent valuation 

 

28

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experts. The valuations have been based primarily upon future cash flowprojections for the acquired assets, discounted to present value using arisk-adjusted discount rate. For certain classes of intangible assets, thevaluations have been based upon estimated cost of replacement. The assigneduseful lives, which range from one to five years, are based upon periods ofestimated cash flows and other factors. If SafeNet used different assumptionsand estimates in the calculation of the fair value of identified intangibleassets and the estimation of the related useful lives, the amounts allocated tothese assets, as well as the related amortization expense, would have beensignificantly different than the amounts recorded.

 

Effective January 1, 2002,SafeNet adopted the provisions of FASB Statement No. 142, *Goodwill and Other Intangible Assets*.Under Statement 142, goodwill is no longer amortized but is reviewed annuallyfor impairment, or more frequently if impairment indicators exist. Impairmentexists when the carrying amount of goodwill exceeds its implied fair valueusing impairment testing methodology in Statement 142. Indicators of potentialimpairment include operating losses, loss of a significant customer and adverseindustry developments. The first annual impairment test for goodwill, all ofwhich was assigned to the Embedded Security division, was performed on October 1,2002. The impairment test was based upon a comparison of the estimated fairvalue of the Embedded Security division to the sum of the carrying value of theassets and liabilities allocated to that division. The fair values used in thisevaluation were estimated based upon discounted future cash flow projectionsfor the division as well as comparable revenue and earnings multiples. In orderto project future cash flows, management made a number of assumptionsconcerning such things as future sales volume levels, future price levels, andrates of increase in operating expenses. Since the estimated fair value of thedivision exceeded the carrying value of the recorded net assets, no impairmentwas identified or recorded. However, if SafeNet used different assumptions andestimates in the calculation of the fair value of the division, an impairmentof goodwill could have been identified.

* *

*Revenue Recognition*

 

SafeNet derives revenue from software and technology licenses, productsales, maintenance and other services. Software and technology licenses containmultiple elements, including the product license, maintenance and/or otherservices. The recognition of revenue under these arrangements requiresmanagement to make judgments about the likelihood of granting futureconcessions and the ultimate collectibility of fees.

 

Revenues that are earned under long-term contracts to develop highassurance encryption technology are recognized using contract accounting. Undercontract accounting, revenue from these arrangements is recognized using thepercentage-of-completion method. Progress to completion is measured usingcontract milestones. Accounting for these contracts requires the estimation ofthe cost, scope and duration of each milestone and each contract. If the Companydoes not accurately estimate the resources required or the scope of work to beperformed, or does not manage its projects properly within the planned periodsof time or satisfy its obligations under the contracts, then future margins maybe significantly and negatively affected or losses on existing contracts mayneed to be recognized. Any such resulting reductions in margins or contractlosses could be material to the Company’s results of operations.

** **

**Significant BusinessAcquisition Subsequent to December 31, 2002**

 

In February 2003, SafeNet completed its acquisition of Cylink.Operations of Cylink were integrated into the Enterprise Security Division ofSafeNet and function as part of that business unit. This acquisition will havea significant impact on the Company’s business operations going forward. SeeItem 1 - “Business - Significant Business Acquisition Subsequent to December31, 2002”.

 

The results of Cylink’s business operations will be included in theCompany’s Consolidated Financial Statements from February 6, 2003 forward.

 

The aggregate purchase price for Cylink was approximately $35.1million, consisting primarily of 1,648,000 shares of common stock valued at$31.2 million, 194,000 options and warrants assumed with an aggregate value of$1.7 million, and estimated direct costs of the acquisition of $2.2 million.The Company is in the process of obtaining third-party valuations on thisacquisition and the assets included.

 

29

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On February 11, 2003, theCompany filed a Form 8-K related to the acquisition of Cylink. The Company willfile an 8-K/A on or about April 21, 2003 that will include historical auditedfinancial statements of the acquired company and unaudited pro forma financialinformation.

 

See Footnote 16 in Notes toConsolidated Financial Statements.

 

**ITEM 7A — QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

Market risk is the risk of lossto future earnings, to fair values or to future cash flows that may result fromchanges in the price of financial instruments. SafeNet is exposed to financialmarket risks, primarily related to changes in foreign currency exchange rates.SafeNet currently does not have any derivative financial instruments to protectagainst adverse currency movements. SafeNet manages its exposure to marketrisks related to operations through regular operating and financing activities.All of the potential impacts noted below are based on a sensitivity analysisperformed as of December 31, 2002. Actual results may differ materially

 

SafeNet derives approximately10% of its revenues from customers outside of the U.S. This business istransacted primarily through a wholly owned subsidiary located in theNetherlands that operates using the Euro as the functional currency. Expensesare also incurred in Euros to match the subsidiary’s revenues and minimizeexposure of operating margins to exchange rate fluctuations. A hypothetical 10%adverse change in the average Euro exchange rate would have decreased netoperating income in 2002 by approximately $353,000. SafeNet views theinvestment in this subsidiary as long-term. The effect of a change in the Euroexchange rate on the net investment in the foreign subsidiary is reflected inother comprehensive income (loss). A 10% depreciation in the Euro relative tothe U.S. dollar would result in a decrease in consolidated stockholders’ equityat December 31, 2002 of approximately $363,000.

 

At December 31, 2002 and2001, SafeNet did not have any interest bearing obligations. In addition,SafeNet does not hold any derivative instruments and does not have anycommodity market risk.

 

**SAFENET, INC.**

**AND SUBSIDIARIES**

 

**ITEM 8 – FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

**INDEX TO FINANCIAL STATEMENTS**

 
| Report of Independent Auditors                                                                                                                                                                                                            |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Consolidated Balance Sheets as of December 31, 2002 and 2001                                                                                                                                                                         |
| Consolidated Statements of Operations for  the years ended December 31, 2002, 2001 and 2000                                                                                                                                          |
| Consolidated Statements of Comprehensive  (Loss) Income for the years ended December 31, 2002, 2001 and 2000                                                                                                                         |
| Consolidated Statements of Stockholders’  Equity for the years ended December 31, 2002, 2001 and 2000                                                                                                                           |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2002, 2001, and 2000                                                                                                                                         |
| Notes to Consolidated Financial Statements                                                                                                                                                                                                |
| The following consolidated financial  statement schedule of SafeNet, Inc. and subsidiaries is included in this  item:                                                                                                                     |
| Schedule II Valuation and Qualifying  Accounts                                                                                                                                                                                       |
|                                                                                                                                                                                                                                      |
| All other schedules for which provision is  made in the applicable accounting regulation of the Securities and Exchange  Commission are not required under the related instructions or are  inapplicable and therefore have been omitted. |

 

30

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**REPORT OF INDEPENDENT AUDITORS**

 

**The Board of DirectorsSafeNet, Inc.**

 

We have audited theaccompanying consolidated balance sheets of SafeNet, Inc. and subsidiaries asof December 31, 2002 and 2001, and the related consolidated statements ofoperations, comprehensive income (loss), stockholders’ equity, and cash flowsfor each of the three years in the period ended December 31, 2002. Ouraudits also included the financial statement schedule listed in the Index atItem 14(a). These financial statements and schedule are the responsibilityof the Company’s management. Our responsibility is to express an opinion onthese financial statements and schedule based on our audits.

 

We conducted our audits inaccordance with auditing standards generally accepted in the United States.Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financialstatements referred to above present fairly, in all material respects, theconsolidated financial position of SafeNet, Inc. and subsidiaries atDecember 31, 2002 and 2001, and the consolidated results of theiroperations and their cash flows for the each of the three years in the periodended December 31, 2002, in conformity with accounting principlesgenerally accepted in the United States. Also, in our opinion, the relatedfinancial statement schedule, when considered in relation to the basicfinancial statements taken as a whole, presents fairly, in all materialrespects, the information set forth therein.

 

As discussed in Note 7 to thefinancial statements, in 2002 the Company changed its method of accounting forgoodwill. 

 
|                   | /s/ Ernst  & Young LLP |
|------------------------|----------------------------|
|                   |                       |
| Baltimore,  Maryland   |                       |
| February 6,  2003 |                       |

 

31

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**SAFENET, INC.**

**AND SUBSIDIARIES**

 

**Consolidated Balance Sheets**

(Amounts in thousands, except per share data) 

 
|                                                                                                                                 |   | **December  31,** |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|--------|
|                                                                                                                                 |   | **2002**          |   | **2001** |   |
| **Assets**                                                                                                                           |   |              |   |   |   |
| Current assets:                                                                                                                      |   |              |   |   |   |
| Cash and cash equivalents                                                                                                            |   | $                 | 3,399  |   | $ | 14,819 |   |
| Held-to-maturity securities                                                                                                          |   | 28,763            |   | 15,865 |   |
| Accounts receivable, less allowance of $244  in 2002 and $150 in 2001                                                                |   | 4,534             |   | 3,225 |   |
| Inventories, less reserve of $958 in 2002  and $482 in 2001                                                                          |   | 1,008             |   | 1,260 |   |
| Prepaid expenses                                                                                                                     |   | 1,002             |   | 850 |   |
| Current assets of discontinued operations                                                                                            |   | 93                |   | 784 |   |
|                                                                                                                                 |   |              |   |   |   |
| Total current assets                                                                                                                 |   | 38,799            |   | 36,803 |   |
| Property and equipment, net                                                                                                          |   | 1,246             |   | 969 |   |
| Computer software development costs, less  accumulated amortization of $1,513 in 2002 and $3,113 in 2001                             |   | 479               |   | 727 |   |
| Goodwill                                                                                                                             |   | 12,826            |   | — |   |
| Intangible assets, less accumulated  amortization of $1,640 in 2002                                                                  |   | 595               |   | — |   |
| Non-current assets of discontinued  operations                                                                                       |   | —            |   | 537 |   |
| Other assets                                                                                                                         |   | 1,374             |   | 841 |   |
|                                                                                                                                 |   |              |   |   |   |
| Total assets                                                                                                                         |   | $                 | 55,319 |   | $ | 39,877 |   |
|                                                                                                                                 |   |              |   |   |   |
| **Liabilities and Stockholders’ Equity**                                                                                        |   |              |   |   |   |
| Current liabilities:                                                                                                                 |   |              |   |   |   |
| Accounts payable                                                                                                                     |   | $                 | 1,456  |   | $ | 988 |   |
| Accrued compensation and related expenses                                                                                            |   | 2,162             |   | 713 |   |
| Other accrued expenses                                                                                                               |   | 1,424             |   | 577 |   |
| Advance payments and deferred revenue                                                                                                |   | 1,393             |   | 1,918 |   |
| Current liabilities of discontinued  operations                                                                                      |   | 377               |   | 222 |   |
|                                                                                                                                 |   |              |   |   |   |
| Total current liabilities                                                                                                            |   | 6,812             |   | 4,418 |   |
| Deferred income taxes                                                                                                                |   | 129               |   | — |   |
| Commitments and contingencies                                                                                                        |   | —            |   | — |   |
| Stockholders’ equity:                                                                                                           |   |              |   |   |   |
| Preferred stock, $.01 par value per share.  Authorized 500 shares, no shares issued and outstanding                                  |   | —            |   | — |   |
| Common stock, $.01 par value per share.  Authorized 50,000 shares, issued and outstanding shares of 7,894 in 2002 and  7,108 in 2001 |   | 79                |   | 71 |   |
| Additional paid-in capital                                                                                                           |   | 65,665            |   | 52,400 |   |
| Accumulated deficit                                                                                                                  |   | (20,225           | )      | (15,486 | ) |
| Accumulated other comprehensive income  (loss)                                                                                       |   | 2,859             |   | (1,526 | ) |
|                                                                                                                                 |   |              |   |   |   |
| Total stockholders’ equity                                                                                                      |   | 48,378            |   | 35,459 |   |
|                                                                                                                                 |   |              |   |   |   |
| Total liabilities and stockholders’ equity                                                                                      |   | $                 | 55,319 |   | $ | 39,877 |   |

 

See notes to consolidatedfinancial statements.

