##### 



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-K
 (Mark One)
 þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the fiscal year ended December 31, 2005
 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.
  Delaware
    
    52-1287752(State or other jurisdiction of
incorporation or organization)
    
    (IRS Employer
Identification No.)4690 Millennium DriveBelcamp, Maryland
    
    21017(Address of principal executive offices)
    
    (Zip Code)
 (443) 327-1200
   Name of eachTitle of each class
    
    exchange on which registeredCommon Stock, $.01 par value
    
    NASDAQ National Market
 o þ
 o þ
 o
  o þ o
 o þ
   DOCUMENTS INCORPORATED BY REFERENCE




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INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
  PART I.
 ITEM 1. BUSINESS
 Overview
   2




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
    
    Core encryption: WAN, VPN, SSL VPN, two-factor authentication, wireless VPN, satellite
link encryption;
    
    Communication security;
    
    Digital rights management;
    
    Digital identities;
    
    Adding other security applications, such as intrusion detection, anti-virus, firewalls,
and content inspection technology;
    
    SafeEnterprise Security System to address the enterprise security needs of government
and commercial customers; and
    
    Security for wireless devices, PCs and personal devices.
  www.safenet-inc.com 10-K 8-K
 3




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Industry Background
  4




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
    
    Remote access VPNs connect teleworkers and mobile workers to the corporate network;
    
    Site-to-site VPNs connect the central office of an enterprise to its various
branch and satellite offices; and
    
    Extranet VPNs connect an enterprise and its suppliers and business partners,
allowing them to exchange real-time information such as inventory levels or pricing.
  5




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6




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The SafeNet Solution
  
   7




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
    
    Broad Product Line.We offer our WAN and VPN solutions as a system that integrates our
hardware and software products, or separately as discrete hardware and software products.
This enables us to address the needs of large enterprise customers who require complex and
integrated systems, as well as customers who may require individual hardware or software
components. Our products and services enable our customers to expand their existing WANs
efficiently and to integrate these networks with lower cost Internet technologies.
    
    High Level of Security.Our products and services have been designed to meet the high
level security needs of our government, financial institutions and other commercial
customers. We have sold our products and services to other key government agencies,
including the Department of Defense, which has used them for battlefield
command-and-control applications. In addition, we are developing chips to address
classified government security needs and the security requirements of critical
infrastructure, such as banks and utilities, as required by the Department of Homeland
Security. Our products are designed to meet the standards set forth in the U.S.
governments Crypto Modernization Program.
    
    High Performance Systems.Our appliances are designed to maximize the performance of
our solutions across WANs and the Internet. Using our VPN products, our customers are
able to transmit secured data at up to 1 Gbps of bi-directional throughput. Our products
can support up to 10,000 IPSec tunnels and a maximum of 100,000 simultaneous secure
transactions with minimal degradation in network performance.We added an appliance that offers encryption over SONET. With high-speed throughput and
extremely low latency these products are ideal for high-speed data and time-sensitive voice
and video applications. It employs the federally endorsed AES algorithm with the
flexibility to be deployed in OC3/STM1 (155Mbps), OC12/STM4 (622Mbps), OC48/STM16
(2.4Gbps), and OC192/STM64 (10Gbps) SONET networks.
    
    Ease of Deployment and Management.Our products require minimal configuration and can
be deployed quickly and cost-effectively by end-user customers. Our WAN and VPN security
products are centrally managed with our security management software, which enables policy
management and cost-effective, secure, scalable monitoring of network devices and
applications, network traffic, and security events.
    
    Standards-Based and Network Compatible.We offer products that are based on industry
and government standards, including certain required standards, and accepted network
communication
protocols. These standards and protocols allow our products to interoperate with a large
number of products from other vendors.
 8




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##### 




    
    Ease of Development.We offer a complete development environment in which OEMs can
build a wide variety of encryption products. This allows OEMs to accelerate time to
market, reduce development costs and provide system-level implementation of encryption
technology.
    
    Flexible Packaging.Our core technology is available for license to OEMs in various
forms, such as embedded intellectual property blocks, silicon chips, or accelerator cards.
In particular, embedded intellectual property allows selected elements of our VPN
technology to be adapted in single or multiple implementations. This feature allows OEMs
to incorporate selective blocks in their silicon chips or processors, resulting in cost
effective, high throughput, low power consuming designs.
    
    Price to Performance.Our products are designed for rapid and cost-effective
implementation and to match the stringent cost requirements of our customers with their
performance needs. As such, our development staff follows a design approach to reduce
overall product costs.
 Strategy
  
    
    Extend our Technology and Introduce New Products.We intend to leverage our
technology and product strength and expertise to further expand our core product
functionality, continue to develop complementary products, and expand our target market.
We will continue to invest in research and development and expect to announce new product
and technology offerings during 2006. We have assembled a team of experienced
developers and engineers with security expertise and encourage a corporate culture that
fosters continuous product innovation.
    
    Further Penetrate our Existing Enterprise Customer Base.We have an established
customer base of government, financial institutions and other commercial enterprises. The
strategic importance of our products allows us to develop long-term relationships with the
key technology and security decision-makers within our customer base. The breadth of our
existing enterprise product line allows us to address a wide range of customer needs. We
intend to generate incremental sales from our existing customer base through the
introduction of new and enhanced products and services. We believe that the acquisitions
of Rainbow Technologies, Datakey, DMDsecure, MediaSentry, and Eracom will continue to
provide us with an opportunity to sell new products and services into the larger combined
customer base.
    
    Target the Government and Financial Institution Markets.We have established and
created a Government Solutions Sales Unit to focus not just on government agencies and
departments, but also on systems integrators to produce more multi-year large dollar
contracting opportunities. We intend to expand our position in these markets and leverage
this position to target new high growth market opportunities as they arise.
    
    Further Penetrate the Digital Rights Management Market.We have established a Rights
Management Business Unit as part of our Embedded Security Division to develop new
initiatives for our Sentinel brand of software protection and license management products.
Through this new business we have begun to offer