 

32

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**SAFENET, INC.**

**AND SUBSIDIARIES**

 

**ConsolidatedStatements of Operations**

(Amounts in thousands, except per share data) 

 
|                                                                                              |   | **Year ended  December 31** |   |
|---------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                                              |   | **2002**                    |   | **2001** |   | **2000** |   |
|                                                                                              |   |                        |   |   |   |   |   |
| Revenues:                                                                                         |   |                        |   |   |   |   |   |
| Licenses and royalties                                                                            |   | $                           | 7,398  |   | $ | 4,031 |   | $ | 15,223 |   |
| Products                                                                                          |   | 21,588                      |   | 9,732 |   | 7,901 |   |
| Service and maintenance                                                                           |   | 3,249                       |   | 2,699 |   | 2,154 |   |
|                                                                                              |   |                        |   |   |   |   |   |
| Total revenues                                                                                    |   | 32,235                      |   | 16,462 |   | 25,278 |   |
|                                                                                              |   |                        |   |   |   |   |   |
| Cost of revenues:                                                                                 |   |                        |   |   |   |   |   |
| Licenses and royalties                                                                            |   | 811                         |   | 644 |   | 2,637 |   |
| Products                                                                                          |   | 7,699                       |   | 3,423 |   | 2,810 |   |
| Service and maintenance                                                                           |   | 453                         |   | 458 |   | 387 |   |
|                                                                                              |   |                        |   |   |   |   |   |
| Total cost of revenues                                                                            |   | 8,963                       |   | 4,525 |   | 5,834 |   |
|                                                                                              |   |                        |   |   |   |   |   |
| Gross profit                                                                                      |   | 23,272                      |   | 11,937 |   | 19,444 |   |
|                                                                                              |   |                        |   |   |   |   |   |
| Operating expenses:                                                                               |   |                        |   |   |   |   |   |
| Research and development expenses                                                                 |   | 8,504                       |   | 6,118 |   | 6,342 |   |
| Sales and marketing expenses                                                                      |   | 7,341                       |   | 5,061 |   | 4,756 |   |
| General and administrative expenses                                                               |   | 4,108                       |   | 2,203 |   | 2,681 |   |
| Write-off of acquired in-process research  and development                                        |   | 3,375                       |   | — |   | — |   |
| Amortization of acquired intangible assets                                                        |   | 1,488                       |   | — |   | — |   |
| Other                                                                                             |   | —                      |   | — |   | (275 | ) |
|                                                                                              |   |                        |   |   |   |   |   |
| Total operating expenses                                                                          |   | 24,816                      |   | 13,382 |   | 13,504 |   |
|                                                                                              |   |                        |   |   |   |   |   |
| Operating (loss) income                                                                      |   | (1,544                      | )      | (1,445 | ) | 5,940 |   |
| Other income (expense):                                                                           |   |                        |   |   |   |   |   |
| Investment income                                                                                 |   | 539                         |   | 1,337 |   | 1,321 |   |
| Other expense, net                                                                                |   | 130                         |   | (1 | ) | (1 | ) |
|                                                                                              |   |                        |   |   |   |   |   |
| (Loss) income from continuing operations  before income taxes                                     |   | (875                        | )      | (109 | ) | 7,260 |   |
| Income tax benefit                                                                                |   | (90                         | )      | — |   | — |   |
|                                                                                              |   |                        |   |   |   |   |   |
| (Loss) income from continuing operations                                                          |   | (785                        | )      | (109 | ) | 7,260 |   |
| Loss from operations of discontinued GDS  business (including loss on disposal of $3,506 in 2002) |   | (3,954                      | )      | (3,453 | ) | (1,503 | ) |
|                                                                                              |   |                        |   |   |   |   |   |
| Net (loss) income                                                                            |   | $                           | (4,739 | ) | $ | (3,562 | ) | $ | 5,757 |   |
|                                                                                              |   |                        |   |   |   |   |   |
| (Loss) income from continuing operations  per common share                                        |   |                        |   |   |   |   |   |
| Basic                                                                                             |   | $                           | (0.10  | ) | $ | (0.01 | ) | $ | 1.08 |   |
|                                                                                              |   |                        |   |   |   |   |   |
| Diluted                                                                                           |   | $                           | (0.10  | ) | $ | (0.01 | ) | $ | 1.01 |   |
|                                                                                              |   |                        |   |   |   |   |   |
| Loss from operations of discontinued GDS  business per common share                               |   |                        |   |   |   |   |   |
| Basic                                                                                             |   | $                           | (0.51  | ) | $ | (0.49 | ) | $ | (0.23 | ) |
|                                                                                              |   |                        |   |   |   |   |   |
| Diluted                                                                                           |   | $                           | (0.51  | ) | $ | (0.49 | ) | $ | (0.21 | ) |
|                                                                                              |   |                        |   |   |   |   |   |
| Net (loss) income per common share                                                           |   |                        |   |   |   |   |   |
| Basic                                                                                             |   | $                           | (0.61  | ) | $ | (0.50 | ) | $ | 0.85 |   |
|                                                                                              |   |                        |   |   |   |   |   |
| Diluted                                                                                           |   | $                           | (0.61  | ) | $ | (0.50 | ) | $ | 0.80 |   |

 

See notes to consolidatedfinancial statements.

 

33

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**SAFENET, INC.**

**AND SUBSIDIARIES**

 

**ConsolidatedStatements of Comprehensive (Loss) Income**

(Amounts in thousands) 

 

|                                                                                                                |   | **Year ended  December 31** |   |
|---------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                                                                |   | **2002**                    |   | **2001** |   | **2000** |   |
|                                                                                                                |   |                        |   |   |   |   |   |
| Net (loss) income                                                                                              |   | $                           | (4,739 | ) | $ | (3,562 | ) | $ | 5,757 |   |
| Other comprehensive income (loss) -                                                                                 |   |                        |   |   |   |   |   |
| Foreign currency translation adjustment                                                                             |   | 2,904                       |   | (165 | ) | (112 | ) |
| Reclassification adjustment - realization  of foreign currency translation adjustment upon disposal of GDS business |   | 1,526                       |   | — |   | — |   |
| Other                                                                                                               |   | (46                         | )      | (84 | ) | 130 |   |
|                                                                                                                |   |                        |   |   |   |   |   |
| Comprehensive (loss) income                                                                                    |   | $                           | (355   | ) | $ | (3,811 | ) | $ | 5,775 |   |

 

See notes to consolidatedfinancial statements.

 

**SAFENET, INC.**

**AND SUBSIDIARIES**

 

**ConsolidatedStatements of Stockholders’ Equity**

(Amounts in thousands) 

 

|                                                                                                                |   |              |       |                             |       |                     |       |    |                                  | **Accumulated  Other  Comprehensive  (Loss)  Income** |    |   |   |
|---------------------------------------------------------------------------------------------------------------------|--------|-------------------|------------|----------------------------------|------------|--------------------------|------------|---------|---------------------------------------|-------------------------------------------------------|---------|--------|--------|
|                                                                                                                |   |              |       |                             |       |                     |       |    |                                  |                                                  |    |   |
|                                                                                                                |   |              |       | **Additional  Paid-in  Capital** |       | **Accumulated  Deficit** |       |    | **Total  Stockholders’  Equity** |                                                  |
|                                                                                                                |   | **Common  stock** |       |                             |       |                     |       |
|                                                                                                                |   | **Shares**        | ** ** | **Amount**                       | ** ** | ** **               | ** ** |    |                                  |
|                                                                                                                |   |              |       |                             |       |                     |       |    |                                  |                                                  |    |   |   |
| Balance at January 1, 2000                                                                                     |   | 6,542             |       | $                                | 65         |                     | $          | 46,547  |                                  | $                                                     | (17,681 | )      | $      | (1,295 | ) | $ | 27,636 |   |
| Stock options exercised                                                                                             |   | 392               |       | 4                                |       | 4,082                    |       | —  |                                  | —                                                |    | 4,086  |   |
| Stock warrants exercised                                                                                            |   | 7                 |       | —                           |       | 118                      |       | —  |                                  | —                                                |    | 118    |   |
| Stock option compensation                                                                                           |   | —            |       | —                           |       | 128                      |       | —  |                                  | —                                                |    | 128    |   |
| Net income                                                                                                          |   | —            |       | —                           |       | —                   |       | 5,757   |                                  | —                                                |    | 5,757  |   |
| Foreign currency translation adjustment                                                                             |   | —            |       | —                           |       | —                   |       | —  |                                  | (112                                                  | )       | (112   | )      |
| Other                                                                                                               |   | —            |       | —                           |       | (20                      | )          | —  |                                  | 130                                                   |    | 110    |   |
|                                                                                                                |   |              |       |                             |       |                     |       |    |                                  |                                                  |    |   |   |
| Balance at December 31, 2000                                                                                   |   | 6,941             |       | 69                               |       | 50,855                   |       | (11,924 | )                                     | (1,277                                                | )       | 37,723 |   |
| Stock options exercised                                                                                             |   | 167               |       | 2                                |       | 1,547                    |       | —  |                                  | —                                                |    | 1,549  |   |
| Net loss                                                                                                            |   | —            |       | —                           |       | —                   |       | (3,562  | )                                     | —                                                |    | (3,562 | )      |
| Foreign currency translation adjustment                                                                             |   | —            |       | —                           |       | —                   |       | —  |                                  | (165                                                  | )       | (165   | )      |
| Other                                                                                                               |   | —            |       | —                           |       | (2                       | )          | —  |                                  | (84                                                   | )       | (86    | )      |
|                                                                                                                |   |              |       |                             |       |                     |       |    |                                  |                                                  |    |   |   |
| Balance at December 31, 2001                                                                                   |   | 7,108             |       | 71                               |       | 52,400                   |       | (15,486 | )                                     | (1,526                                                | )       | 35,459 |   |
| Issuance of stock in connection with the  acquisition of Securealink                                                |   | 575               |       | 6                                |       | 10,630                   |       | —  |                                  | —                                                |    | 10,636 |   |
| Issuance of stock under Employee Stock  Purchase Plan                                                               |   | 6                 |       | —                           |       | 217                      |       | —  |                                  | —                                                |    | 217    |   |
| Stock options exercised                                                                                             |   | 205               |       | 2                                |       | 1,968                    |       | —  |                                  | —                                                |    | 1,970  |   |
| Income tax benefit related to stock option  exercises                                                               |   | —            |       | —                           |       | 450                      |       | —  |                                  | —                                                |    | 450    |   |
| Net loss                                                                                                            |   | —            |       | —                           |       | —                   |       | (4,739  | )                                     | —                                                |    | (4,739 | )      |
| Reclassification adjustment - realization  of foreign currency translation adjustment upon disposal of GDS business |   | —            |       | —                           |       | —                   |       | —  |                                  | 1,526                                                 |    | 1,526  |   |
| Foreign currency translation adjustment                                                                             |   | —            |       | —                           |       | —                   |       | —  |                                  | 2,904                                                 |    | 2,904  |   |
| Other                                                                                                               |   | —            |       | —                           |       | —                   |       | —  |                                  | (45                                                   | )       | (45    | )      |
|                                                                                                                |   |              |       |                             |       |                     |       |    |                                  |                                                  |    |   |   |
| Balance at December 31, 2002                                                                                   |   | 7,894             |       | $                                | 79         |                     | $          | 65,665  |                                  | $                                                     | (20,225 | )      | $      | 2,859 |   | $ | 48,378 |   |
|                                                                                                                     |        |                   |            |                                  |            |                          |            |         |                                       |                                                       |         |        |        |  |  |  |  |  |  |  |  |  |

 

See notes to consolidatedfinancial statements.

 

34

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**SAFENET, INC.**

**AND SUBSIDIARIES**

 

**ConsolidatedStatements of Cash Flows**

(Amounts in thousands) 

 

|                                                                                                     |   | **Year ended  December 31** |   |
|----------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                                                     |   | **2002**                    |   | **2001** |   | **2000** |   |
| Cash flows from operating activities:                                                                    |   |                        |   |   |   |   |   |
| Net (loss) income                                                                                   |   | $                           | (4,739 | ) | $ | (3,562 | ) | $ | 5,757 |   |
| Adjustments to reconcile net  (loss) income to net cash provided by (used in) operating activities: |   |                        |   |   |   |   |   |
| Write-off of acquired in-process research  and development                                               |   | 3,375                       |   | — |   | — |   |
| Loss on disposal of discontinued GDS  business, less cash portion                                        |   | 2,687                       |   | — |   | — |   |
| Depreciation                                                                                             |   | 975                         |   | 662 |   | 680 |   |
| Amortization of computer software  development costs                                                     |   | 574                         |   | 954 |   | 1,150 |   |
| Amortization of acquired intangible assets                                                               |   | 1,488                       |   | 85 |   | 85 |   |
| Income tax benefit from stock option  exercises                                                          |   | 450                         |   | — |   | — |   |
| Stock compensation                                                                                       |   | —                      |   | — |   | 128 |   |
| Other non-cash charges                                                                                   |   | 501                         |   | — |   | — |   |
| Changes in operating assets and  liabilities:                                                            |   |                        |   |   |   |   |   |
| Accounts receivable, net                                                                                 |   | (551                        | )      | 167 |   | 125 |   |
| Inventories, net                                                                                         |   | 270                         |   | 1,369 |   | 19 |   |
| Accounts payable                                                                                         |   | (257                        | )      | (778 | ) | 615 |   |
| Accrued compensation and related costs                                                                   |   | 977                         |   | (937 | ) | 492 |   |
| Other accrued expenses                                                                                   |   | 329                         |   | (8 | ) | 540 |   |
| Advance payments and deferred revenue                                                                    |   | (529                        | )      | 959 |   | (511 | ) |
| Other                                                                                                    |   | 383                         |   | (621 | ) | 92 |   |
|                                                                                                     |   |                        |   |   |   |   |   |
| Net cash provided by (used in) operating  activities                                                     |   | 5,933                       |   | (1,710 | ) | 9,172 |   |
|                                                                                                     |   |                        |   |   |   |   |   |
| Cash flows from investing activities:                                                                    |   |                        |   |   |   |   |   |
| Maturities of short-term investments                                                                     |   | 25,378                      |   | 8,433 |   | 501 |   |
| Purchases of short-term investments                                                                      |   | (38,277                     | )      | (17,966 | ) | (6,332 | ) |
| Purchases of property and equipment                                                                      |   | (507                        | )      | (399 | ) | (607 | ) |
| Expenditures for computer software  development                                                          |   | (326                        | )      | (167 | ) | (631 | ) |
| Cash paid for Securealink, net of cash  acquired                                                         |   | (3,769                      | )      | — |   | — |   |
| Deferred acquisition costs                                                                               |   | (625                        | )      | — |   | — |   |
| Other investments                                                                                        |   | (565                        | )      | — |   | — |   |
|                                                                                                     |   |                        |   |   |   |   |   |
| Net cash used in investing activities                                                                    |   | (18,691                     | )      | (10,099 | ) | (7,069 | ) |
|                                                                                                     |   |                        |   |   |   |   |   |
| Cash flows from financing activities:                                                                    |   |                        |   |   |   |   |   |
| Proceeds from stock options exercised and  shares issued under employee stock purchase plan              |   | 2,187                       |   | 1,549 |   | 4,086 |   |
| Proceeds from stock warrants exercised                                                                   |   | —                      |   | — |   | 118 |   |
| Repayment of Securealink line of credit                                                                  |   | (1,484                      | )      | — |   | — |   |
| Other                                                                                                    |   | —                      |   | — |   | (20 | ) |
|                                                                                                     |   |                        |   |   |   |   |   |
| Net cash provided by financing activities                                                                |   | 703                         |   | 1,549 |   | 4,184 |   |
|                                                                                                     |   |                        |   |   |   |   |   |
| Effect of exchange rate changes on cash                                                                  |   | 460                         |   | (115 | ) | (79 | ) |
|                                                                                                     |   |                        |   |   |   |   |   |
| Net (decrease) increase in cash and  cash equivalents                                               |   | (11,595                     | )      | (10,375 | ) | 6,208 |   |
| Cash and cash equivalents at beginning of year                                                           |   | 14,994                      |   | 25,369 |   | 19,161 |   |
|                                                                                                     |   |                        |   |   |   |   |   |
| Cash and cash equivalents at end of year                                                                 |   | $                           | 3,399  |   | $ | 14,994 |   | $ | 25,369 |   |
|                                                                                                     |   |                        |   |   |   |   |   |
| Cash and cash equivalents at end of year:                                                                |   |                        |   |   |   |   |   |
| Continuing operations                                                                                    |   | $                           | 3,399  |   | $ | 14,819 |   | $ | 22,796 |   |
| Discontinued operations                                                                                  |   | —                      |   | 175 |   | 2,573 |   |
|                                                                                                     |   |                        |   |   |   |   |   |
|                                                                                                     |   | $                           | 3,399  |   | $ | 14,994 |   | $ | 25,369 |   |
|                                                                                                     |   |                        |   |   |   |   |   |
| Cash paid for income taxes                                                                               |   | $                           | — |   | $ | 73 |   | $ | 5 |   |

 

See notes to consolidatedfinancial statements.

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(Amounts in Thousands)**

 

**(1) BUSINESS**

 

SafeNet, Inc. (“SafeNet” or the“Company”) delivers a widely deployed Virtual Private Network, or VPN,technology for secure business communications over the Internet, offering bothOriginal Equipment Manufacturer (“OEM”) technology and end-user products forVPN and e-commerce applications. The Company provides its network securitysolutions worldwide for financial, enterprise, telecommunications,

 

35

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and government use. TheCompany’s technology is sold and licensed in various formats, includingsoftware, hardware, silicon chips, and intellectual property.

 

In January 2002, the Companyacquired Pijnenburg Securealink, Inc. (“Securealink”), a European manufacturerof security chips for e-commerce transactions (see Note 4). In February 2003,the Company acquired Cylink, Inc. (“Cylink”). Cylink develops, markets, andsupports a comprehensive portfolio of hardware and software security productsfor mission-critical private networks and business communications over theInternet (see Note 16).

 

As discussed in Note 3, inFebruary 2002, the Company made a decision to discontinue the operations of itsSwiss subsidiary, GretaCoder Data Systems (“GDS”). The financial position andresults of operations of GDS have been disclosed as discontinued operations inthe accompanying consolidated financial statements.

 

**(2) SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

**Principles of Consolidation**

 

The consolidated financialstatements include the accounts of the Company and its subsidiaries, all ofwhich are wholly owned. Significant intercompany accounts and transactions havebeen eliminated in consolidation.

 

**Use of Estimates**

 

The preparation of consolidatedfinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect reported amounts reported in the consolidated financialstatements and the accompanying notes. Actual results could differ from thoseestimates.

 

**Cash Equivalents**

 

The Company considers allhighly liquid investments with maturities of three months or less whenpurchased to be cash equivalents. The Company had approximately $3,399 and$14,819 of cash equivalents at December 31, 2002 and 2001, respectively, consistingprimarily of overnight repurchase agreements, short-term money market funds andcommercial paper.

 

**Held-to-Maturity Securities**

 

Management determines theappropriate classification of debt securities at the time of purchase andreevaluates such designation as of each balance sheet date. Debt securities areclassified as held-to-maturity when the Company has the positive intent andability to hold the securities to maturity. Held-to-maturity securities arestated at amortized cost, adjusted for amortization of premiums and accretionof discounts to maturity computed under the effective interest method. Suchamortization is included in investment income. Interest on securitiesclassified as held-to-maturity is included in investment income. The Companyhad $28,763 and $15,865 of held-to-maturity securities at December 31,2002 and 2001, respectively, consisting primarily of corporate debtinstruments. As of December 31, 2002, substantially all of theheld-to-maturity securities are due in one year or less.

 

**Accounts Receivable**

 

The Company reports accountsreceivable at net realizable value. The Company maintains an allowance fordoubtful accounts for estimated losses resulting from the inability of itscustomers to make required payments. The Company calculates its allowance basedon a specific analysis of past due balances and also considers historicaltrends of write-offs.

 

**Inventories**

 

Inventories are stated at thelower of cost or market. Cost is determined by the first-in, first-out method.

 

36

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**Property and Equipment**

 

Property and equipment isstated at cost and depreciation is computed using the straight-line method overestimated useful lives ranging primarily from three to seven years. Amortizationof leasehold improvements is computed using the straight-line method over thelesser of the useful life of the asset or the remaining term of the lease.

 

**Computer Software Development Costs**

 

Costs for the development ofnew software products and substantial enhancements to existing softwareproducts are expensed as research and development costs as incurred untiltechnological feasibility has been established, at which time any additionaldevelopment costs are capitalized until the product is available for generalrelease to customers. The Company defines the establishment of technologicalfeasibility as the completion of a working model of the software product thathas been tested to be consistent with the product design specifications andthat is free of any uncertainties related to known high-risk developmentissues.

 

Amortization of softwaredevelopment costs, which is included in cost of revenues, begins upon generalrelease of the software. These costs are amortized on a product by-productbasis using the greater of: (i) the amount computed using the ratio thatcurrent gross revenues for each product bear to the total of current andanticipated future revenue for that product, or (ii) the amount computed usingthe straight-line method over the estimated economic useful life of three tofive years. Such costs are amortized beginning on product release dates. TheCompany assesses the recoverability of computer software development costs bycomparing the unamortized balance to the net realizable value of the asset andwrites off the amount by which the unamortized capitalized costs exceed theestimated net realizable value. During the year ended December 31, 2001,the Company wrote off $218 of capitalized software development costs for whichthe unamortized balance exceeded the estimated net realizable value. This writeoff has been included as a charge to 2001 research and development expenses.

 

**Goodwill and Other Intangible Assets**

 

Goodwill is initially measuredas the excess of the cost of an acquired company over the sum of the amountsassigned to tangible and intangible assets acquired less liabilities assumed.The Company does not amortize goodwill, but rather reviews the carrying valueof the asset for impairment at least annually in accordance with the provisionsof FASB Statement No. 142, *Goodwill and Intangible Assets*, theprovisions of which the Company adopted effective January 1, 2002.Intangible assets with finite lives are amortized over their estimated usefullives ranging from one to five years, with a weighted average useful live of28 months (see Note 8).

 

**Impairment of Long-Lived Assets andLong-Lived Assets to Be Disposed Of**

 

Long-lived assets, includingamortized intangible assets, are reviewed for impairment whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe fully recoverable. If an impairment indicator is present, the Companyevaluates whether an impairment exists on the basis of undiscounted expectedfuture cash flows from the assets over the remaining amortization period. Ifimpairment exists, the asset is reduced by the estimated difference between itsfair value and its carrying value. Fair value is usually determined usingdiscounted cash flows. Assets to disposed of are reported at the lower ofcarrying value or fair value less costs to sell.

 

**Product Warranties**

 

The Company warrants to theoriginal purchaser that each of its hardware products will be free from defectsin materials and workmanship generally for a period of one year from the dateof purchase. Expected future product warranty expense is recorded when theproduct is sold.

 

37

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**Revenue Recognition**

 

The Company derives revenuefrom software and technology licenses, product sales, maintenance (postcontract customer support), and services. Software and technology licensestypically contain multiple elements, including the product license,maintenance, and/or other services. The Company allocates the total arrangementfee among each deliverable based on the fair value of each of the deliverablesdetermined based on vendor-specific objective evidence.

 

***Licenseand Royalties***

 

License revenue is comprised ofperpetual and time-based license fees, which are derived from arrangements withend-users, original equipment manufacturers and resellers. For each softwarelicense arrangement, the Company defers revenue recognition until:(a) persuasive evidence of an arrangement exists; (b) delivery of thesoftware or technology has occurred and there are no remaining obligations orsubstantive customer acceptance provisions; (c) the fee is fixed ordeterminable; and (d) collection of the fee is probable. For bothperpetual and time-based licenses, once all of these conditions are satisfied,the Company recognizes license revenue based on the residual method after allelements other than maintenance have been delivered as prescribed by SOP 98-9, *Modificationof SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions*.Royalties are recognized as they are earned.

 

Revenues that are earned underlong-term contracts to develop high assurance encryption technology arerecognized using contract accounting. Under contract accounting, revenue fromthese arrangements is recognized using the percentage-of-completion method.Progress to completion is measured using contract milestones. Managementconsiders contract milestones to be the best available measure of progress onthese contracts since each milestone contains customer-specified acceptancecriteria. Any estimated losses are provided for in their entirety in the periodthey are first determined. Actual remaining costs under fixed price contractscould vary significantly from the Company’s estimates, and such differencescould be material to the financial statements.

 

***Products***

 

The Company also sells hardwareand related encryption products. For each product sale, the Company defersrevenue recognition until: (a) persuasive evidence of an arrangementexists; (b) delivery has occurred and there are no remaining obligationsor substantive customer acceptance provisions; (c) the selling price tothe customer is fixed or determinable; and (d) collectibility of theselling price is reasonably assured.

 

***Maintenanceand Other Services***

 

Maintenance revenue is derivedfrom support arrangements. Maintenance arrangements provide technical customersupport and the right to unspecified upgrades on an if-and-when-availablebasis. In accordance with SOP 97-2, *Software Revenue Recognition*, vendor specificobjective evidence of fair value of maintenance is determined based on theprice charged for the maintenance element when sold separately. The maintenanceterm is typically one year in duration and maintenance revenue is recognizedratably over the maintenance term. Unrecognized maintenance fees are includedin deferred revenue.

 

Other service revenue iscomprised of revenue from consulting fees, training, engineering services andlong-term arrangements for custom development of high assurance encryptiondevices. Except for services provided under long-term arrangements, servicerevenue is recognized when the services are provided to the customer. TheCompany’s policy is to recognize software license revenue when these associatedservices are not essential to the functionality of the product. To date, theseservices have not been essential to the functionality of the product. Vendorspecific objective evidence of fair value of these services is determined byreference to the price that a customer will be required to pay when theservices are sold separately, which is based on the price history that theCompany has developed for separate sales of these services.

 

38

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**Foreign Currency Translation**

 

The financial statements offoreign subsidiaries for which the local currency is the functional currencyhave been translated into U.S. dollars in accordance with FASB StatementNo. 52, *Foreign Currency Translation*. All balance sheet accountshave been translated using the exchange rates in effect at the balance sheetdate. Income statement amounts have been translated using the average exchangerate for the year. The gains and losses resulting from the changes in exchangerates from year to year have been reported in other comprehensive income.Transactions of foreign subsidiaries for which the U.S. dollar is thefunctional currency have been remeasured into U.S. dollars with any resultinggain or loss reported as a component of income. The effect on the consolidatedstatements of operations of all transaction gains and losses is insignificantfor all years presented.

 

**Income Taxes**

 

The Company uses the liabilitymethod in accounting for income taxes. Under this method, deferred income taxassets and liabilities are determined based on difference between financialreporting and tax bases of assets and liabilities and are measured using theenacted tax rates and laws that will be in effect when the differences areexpected to reverse.

 

**Employee Stock-Based Compensation**

 

At December 31, 2002, theCompany had five stock-based employee compensation plans, which are describedmore fully in Note 12. The Company accounts for those plans using the intrinsicvalue method prescribed by APB Opinion No. 25, *Accounting for Stock Issued toEmployees*, and related Interpretations. No stock-based employeecompensation cost is reflected in net income, as all options granted underthose plans had an exercise price equal to the market value of the underlyingcommon stock on the date of grant.

 

The following table illustratesthe effect on net (loss) income and earnings per share if the Company hadapplied the fair value recognition provisions of FASB Statement No. 123, *Accountingfor Stock-Based Compensation*, to stock-based employee compensation. 

 

|                                                                                                                                          |   | **Year ended  December 31** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                                                                                          |   | **2002**                    |   | **2001** |   | **2000** |   |
|                                                                                                                                          |   |                        |   |   |   |   |   |
| Net (loss) income, as reported                                                                                                           |   | $                           | (4,739 | ) | $ | (3,562 | ) | $ | 5,757 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |   | (3,762                      | )      | (5,436 | ) | (4,117 | ) |
|                                                                                                                                          |   |                        |   |   |   |   |   |
| Pro forma net (loss) income                                                                                                              |   | $                           | (8,501 | ) | $ | (8,998 | ) | $ | 1,640 |   |
|                                                                                                                                          |   |                        |   |   |   |   |   |
| Earnings per share:                                                                                                                           |   |                        |   |   |   |   |   |
| Basic—as reported                                                                                                                        |   | $                           | (0.61  | ) | $ | (0.50 | ) | $ | 0.85 |   |
| Basic—pro forma                                                                                                                          |   | $                           | (1.10  | ) | $ | (1.26 | ) | $ | 0.24 |   |
| Diluted—as reported                                                                                                                      |   | $                           | (0.61  | ) | $ | (0.50 | ) | $ | 0.80 |   |
| Diluted—pro forma                                                                                                                        |   | $                           | (1.10  | ) | $ | (1.26 | ) | $ | 0.24 |   |

 

Pro forma information regardingnet income and earnings per share required by Statement 123, and has beendetermined as if the Company had accounted for its employee stock options underthe fair value method of that Statement. The weighted-average grant date fairvalue per share of options granted during 2002, 2001, and 2000 was $8.85,$11.50, and $20.45, respectively. The fair value for these options wasestimated at the dates of grant using a Black-Scholes option-pricing model withthe following weighted-average assumptions for 2002, 2001, and 2000,respectively: risk-free interest rates of 3.88%, 4.42%, and 5.10%; expectedvolatility of 119%, 139%, and 180%; dividend yield and expected dividend growthrate of 0% in all years; and weighted-average expected remaining life of 3 to7 years in all years. For purposes of pro forma disclosures, the estimatedfair value of the options is amortized to expense over the options’ vestingperiod.

 

39

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**Comprehensive (Loss) Income**

 

Comprehensive(loss) income includes all changes in equity that result from recognizedtransactions and other economic events of a period other than transactions withowners in their capacity as owners. Certain non-owner changes in equity,consisting primarily of foreign currency translation adjustments, are includedin “other comprehensive (loss) income.” The Company reports comprehensive(loss) income in the statement of comprehensive (loss) income anddiscloses the accumulated total of other comprehensive (loss) income inthe stockholders’ equity section of the balance sheet.

 

**Fair Value of Financial Instruments**

 

The carrying amount of financialinstruments, including cash and cash equivalents and held-to-maturitysecurities approximates fair value based on the short-term nature of theseinstruments.

 

**Reclassifications**

 

Where appropriate, certainamounts in the prior year consolidated financial statements have beenreclassified to conform to the 2002 presentation.

 

**Recent Accounting Pronouncement**

 

In June 2002, the FinancialAccounting Standards Board issued Statement No. 146, *Accounting for Costs Associated withExit or Disposal Activities*, which addresses accounting andreporting for costs associated with exit or disposal activities and nullifiesEITF Issue No. 94-3, *Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring).*Statement No. 146 requiresthat a liability for a cost associated with an exit or disposal activity berecognized at fair value when the liability is incurred rather than at the dateof a commitment to an exit plan. Costs covered by Statement No. 146include one-time termination benefits and certain contract termination costs,including operating lease termination costs that are associated with an exit ordisposal activity. The provisions of this Statement are effective for exit ordisposal activities that are initiated after December 31, 2002.

 

**(3) DISCONTINUED OPERATIONS**

 

As discussed further in Note 4,on January 2, 2002, SafeNet acquired 100 percent of the outstanding commonshares of Pijnenburg Securealink, Inc. (“Securealink”). SafeNet’s acquisitionof Securealink resulted in changes to SafeNet’s business initiatives. One ofthe areas impacted was the Company’s Swiss subsidiary, GDS. Based on the amountof GDS operating and cash losses during 2000 and 2001, as well as a significantdownturn in future business prospects due to the loss of two substantialcontracts in February 2002, SafeNet management made the decision to discontinueoperations at GDS. Certain employees from GDS’s sales and marketing team weretransferred to SafeNet to create a new European sales office focused on sellingSafeNet’s Enterprise Security products in Europe. All of the operations at GDS,including research and development, manufacturing and administration wereclosed and 26 employees were terminated during the first and second quarters of2002.

 

As a result of the discontinuedoperations, the Company recorded a one-time charge of $3,506 in the firstquarter of 2002 related to the write-off of the abandoned assets and theaccrual of the estimated costs of the closing and severance and related costs.The disposition of GDS operations represents the disposal of a business segmentunder FASB Statement No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*. Accordingly, the results of this operation havebeen classified as discontinued during all periods presented. For businesssegment reporting purposes, GDS’s business results were previously classifiedas the segment “European Operations.”

 

Summarized operating resultsfrom the discontinued operation included in the consolidated statements ofoperations, excluding the loss on disposal, are as follows for the years endedDecember 31: 

 

40

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|                   |   | **2002** |   | **2001** |   | **2000** |   |
|------------------------|--------|----------|--------|----------|--------|----------|--------|
|                   |   |     |   |     |   |     |   |
| Revenues               |   | $        | 198    |     | $      | 1,655    |   | $ | 3,547 |   |
| Loss from operations   |   | (448     | )      | (3,453   | )      | (1,503   | )      |
| Loss on disposal       |   | (3,506   | )      | —   |   | —   |   |
|                   |   |     |   |     |   |     |   |
| Net (loss) income |   | $        | (3,954 | )        | $      | (3,453   | )      | $ | (1,503 | ) |

 

Assets and liabilities of thediscontinued operations at December 31 were as follows: 

 

|                                  |   | **2002** |   | **2001** |   |
|---------------------------------------|--------|----------|--------|----------|--------|
|                                  |   |     |   |     |   |
| Cash and cash equivalents             |   | $        | — |     | $      | 175 |   |
| Inventories, net                      |   | —   |   | 232      |   |
| Other current assets                  |   | 93       |   | 377      |   |
| Property and equipment, net           |   | —   |   | 221      |   |
| Other assets                          |   | —   |   | 316      |   |
| Current liabilities                   |   | (377     | )      | (222     | )      |
|                                  |   |     |   |     |   |
| Net assets of discontinued operations |   | $        | (284   | )        | $      | 1,099 |   |

 

The fair value of assets to bedisposed was based on estimated net realizable value at the time of disposal.The significant components of the loss on disposal of the GDS operations is asfollows: 

 

| Severance costs                                          |   | $      | 697    |   |
|----------------------------------------------------------|--------|--------|--------|--------|
| Lease termination costs                                  |   | 573    |   |
| Goodwill                                                 |   | 316    |   |
| Reclassification of foreign currency  translation losses |   | 1,526  |   |
| Other                                                    |   | 394    |   |
|                                                     |   |   |   |
| Total                                                    |   | $      | 3,506  |   |

** **

**(4) ACQUISITION OF SECUREALINK**

 

On January 2, 2002,SafeNet acquired 100% of the outstanding common shares of Securealink inaccordance with an Agreement and Plan of Reorganization dated December 14,2001. The purchase price the Company paid to the stockholders of Securealink inconnection with the acquisition totaled $14,778 and consisted of an aggregateof 575 shares of SafeNet, Inc. common stock valued at $10,636, $2,000 in cash,contingent convertible promissory notes with an aggregate principal amount of$2,000, the resolution and payment of which were satisfied on May 16, 2002in the aggregate amount of $1,617, and direct costs of acquisition of $525. Thefair market value of common shares was based on the average market price of theshares over the period from three days before to three days after the closingdate. The cash portion of the consideration was funded with cash on hand.

 

The amount and type ofconsideration was determined on the basis of arm’s length negotiations betweenthe Company and Securealink. Securealink develops security chips and sells themin Europe and throughout the world. Securealink is continuing to operate as aprovider of security chips and is now a subsidiary of SafeNet. As a result ofthe acquisition, SafeNet has broadened its market with the addition of newtechnologies and a larger presence in Europe. Additionally, Securealink bringsover thirty cryptographic experts who have complimented and strengtheneddevelopment team. The results of Securealink have been included in theCompany’s consolidated results beginning on the date of acquisition.

 

The following table summarizesthe changes to assets (other than cash) and liabilities in connection with thisacquisition: 

 

41

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| Current assets, excluding cash of $374              |   | $      | 1,271  |   |
|-----------------------------------------------------|--------|--------|--------|--------|
| Property and equipment                              |   | 787    |   |
| Goodwill                                            |   | 10,859 |   |
| Acquired in-process research and  development costs |   | 3,375  |   |
| Intangible assets subject to amortization           |   | 1,905  |   |
|                                                |   |   |   |
| Total assets acquired, excluding cash               |   | $      | 18,197 |   |
|                                                |   |   |   |
| Short-term borrowings                               |   | $      | (1,484 | )      |
| Deferred income taxes                               |   | (670   | )      |
| Other current liabilities                           |   | (1,639 | )      |
|                                                |   |   |   |
| Total liabilities assumed                           |   | (3,793 | )      |
|                                                |   |   |   |
| Purchase price, net of cash received                |   | $      | 14,404 |   |

 

All of the assets andliabilities were assigned to the Embedded Security segment. As noted above,$3,375 of the purchase price represents the estimated fair value of acquiredin-process research and development projects that had not yet reachedtechnological feasibility and had no alternative future use. Accordingly, thisamount was immediately expensed in the Consolidated Statement of Operations onthe acquisition date. The value assigned to purchased in-process technologyrelates entirely to the development of a new application specific integratedcircuit.

 

The estimated fair value ofthis project was determined by employment of a discounted cash flow model. Thediscount rate used takes into account the stage of completion and the riskssurrounding the successful development and commercialization of the purchasedin-process technology project.

 

The unaudited pro formacombined historical results, as if Securealink had been acquired onJanuary 1, 2001, is as follows: 

 

| Revenues                                   |   | $      | 23,345 |   |
|--------------------------------------------|--------|--------|--------|--------|
| Loss from continuing operations            |   | $      | (4,373 | )      |
| Net loss                                   |   | $      | (7,825 | )      |
| Loss per common share - basic and diluted: |   |   |   |
| Loss from continuing operations            |   | $      | (0.57  | )      |
| Net loss                                   |   | $      | (1.03  | )      |

 

The pro forma results includethe estimated amortization of intangibles and interest expense on thepromissory notes used to finance part of the purchase. As described in Note 2,the Company does not record amortization expense related to the goodwill. Thepro forma results are not necessarily indicative of the results that would haveoccurred if the acquisition had actually been completed on January 1,2001, nor are they necessarily indicative of future consolidated results.

 

**(5) INVENTORIES**

 

Inventories related tocontinuing operations consisted of the following at December 31: 

 

|                                      |   | **2002** |   | **2001** |   |
|-------------------------------------------|--------|----------|--------|----------|--------|
|                                      |   |     |   |     |   |
| Raw materials                             |   | $        | 252    |     | $      | 222 |   |
| Finished goods                            |   | 1,714    |   | 1,520    |   |
|                                      |   |     |   |     |   |
|                                      |   | 1,966    |   | 1,742    |   |
| Reserve for excess and obsolete inventory |   | (958     | )      | (482     | )      |
|                                      |   | $        | 1,008  |     | $      | 1,260 |   |

 

42

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**(6) PROPERTY AND EQUIPMENT**

 

Property and equipment relatedto continuing operations consisted of the following at December 31: 

 

|                                      |   | **2002** |   | **2001** |   |
|-------------------------------------------|--------|----------|--------|----------|--------|
|                                      |   |     |   |     |   |
| Furniture and equipment                   |   | $        | 4,350  |     | $      | 3,036 |   |
| Computer software                         |   | 912      |   | 521      |   |
| Leasehold improvements                    |   | 718      |   | 536      |   |
|                                      |   |     |   |     |   |
|                                      |   | 5,980    |   | 4,093    |   |
| Accumulated depreciation and amortization |   | (4,734   | )      | (3,124   | )      |
|                                      |   |     |   |     |   |
|                                      |   | $        | 1,246  |     | $      | 969 |   |

** **

**(7) GOODWILL**

 

In June 2001, the FinancialAccounting Standards Board issued Statement of Financial Accounting StandardsNo. 142, *Goodwill and Other Intangible Assets*. Statement 142prohibits the amortization of goodwill and intangible assets with indefiniteuseful lives. Statement 142 requires that these assets be reviewed forimpairment at least annually. Intangible assets with finite lives will continueto be amortized over their estimated useful lives. Additionally, Statement 142requires that goodwill included in the carrying value of equity methodinvestments no longer be amortized.

 

The following table sets forththe Company’s net income (loss) for all periods presented adjusted toexclude amortization expense recognized in those periods related to goodwill.There was no impact on income (loss) from continuing operations for allperiods presented. 

 

|                                       |   | **Year ended  December 31,** |   |
|--------------------------------------------|--------|------------------------------|--------|
|                                       |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                       |   |                         |   |   |   |   |   |
| Reported net (loss) income            |   | $                            | (4,739 | ) | $ | (3,562 | ) | $ | 5,757 |   |
| Add back: Goodwill amortization            |   | —                       |   | 85 |   | 85 |   |
|                                       |   |                         |   |   |   |   |   |
| Adjusted net (loss) income            |   | $                            | (4,739 | ) | $ | (3,477 | ) | $ | 5,842 |   |
|                                       |   |                         |   |   |   |   |   |
| **Basic (loss) earnings per share**   |   |                         |   |   |   |   |   |
| Reported net (loss) income            |   | $                            | (0.61  | ) | $ | (0.50 | ) | $ | 0.85 |   |
| Add back: Goodwill amortization            |   | —                       |   | 0.01 |   | 0.01 |   |
|                                       |   |                         |   |   |   |   |   |
| Adjusted net (loss) income            |   | $                            | (0.61  | ) | $ | (0.49 | ) | $ | 0.86 |   |
|                                       |   |                         |   |   |   |   |   |
| **Diluted (loss) earnings per share** |   |                         |   |   |   |   |   |
| Reported net (loss) income            |   | $                            | (0.61  | ) | $ | (0.50 | ) | $ | 0.80 |   |
| Add back: Goodwill amortization            |   | —                       |   | 0.01 |   | 0.01 |   |
|                                       |   |                         |   |   |   |   |   |
| Adjusted net (loss) income            |   | $                            | (0.61  | ) | $ | (0.49 | ) | $ | 0.81 |   |

 

43

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The changes in the carryingamount of goodwill for the year ended December 31, 2002 consist ofgoodwill acquired in connection with the acquisition of Securealink (see Note4) and the impact of translating the Euro denominated goodwill into U.S.dollars at the balance sheet date.

 

**(8) ACQUIRED INTANGIBLE ASSETS**

 

Acquired intangible assetsconsisted of the following at December 31, 2002, all related to theEmbedded Security segment: 

 

|                                 |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   |
|--------------------------------------|--------|-----------------------------|--------|-------------------------------|--------|
|                                 |   |                        |   |
|                                 |   |                        |   |                          |   |
| Patents and related                  |   | $                           | 738    |                          | $      | (143 | ) |
| Developed technology                 |   | 1,336                       |   | (1,336                        | )      |
| Purchase orders and contract backlog |   | 161                         |   | (161                          | )      |
|                                 |   |                        |   |                          |   |
| Total                                |   | $                           | 2,235  |                          | $      | (1,640 | ) |

 

The amortization expense forthe year ended December 31, 2002 was $1,488. The estimated amortizationexpense for the years ending December 31 is as follows: 

 

| 2003 |   | $ | 149 |   |
|------|--------|---|-----|--------|
| 2004 |   | $ | 149 |   |
| 2005 |   | $ | 149 |   |
| 2006 |   | $ | 148 |   |

** **

**(9) INCOME TAXES**

 

The Company recorded noprovision for income taxes on earnings from continuing operations for the yearsended December 31, 2002 and 2001. Significant components of the Company’sincome tax benefit on earnings from continuing operations for the year endedDecember 31, 2002 are as follows: 

 

| Current:            |   |   |   |
|---------------------|--------|--------|--------|
| Federal             |   | $      | — |   |
| State               |   | 179    |   |
| Foreign             |   | — |   |
|                |   |   |   |
|                |   | 179    |   |
| Deferred (benefit): |   |   |   |
| Federal             |   | 271    |   |
| State               |   | — |   |
| Foreign             |   | (540   | )      |
|                |   |   |   |
|                |   | (269   | )      |
|                |   |   |   |
| Total benefit       |   | $      | (90    | ) |

 

Deferred tax assets andliabilities arising from continuing operations are comprised of the followingat December 31: 

 

|                                   |   | **2002** |   | **2001** |   |
|----------------------------------------|--------|----------|--------|----------|--------|
|                                   |   |     |   |     |   |
| Deferred tax assets:                   |   |     |   |     |   |
| Inventories                            |   | $        | 272    |     | $      | 278 |   |
| Net operating loss carryforward        |   | 7,191    |   | 8,428    |   |
| Stock option and deferred compensation |   | 200      |   | 142      |   |
| Other                                  |   | 478      |   | 336      |   |
|                                   |   |     |   |     |   |
|                                   |   | 8,141    |   | 9,184    |   |
|                                   |   |     |   |     |   |
| Deferred tax liabilities:              |   |     |   |     |   |
| Other                                  |   | (129     | )      | (12      | )      |
|                                   |   |     |   |     |   |
|                                   |   | (129     | )      | (12      | )      |
|                                   |   |     |   |     |   |
| Net deferred tax asset                 |   | 8,012    |   | 9,172    |   |
| Less valuation allowance               |   | (8,141   | )      | (9,172   | )      |
|                                   |   |     |   |     |   |
|                                   |   | $        | (129   | )        | $      | — |   |

 

44

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The reconciliation of thereported income tax expense (benefit) to the amount that would result byapplying the U.S. federal statutory tax rate of 34% to income (loss) fromcontinuing operations is as follows: 

 

|                                                                               |   | **2002** |   | **2001** |   | **2000** |   |
|------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                                               |   |     |   |     |   |     |   |
| Tax expense (benefit) at U.S.  statutory rate                                 |   | $        | (298   | )        | $      | (37      | )      | $ | 2,468 |   |
| Effect of permanent differences                                                    |   | 1,182    |   | 24       |   | 17       |   |
| State income taxes, net of federal benefit                                         |   | 179      |   | (5       | )      | 335      |   |
| Change in valuation allowance, excluding  charge related to stock option exercises |   | (1,031   | )      | 18       |   | (2,803   | )      |
| Other, net                                                                         |   | (122     | )      | —   |   | (17      | )      |
|                                                                               |   |     |   |     |   |     |   |
|                                                                               |   | $        | (90    | )        | $      | —   |   | $ | — |   |

 

In assessing the realization ofdeferred tax assets, management considers whether it is more likely than notthat all or some portion of the deferred tax assets will not be realized. Theultimate realization of the deferred tax assets is dependent upon thegeneration of future taxable income during the periods in which temporarydifferences are deductible and net operating losses are utilized. Based onconsideration of these factors, the Company has established a valuationallowance of $8,141 and $9,172 at December 31, 2002 and 2001,respectively.

 

Prior to the third quarter offiscal year 2000, the Company followed the practice of computing its income taxexpense using the assumption that current year stock option deductions wereused first to offset its financial statement taxable income. The remaining netoperating loss carryforwards could then be used to offset any excess offinancial statement taxable income over current year stock option deductions.Because the stock option deductions are not recognized as an expense forfinancial reporting purposes, the tax benefit from stock option deductions mustbe credited to additional paid-in capital with an offsetting charge to incometax expense in the statement of operations.

 

Effective July 1, 2000,the Company changed its method of accounting for income taxes to recognize thetax benefits from current and prior years’ stock option deductions after theutilization of net operating losses from operations (i.e., net operating lossesdetermined without deductions for the exercise of non-qualified stock optionsand disqualified disposition of incentive stock options) to reduce income taxexpense. The Company believed that this change was to a preferable methodbecause the Company will not realize any tax benefit from stock compensationdeductions until it has fully utilized its current and prior net operating losscarryforwards from operations. Thus, this method more accurately reflects theincremental effect of the Company’s stock option deductions in the appropriateaccounting period. Because 

 

45

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the Company was generating netoperating losses prior to 2000 rather than utilizing them, this accountingchange had no effect on prior years’ tax provisions or additional paid-incapital.

 

At December 31, 2002, theCompany had net operating loss carryforwards related to its discontinued Swisssubsidiary of approximately $7,111, which expire from 2007 to 2009 and areavailable to offset future taxable income of that subsidiary. Also atDecember 31, 2002, the Company had net operating loss carryforwardsrelated to its Netherlands subsidiary of approximately $4,132, which do notexpire and are available to offset future taxable income of that subsidiary.And finally, at December 31, 2002, the Company had net operating losscarryforwards for U.S. income tax purposes of approximately $14,875, whichexpire from 2011 to 2022 and are available to offset future U.S. taxableincome. The exercise of non-qualified stock options and disqualifieddisposition of incentive stock options (“stock option deductions”) havegenerated all of the remaining U.S. net operating loss carryforwards. Whenthese net operating loss carryforwards are utilized, the resulting reduction inthe valuation allowance will be recorded as a direct increase to stockholders’equity. During the year ended December 31, 2002, an increase tostockholders’ equity of $450 was recorded related to the tax benefit of stockoption deductions.

 

**(10) LEASES**

 

The Company leases officefacilities and equipment under non-cancelable operating leases expiring atvarious dates through 2007. The leases require the Company to pay aproportionate share of real estate taxes, insurance and maintenance. TheCompany recognizes rent expense on a straight-line basis. The future minimumpayments under the leases for the years ending December 31, are asfollows: 

 

| 2003 |   | $ | 700 |   |
|------|--------|---|-----|--------|
| 2004 |   | $ | 235 |   |
| 2005 |   | $ | 220 |   |
| 2006 |   | $ | 199 |   |
| 2007 |   | $ | 199 |   |

 

Rent expense under alloperating leases related to continuing operations for the years endedDecember 31, 2002, 2001, and 2000 was $517, $360, and $334, respectively.

 

**(11) PENSION PLANS**

 

The Company sponsors a definedcontribution pension plan for employees who have completed three months ofservice. The Plan permits pre-tax contributions by participants pursuant toSection 401(k) of the Internal Revenue Code (the Code) of 3% to 15% ofbase compensation up to the maximum allowable contributions as determined bythe Code. The Company matches up to 50% of the first 4% of employeecompensation that is contributed to the plan. The Company’s matchingcontributions vest with the participant over a 5-year period on a pro ratabasis. The Company may also make additional discretionary contributions. TheCompany incurred expenses for its matching contributions for the years endedDecember 31, 2002, 2001 and 2000 totaling $77, $137 and $73, respectively.

 

**(12) STOCK COMPENSATION PLANS**

 

**Stock Option Plans**

 

The Company sponsors four stockoption plans that provide for the granting of stock options to officers,directors, consultants and employees of the Company. Options have been grantedwith exercise prices that are equal to the fair market value of the commonstock on the date of grant and, subject to termination of employment, expireseven years from the date of grant. Either incentive stock options ornon-qualified stock options may be granted under the plans. The vesting andexercise periods are determined by the Board of Directors and may not exceedten years. Options issued to date generally vest in equal amounts over avesting period of either three or four years. Option activity during 2000, 2001and 2002 was as follows: 

 

46

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|                                  |   | **Number  of Shares** |   | **Range of  Exercise Prices** |   | **Weighted  Average  Exercise  Price** |   |
|---------------------------------------|--------|-----------------------|--------|-------------------------------|--------|----------------------------------------|--------|
|                                  |   |                  |   |                          |   |                                   |   |
| Outstanding at January 1, 2000   |   | 1,199                 |   | $ 3.09 to $31.50              |   | $                                      | 10.28  |   |
| Granted                               |   | 752                   |   | $ 14.75 to $43.50             |   | $                                      | 22.66  |   |
| Canceled                              |   | (217                  | )      | $ 4.50 to $25.63              |   | $                                      | 11.25  |   |
| Exercised                             |   | (392                  | )      | $ 3.09 to $20.25              |   | $                                      | 10.42  |   |
|                                  |   |                  |   |                          |   |                                   |   |
| Outstanding at December 31, 2000 |   | 1,342                 |   | $ 3.09 to $43.50              |   | $                                      | 17.01  |   |
| Granted                               |   | 825                   |   | $ 5.85 to $43.63              |   | $                                      | 11.79  |   |
| Canceled                              |   | (117                  | )      | $ 3.25 to $43.50              |   | $                                      | 25.78  |   |
| Exercised                             |   | (167                  | )      | $ 3.09 to $24.87              |   | $                                      | 9.41   |   |
|                                  |   |                  |   |                          |   |                                   |   |
| Outstanding at December 31, 2001 |   | 1,883                 |   | $ 4.38 to $43.63              |   | $                                      | 14.85  |   |
| Granted                               |   | 404                   |   | $ 11.10 to $16.51             |   | $                                      | 13.09  |   |
| Canceled                              |   | (106                  | )      | $ 8.53 to $33.63              |   | $                                      | 17.94  |   |
| Expired                               |   | (52                   | )      | $ 9.19 to $18.06              |   | $                                      | 9.47   |   |
| Exercised                             |   | (205                  | )      | $ 5.13 to $24.13              |   | $                                      | 9.50   |   |
|                                  |   |                  |   |                          |   |                                   |   |
| Outstanding at December 31, 2002 |   | 1,924                 |   | $ 4.38 to $43.63              |   | $                                      | 15.08  |   |
|                                  |   |                  |   |                          |   |                                   |   |
| Exercisable at December 31, 2002 |   | 1,121                 |   | $ 4.38 to $43.63              |   | $                                      | 14.92  |   |

 

The following table summarizesinformation about stock options outstanding at December 31, 2002: 

 

|                          |   | **Options  Outstanding** |   | **Options  Exercisable**                           |   |
|-------------------------------|--------|--------------------------|--------|----------------------------------------------------|--------|
|                          |   |                     |   |                                               |   |   |   |   |   |   |   |
| **Range of  Exercise Prices** |   | **Number  of shares**    |   | **Weighted  Average  Remaining  Contractual Life** |   | **Weighted  Average  Exercise  Price** |   | **Number  of Shares** |   | **Weighted  Average  Exercise  Price** |   |
|                          |   |                     |   |                                               |   |   |   |   |   |   |   |
| $ 4.38 to $8.70               |   | 415                      |   | 3.9 years                                          |   | $ | 6.91 |   | 240 |   | $ | 7.00 |   |
| $ 9.19 to $17.56              |   | 1,035                    |   | 5.3 years                                          |   | $ | 13.16 |   | 610 |   | $ | 13.23 |   |
| $ 18.13 to $26.00             |   | 359                      |   | 3.3 years                                          |   | $ | 22.98 |   | 207 |   | $ | 22.68 |   |
| $ 31.50 to $43.63             |   | 115                      |   | 3.3 years                                          |   | $ | 37.30 |   | 64 |   | $ | 35.71 |   |
|                          |   |                     |   |                                               |   |   |   |   |   |   |   |
|                          |   | 1,924                    |   | 4.4 years                                          |   | $ | 15.08 |   | 1,121 |   | $ | 20.62 |   |

 

At December 31, 2002, theCompany had reserved 2,313 shares of common stock for exercise of outstandingstock options and additional stock options authorized for granting underexisting stock option plans.

 

**Employee Stock Purchase Plan**

 

During 2002, the Companyadopted the SafeNet, Inc. Employee Stock Purchase Plan. The plan allowseligible employees to purchase shares of common stock at 85% of the lower ofthe closing price of the Company’s common stock on the first trading day or thelast trading day of each semi-annual offering period. Employees may authorize theCompany to withhold up to 10% of their compensation during any offering period,subject to certain limitations. During 2002, 7 shares were issued under theplan at a price of $15.06 per share.

 

47

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**(13) SEGMENTS OF THE COMPANY AND RELATEDINFORMATION**

 

The Company has two reportablesegments related to continuing operations: products, chips and softwaredesigned and manufactured for sale to companies that will embed the Company’sproducts into their products for ultimate sale to end-users (“Embedded SecurityDivision”), and network security products designed and manufactured for directsales to end-users and remote access software sold to OEM’s (“EnterpriseSecurity Division”). The reportable segments are strategic business units thatoffer different products. The segments are managed separately because eachsegment requires different technology and marketing strategies. The EmbeddedSecurity Division and Enterprise Security Division include some international salesmainly to South America, Europe and Asia. 

 
|                                                                            |   | **Year ended  December 31,** |   |
|---------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                            |   | **2002**                     |   | **2001** |   | **2000** |   |
|                                                                            |   |                         |   |   |   |   |   |
| Revenue from external customers:                                                |   |                         |   |   |   |   |   |
| Embedded security division                                                      |   | $                            | 18,292 |   | $ | 5,477 |   | $ | 6,418 |   |
| Enterprise security division                                                    |   | 13,943                       |   | 10,985 |   | 18,860 |   |
|                                                                            |   |                         |   |   |   |   |   |
| Consolidated revenues                                                           |   | $                            | 32,235 |   | $ | 16,462 |   | $ | 25,278 |   |
|                                                                            |   |                         |   |   |   |   |   |
| Significant non-cash items other than  depreciation and amortization expense    |   |                         |   |   |   |   |   |
| Embedded security division                                                      |   | $                            | 3,375  |   | $ | — |   | $ | — |   |
| Enterprise security division                                                    |   | —                       |   | — |   | — |   |
|                                                                            |   |                         |   |   |   |   |   |
| Consolidated significant non-cash charges                                       |   | $                            | 3,375  |   | $ | — |   | $ | — |   |
|                                                                            |   |                         |   |   |   |   |   |
| Operating (loss) income:                                                   |   |                         |   |   |   |   |   |
| Embedded security division                                                      |   | $                            | (4,227 | ) | $ | (1,697 | ) | $ | (268 | ) |
| Enterprise security division                                                    |   | 2,683                        |   | 252 |   | 6,208 |   |
|                                                                            |   |                         |   |   |   |   |   |
| Consolidated operating (loss) income                                       |   | $                            | (1,544 | ) | $ | (1,445 | ) | $ | 5,940 |   |
|                                                                            |   |                         |   |   |   |   |   |
| Depreciation and amortization:                                                  |   |                         |   |   |   |   |   |
| Embedded security division                                                      |   | $                            | 2,180  |   | $ | 1,163 |   | $ | 1,076 |   |
| Enterprise security division                                                    |   | 857                          |   | 398 |   | 699 |   |
|                                                                            |   |                         |   |   |   |   |   |
| Consolidated depreciation and amortization                                      |   | $                            | 3,037  |   | $ | 1,561 |   | $ | 1,775 |   |
|                                                                            |   |                         |   |   |   |   |   |
| (Loss) income from continuing operations  before income taxes:                  |   |                         |   |   |   |   |   |
| Embedded security division                                                      |   | $                            | (3,794 | ) | $ | (1,253 | ) | $ | 67 |   |
| Enterprise security division                                                    |   | 2,919                        |   | 1,143 |   | 7,193 |   |
|                                                                            |   |                         |   |   |   |   |   |
| Consolidated (loss) income from  continuing operations before income taxes |   | $                            | (875   | ) | $ | (109 | ) | $ | 7,260 |   |

 

48

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| **Geographic Information**                      |   | **December  31,** |   |
|-------------------------------------------------|--------|-------------------|--------|
|                                            |   | **2002**          |   | **2001** |   | **2000** |   |
| Revenues:                                       |   |              |   |   |   |   |   |
| United States                                   |   | $                 | 28,945 |   | $ | 15,134 |   | $ | 23,877 |   |
| All other countries                             |   | 3,290             |   | 1,328 |   | 1,401 |   |
|                                            |   |              |   |   |   |   |   |
| Consolidated revenues                           |   | $                 | 32,235 |   | $ | 16,462 |   | $ | 25,278 |   |
|                                            |   |              |   |   |   |   |   |
| Long-lived assets, from continuing  operations: |   |              |   |   |   |   |   |
| United States                                   |   | $                 | 1,140  |   | $ | 1,696 |   | $ | 2,696 |   |
| All other countries                             |   | 585               |   | — |   | — |   |
|                                            |   |              |   |   |   |   |   |
| Consolidated long-lived assets                  |   | $                 | 1,725  |   | $ | 1,696 |   | $ | 2,696 |   |

 

The Company does not allocateassets to its reportable segments, as assets generally are not specificallyattributable to any particular segment. Accordingly, asset information byreportable segment is not presented. Where the underlying assets can bespecifically attributed to a segment, the related depreciation and amortizationhave been classified accordingly. The remaining depreciation is allocated basedon a percentage of revenue.

 

**(14) SIGNIFICANT CUSTOMERS ANDCONCENTRATIONS OF CREDIT RISK**

 

Financial instruments thatpotentially subject the Company to significant concentrations of credit riskconsist primarily of accounts receivable. The Company performs ongoing creditevaluations of its customers and generally does not require collateral. Salesterms with clients, including distributors, do not provide for right of returnprivileges for credit, refund or other products. The Company’s payment termsare generally 30 days from delivery of products, but could fluctuatedepending on the terms of each specific contract. The Company’s clients, whoinclude both commercial companies and governmental agencies, are in variousindustries, including banking, security, communications and distributors ofelectronic products.

 

In 2002, one commercial clientof the Embedded Security Division accounted for 41% of the Company’sconsolidated revenues. In 2001, one commercial client of the EnterpriseSecurity Division accounted for 15% of the Company’s consolidated revenues. In2000, one commercial client of the Enterprise Security Division accounted for11% and one commercial client of the Embedded Security Division accounted for18% of the Company’s consolidated revenues.

 

As of December 31, 2002, 4commercial clients of the Enterprise Security Division accounted for 11% ofaccounts receivable and 3 commercial clients of the Embedded Security Divisionaccounted for a combined 42% of accounts receivable. As of December 31,2001, three commercial clients of the Enterprise Security Division accountedfor 37% of accounts receivable and two commercial clients of the EmbeddedSecurity Division accounted for a combined 30% of accounts receivable.

 

**(15) (LOSS) INCOME PER SHARE**

 

The following table sets forththe computation of basic and diluted income (loss) from continuingoperations per common share for the years ended December 31: 

 

|                                                                                                             |   | **2002** |   | **2001** |   | **2000** |   |
|------------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                                                                             |   |     |   |     |   |     |   |
| Numerator:                                                                                                       |   |     |   |     |   |     |   |
| (Loss) income from continuing operations                                                                         |   | $        | (785   | )        | $      | (109     | )      | $ | 7,260 |   |
|                                                                                                             |   |     |   |     |   |     |   |
| Denominator:                                                                                                     |   |     |   |     |   |     |   |
| Denominator for basic (loss) income  per share - weighted average shares                                    |   | 7,730    |   | 7,057    |   | 6,751    |   |
| Effect of employee stock options                                                                                 |   | —   |   | —   |   | 444      |   |
|                                                                                                             |   |     |   |     |   |     |   |
| Denominator for diluted (loss) income  per share - adjusted weighted-average shares and assumed conversions |   | 7,730    |   | 7,057    |   | 7,195    |   |
|                                                                                                             |   |     |   |     |   |     |   |
| Basic (loss) income from continuing  operations per share                                                   |   | $        | (0.10  | )        | $      | (0.01    | )      | $ | 1.08 |   |
|                                                                                                             |   |     |   |     |   |     |   |
| Diluted (loss) income from continuing  operations per share                                                 |   | $        | (0.10  | )        | $      | (0.01    | )      | $ | 1.01 |   |

 

49

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Diluted loss from continuingoperations per common share in 2002 and 2001 is equal to basic loss per commonshare because if potentially dilutive securities were included in thecomputation, the result would be anti-dilutive. These securities consist ofcompany stock options.

 

**(16) SUBSEQUENT EVENTS**

 

**ACQUISITION OF CYLINK CORPORATION**

 

On February 6, 2003, SafeNetacquired 100% of the outstanding common shares of Cylink Corporation (“Cylink”)in accordance with an Agreement and Plan of Reorganization dated as ofOctober 30, 2002. The results of operations of Cylink will be included inthe Company’s consolidated results of operations beginning on February 6,2003. Cylink, develops, manufactures, markets and supports a comprehensiveportfolio of hardware and software security products for mission-criticalprivate networks and business communications over the Internet. Cylink’ssolutions enable its customers to merge their operations and transactions ontoexisting networks, maximize network use, reduce the costs of operations andexpand their businesses. As a result of the acquisition, the Company believesthat it will be able to grow its base of government and commercial customers,enhance its product line, expand its international sales and provide broadertechnology and expertise to its customers. It also expects to reduce coststhrough economies of scale.

 

The aggregate purchase pricewas $35,102 consisting primarily of 1,684 shares of common stock valued at$31,256, 194 options and warrants assumed with an aggregate value of $1,691,and estimated direct costs of the acquisition of $2,156. The value of the commonshares issued was determined based on the average market price of the Company’scommon shares over the period including three days before and after the termsof the acquisition were agreed to and announced.

 

The following table summarizesthe estimated fair values of the assets acquired and liabilities assumed at thedate of acquisition. The Company is in the process of completing third-partyvaluations of certain intangible assets; thus, the allocation of the purchaseprice is subject to refinement. 

 

| Current assets                                                                          |   | $      | 17,346 |   |
|-----------------------------------------------------------------------------------------|--------|--------|--------|--------|
| Property and equipment                                                                  |   | 786    |   |
| Goodwill                                                                                |   | 24,997 |   |
| Acquired in-process research and  development assets                                    |   | 3,317  |   |
| Intangible assets subject to amortization  (2.7 year weighted average useful life) |   | 17,432 |   |
| Other assets                                                                            |   | 728    |   |
|                                                                                    |   |   |   |
| Total assets acquired                                                                   |   | $      | 64,606 |   |
|                                                                                    |   |   |   |
| Current liabilities                                                                     |   | $      | 20,225 |   |
| Deferred income taxes, less current portion                                             |   | 4,394  |   |
| Other long-term liabilities                                                             |   | 4,885  |   |
|                                                                                    |   |   |   |
| Total liabilities assumed                                                               |   | $      | 29,504 |   |
| Net assets acquired                                                                     |   | $      | 35,102 |   |

 

50

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The $3,317 assigned to acquiredin-process research and development assets will be written off at the date ofacquisition in accordance with FASB Interpretation No. 4, “Applicabilityof FASB Statement No. 2 to Business Combinations Accounted for by thePurchase Method.”

 

The $24,997 of goodwill wasassigned to the Enterprise Security segment. Of that total amount, none isexpected to be deductible for tax purposes.

 

The unaudited pro formacombined historical results, as if Cylink had been acquired on January 1,2002, is as follows: 

 

| Revenues                                                       |   | $ | 59,759  |   |
|----------------------------------------------------------------|--------|---|---------|--------|
| Loss from continuing operations                                |   | $ | (20,410 | )      |
| Net loss                                                       |   | $ | (24,364 | )      |
| Loss per share from continuing operations -  basic and diluted |   | $ | (2.17   | )      |
| Loss per share — basic and diluted                        |   | $ | (2.59   | )      |

 

The pro forma results includethe estimated amortization of intangibles. As described in Note 2, the Companydoes not record amortization expense related to the goodwill. The pro formaresults are not necessarily indicative of the results that would have occurredif the acquisition had actually been completed on January 1, 2002, nor arethey necessarily indicative of future consolidated results.

 

**ASSET ACQUISITION OF RAQIA NETWORKS, INC.**

 

On February 27, 2003,SafeNet acquired substantially all the assets of Raqia Networks, Inc., adevelopment stage company, consisting primarily of technology-relatedintangible assets. Total consideration paid by SafeNet was 389,640 shares ofSafeNet common stock with an estimated value of $6,715 plus $805 in cash.SafeNet had previously invested $1,000 in Raqia Networks. The Company willobtain an independent valuation of the acquired assets, in order to allocatethe purchase price during the first quarter of 2003.

 

**SCHEDULE II—VALUATIONAND QUALIFYING ACCOUNTS**

(Amounts in thousands) 

 

|                                 |   | **Balance  at  Beginning  of  Period** |   | **Charged  to Costs  and  Expenses** |   | **Charges  to Other  Accounts** |   | **Deductions(a)** |   | **Recovery** |   | **Balance  at End  of  Period** |   |
|--------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|---------------------------------|--------|-------------------|--------|--------------|--------|---------------------------------|--------|
| **Allowance for doubtful accounts:** |   |                                   |   |                                 |   |                            |   |              |   |         |   |                            |   |
| Year ended December 31, 2002    |   | $                                      | 150    |                                 | $      | 94                              |   | $                 | — |         | $      | —                          |   | $ | — |   | $ | 244 |   |
| Year ended December 31, 2001    |   | 196                                    |   | 32                                   |   | —                          |   | 78                |   | —       |   | 150                             |   |
| Year ended December 31, 2000    |   | 215                                    |   | 60                                   |   | —                          |   | 79                |   | —       |   | 196                             |   |
| **Reserve for obsolete inventory:**  |   |                                   |   |                                 |   |                            |   |              |   |         |   |                            |   |
| Year ended December 31, 2002    |   | $                                      | 482    |                                 | $      | 477                             |   | $                 | — |         | $      | —                          |   | $ | — |   | $ | 958 |   |
| Year ended December 31, 2001    |   | 207                                    |   | 284                                  |   | —                          |   | 9                 |   | —       |   | 482                             |   |
| Year ended December 31, 2000    |   | 207                                    |   | —                               |   | —                          |   | —            |   | —       |   | 207                             |   |

 

----

(a) – Deductions representwrite-offs of specifically identified accounts

 

51

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**ITEM 9 – CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

Not applicable.

 

**PART III**

 

**ITEM 10 – DIRECTORS AND EXECUTIVE OFFICERS OFTHE REGISTRANT**

 

The information required by thisitem is incorporated herein by reference to the definitive Proxy Statement ofSafeNet, which will be filed with the Securities and Exchange Commission nolater than 120 days after the close of SafeNet’s fiscal year endedDecember 31, 2002.

 

**ITEM 11 – EXECUTIVE COMPENSATION**

 

The information required bythis item is incorporated herein by reference to the definitive Proxy Statementof SafeNet, which will be filed with the Securities and Exchange Commission nolater than 120 days after the close of SafeNet’s fiscal year endedDecember 31, 2002.

 

**ITEM 12 – SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT**

 

The information required bythis item is incorporated herein by reference to the definitive Proxy Statementof SafeNet, which will be filed with the Securities and Exchange Commission nolater than 120 days after the close of SafeNet’s fiscal year endedDecember 31, 2002.

 

**ITEM 13 – CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

The information required bythis item is incorporated herein by reference to the definitive Proxy Statementof SafeNet, which will be filed with the Securities and Exchange Commission nolater than 120 days after the close of SafeNet’s fiscal year endedDecember 31, 2002.

 

**ITEM 14 – CONTROLS AND PROCEDURES**

 

     ***Evaluation of disclosure controlsand procedures.***

 

As required by Rule 13a-15under the Exchange Act, within 90 days prior to the filing date of thisannual report (the “Evaluation Date”), the Company carried out an evaluation ofthe effectiveness of the design and operation of the Company’s disclosurecontrols and procedures. This evaluation was carried out under the supervisionand with the participation of the Company’s management, including the Company’schief executive officer and chief financial officer. Based upon thatevaluation, the Company’s chief executive officer and chief financial officerconcluded that the Company’s disclosure controls and procedures are effective.Disclosure controls and procedures are controls and other procedures that aredesigned to ensure that information required to be disclosed in the Company’sreports filed or submitted under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms. Disclosure controls and procedures include, without limitation,controls and procedures designed to ensure that information required to bedisclosed in the Company’s reports filed under the Exchange Act is accumulatedand communicated to management, including the Company’s chief executive officerand chief financial officer, as appropriate, to allow timely decisionsregarding required disclosures.

 

     ***Changes in internal controls***.

 

There were no significantchanges in the Company’s internal controls or in other factors that could 

 

52

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significantly affect theCompany’s internal controls subsequent to the Evaluation Date, nor anysignificant deficiencies or material weaknesses in such internal controlsrequiring corrective actions.

 

**PART IV**

 

**ITEM 15 – EXHIBITS, FINANCIAL STATEMENTSCHEDULES AND REPORTS ON FORM 8-K**

 
| **(a)** |   | 1.   The  financial statements filed as part of this report are listed separately on  the Index To Financial Statements on page 30 of this Form 10-K.                                                                                               |
|---------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |                                                                                                                                                                                                                                                                    |
|    |   | 2.   Financial  Statement Schedules: Schedule II Valuation and Qualifying Accounts                                                                                                                                                                  |
|    |   |                                                                                                                                                                                                                                                                    |
|    |   | All other  schedules for which provision is made in the applicable accounting regulation  of the Securities and Exchange Commission are not required under the related  instructions or are inapplicable therefore have been omitted                                    |
|    |   |                                                                                                                                                                                                                                                                    |
| **(b)** |   | Reports on  Form 8-K:  The Company filed a  Current Report on Form 8-K with the Securities and Exchange Commission  on November 1, 2002 in connection with entering into a definitive  agreement and plan of reorganization with Cylink Corporation |
|    |   |                                                                                                                                                                                                                                                                    |
| **(c)** |   | Exhibits  required by Item 601 of Regulation S-K:                                                                                                                                                                                                             |
|    | 2A     | Agreement  and Plan of Reorganization dated October 30, 2002 by and among the  Registrant, Sapphire Acquisition Corp. and Cylink Corporation                                                                                                                       |   | I/B/R(1) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 3A     | Restated  Certificate of Incorporation of Registrant, as filed with the Secretary of  State of Delaware on May 23, 2001                                                                                                                                            |   | I/B/R(2) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 3B     | By-laws of  Registrant                                                                                                                                                                                                                                                  |   | I/B/R(3) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 4      | Specimen of  Common Stock Certificate of Registrant                                                                                                                                                                                                                     |   | I/B/R(3) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 10A    | Sublease  dated November 2, 1993 for facility at 8029 Corporate Drive, Baltimore,  MD                                                                                                                                                                              |   | I/B/R(4) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 10B    | Stock Option  Plan of 1989                                                                                                                                                                                                                                              |   | I/B/R(5) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 10C    | Joint  Development and Marketing Agreement between the Registrant and CyberGuard  Corporation                                                                                                                                                                           |   | I/B/R(6) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 10D    | Agreement  between SafeNet Secure Solutions, Inc. (wholly-owned subsidiary of the  Registrant) and Analog Devices, Inc.                                                                                                                                                 |   | I/B/R(7) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 10E    | 1999  Employee Stock Option Plan                                                                                                                                                                                                                                        |   | I/B/R(8) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 10F    | 1999 Stock  Bonus Plan                                                                                                                                                                                                                                                  |   | I/B/R(8) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 10G    | Non-Employee  Director Stock Option Plan                                                                                                                                                                                                                                |   | I/B/R(8) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 10H    | 2000  Employee and Directors Stock Option Plan                                                                                                                                                                                                                          |   | I/B/R(8) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 10I    | 2001 Omnibus  Stock Option Plan                                                                                                                                                                                                                                         |   | I/B/R(9) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 10J    | Employment  Agreement with Anthony Caputo                                                                                                                                                                                                                               |   | I/B/R(10) |
|    |   |                                                                                                                                                                                                                                                                    |   |   |
|    | 10K    | Employment  Agreement with Cees Jan Koomen                                                                                                                                                                                                                              |   | I/B/R(10) |
|         |        |                                                                                                                                                                                                                                                                         |  |  |  |

 

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|   | 10L    | Employee  Stock Purchase Plan                                                                                                                                                                                 |   | I/B/R(9)  |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------|
|   |   |                                                                                                                                                                                                          |   |      |
|   | 10M    | Second  Amendment to Lease and Partial Termination Agreement dated October 30,  2002 by and between Cylink Corporation and Orchard Jay Investors, LLC for  facilities located in Santa Clara, California |   | I/B/R(11) |
|   |   |                                                                                                                                                                                                          |   |      |
|   | 10N    | Stipulation  and Agreement of Settlement filed on November 5, 2002, in the United  States District Court for the Northern District of California,  No. C98-4292 (VRW)                               |   | I/B/R(11) |
|   |   |                                                                                                                                                                                                          |   |      |
|   | 21     | Subsidiaries  of Registrant                                                                                                                                                                                   |   |      |
|   |   |                                                                                                                                                                                                          |   |      |
|   | 23.1   | Consent of  Ernst & Young LLP, independent auditors                                                                                                                                                       |   |      |
|   |   |                                                                                                                                                                                                          |   |      |
|   | 99.1   | Certification  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                                                                                 |   |      |
|   |   |                                                                                                                                                                                                          |   |      |
|   | 99.2   | Certification  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                                                                                 |   |      |

 

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| (1)    |   | Filed as an  exhibit to the Registration Statement on Form S-4 (File No. 333-101577)  of the Registrant and incorporated herein by reference.                                  |   |   |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|   |   |                                                                                                                                                                                |   |   |
| (2)    |   | Filed as an  exhibit to the Form 10-Q for the quarterly period ended June 30, 2002  and incorporated herein by reference.                                                      |   |   |
|   |   |                                                                                                                                                                                |   |   |
| (3)    |   | Filed as an  exhibit to the Registration Statement on Form S-18 (File No. 33-28673)  of the Registrant and incorporated herein by reference.                                   |   |   |
|   |   |                                                                                                                                                                                |   |   |
| (4)    |   | Filed as an  exhibit to Form 10-KSB for the fiscal year ended December 31, 1993  and incorporated herein by reference.                                                    |   |   |
|   |   |                                                                                                                                                                                |   |   |
| (5)    |   | Filed as an  exhibit to the Registration Statement on Form S-1 (File No. 33-52066) of  the Registrant and incorporated herein by reference.                                    |   |   |
|   |   |                                                                                                                                                                                |   |   |
| (6)    |   | Filed as an  exhibit to Form 10-K for the fiscal year ended December 31, 1996  and incorporated herein by reference.                                                      |   |   |
|   |   |                                                                                                                                                                                |   |   |
| (7)    |   | Filed as an  exhibit to Form 10-Q for the quarterly period ended September 30, 1996  and incorporated herein by reference.                                                     |   |   |
|   |   |                                                                                                                                                                                |   |   |
| (8)    |   | Filed as an  exhibit to a Definitive Proxy Statement on Schedule 14A for the Annual  Meeting of Shareholders held on July 28, 1999 and incorporated herein by  reference. |   |   |
|   |   |                                                                                                                                                                                |   |   |
| (9)    |   | Filed as an  exhibit to the Registration Statement on Form S-8 (File No. 333-98029)  of the Registrant and incorporated herein by reference.                                   |   |   |
|   |   |                                                                                                                                                                                |   |   |
| (10)   |   | Filed as an  exhibit to the Form 10-Q for the quarterly period ended  September 30, 2002 and incorporated herein by reference.                                            |   |   |
|   |   |                                                                                                                                                                                |   |   |
| (11)   |   | Filed as an  exhibit to the Form 10-Q of Cylink Corporation (File No. 0-27742) for  the quarterly period ended September 29,2002 and incorporated herein by  reference.   |   |   |

 

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**SIGNATURES**

 

Pursuant to the requirements ofSection 13 or 15(d) of the Securities Exchange Act of 1934, the registranthas duly caused this report to be signed on behalf of the undersigned, thereuntoduly authorized.

 

SAFENET, INC.

 
|   |   | By:                                                                 | /s/ Anthony A. Caputo |
|--------|--------|---------------------------------------------------------------------|-----------------------|
|   |   | Anthony A. Caputo   Chairman, Chief Executive Officer and President |

 

Date: April 29, 2003 

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated. 

 
| **Signature**            |   | **Title** |                                               | **Date** |
|--------------------------|--------|-----------|----------------------------------------------------|----------|
|                     |   |      |                                               |     |
| /s/ Anthony  A. Caputo   |   |      | Chairman,  Chief Executive Officer And President   |     | April 29,  2003 |
| Anthony A.  Caputo       |   |      |                                               |     |   |
|                     |   |      |                                               |     |   |
| /s/ Carole  D. Argo      |   |      | Senior Vice  President and Chief Financial Officer |     | April 29,  2003 |
| Carole D.  Argo          |   |      | (Principal  Financial and Accounting Officer)      |     |   |
|                     |   |      |                                               |     |   |
| /s/ Thomas  A. Brooks    |   |      | Director                                           |     | April 29,  2003 |
| Thomas A.  Brooks        |   |      |                                               |     |   |
|                     |   |      |                                               |     |   |
| /s/ Shelley  A. Harrison |   |      | Director                                           |     | April 29,  2003 |
| Shelley A.  Harrison     |   |      |                                               |     |   |
|                     |   |      |                                               |     |   |
| /s/ Ira A.  Hunt, Jr.    |   |      | Director                                           |     | April 29,  2003 |
|  Ira A. Hunt, Jr.   |   |      |                                               |     |   |
|                     |   |      |                                               |     |   |
| /s/ Bruce R.  Thaw       |   |      | Director                                           |     | April 29,  2003 |
| Bruce R.  Thaw           |   |      |                                               |     |   |

 

**CHIEF EXECUTIVEOFFICER CERTIFICATION**

 

I, Anthony A. Caputo, Chairman,President and Chief Executive Officer of SafeNet, Inc. (the “Company”), certifythat:

 

     1.        I have reviewed this annual report onForm 10-K/A of the Company;

 

     2.        Based on my knowledge, this annualreport does not contain any untrue statement of a material fact or omit tostate a material fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this annual report;

 

     3.        Based on my knowledge, the financialstatements, and other financial information included in this annual report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the Company as of, and for, the periods presentedin this annual report;

 

     4.        The Company’s other certifying officerand I are responsible for establishing and maintaining disclosure controls andprocedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for theCompany and we have: 

 

a)             designedsuch disclosure controls and procedures to ensure that material informationrelating to the

 

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Company, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisannual report was being prepared;

 

b)            evaluatedthe effectiveness of the Company’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

c)             presentedin this annual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

     5.        The Company’s other certifying officerand I have disclosed, based on our most recent evaluation, to the Company’sauditors and the audit committee of the Company’s board of directors: 

 

a)             allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the Company’s ability to record, process, summarize andreport financial data and have identified for the Company’s auditors anymaterial weaknesses in internal controls; and

 

b)            amyfraud, whether or not material, that involves management or other employees whohave a significant role in the Company’s internal controls; and

 

     6.        The Company’s other certifying officerand I have indicated in this annual report whether or not there were anysignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses. 

 
|                  | **SAFENET, INC.**                                |
|-----------------------|--------------------------------------------------|
|                  |                                             |
|                  | **/s/ Anthony A. Caputo**                        |
| Date: April  29, 2003 | ANTHONY A.  CAPUTO                               |
|                  | Chairman,  President and Chief Executive Officer |

 

**CHIEF FINANCIALOFFICER CERTIFICATION**

 

I, Carole D. Argo, Senior VicePresident and Chief Financial Officer of SafeNet, Inc. (the “Company”), certifythat:

 

     1.        I have reviewed this annual report onForm 10-K/A of the Company;

 

     2.        Based on my knowledge, this annualreport does not contain any untrue statement of a material fact or omit tostate a material fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading 

with respect to the periodcovered by this annual report;

 

     3.        Based on my knowledge, the financialstatements, and other financial information included in this annual report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the Company as of, and for, the periods presentedin this annual report;

 

     4.        The Company’s other certifying officerand I are responsible for establishing and maintaining disclosure controls andprocedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for theCompany and we have: 

 

a)             Designedsuch disclosure controls and procedures to ensure that material informationrelating to the Company, including its consolidated subsidiaries, is made knownto us by others within those entities, particularly during the period in whichthis annual report was being prepared;

 

b)            Evaluatedthe effectiveness of the Company’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

c)             Presentedin this annual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

56

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     5.        The Company’s other certifying officerand I have disclosed, based on our most recent evaluation, to the Company’sauditors and the audit committee of the Company’s board of directors: 

 

a)             allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the Company’s ability to record, process, summarize andreport financial data and have identified for the Company’s auditors anymaterial weaknesses in internal controls; and

 

b)            anyfraud, whether or not material, that involves management or other employees whohave a significant role in the Company’s internal controls; and

 

     6.        The Company’s other certifying officerand I have indicated in this annual report whether or not there were anysignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent 

evaluation, including anycorrective actions with regard to significant deficiencies and materialweaknesses. 

 
|                  | **SAFENET, INC.**                                  |
|-----------------------|----------------------------------------------------|
|                  |                                               |
|                  | **/s/ Carole D. Argo**                             |
| Date: April  29, 2003 | CAROLE D.  ARGO                                    |
|                  | Senior Vice  President and Chief Financial Officer |

 

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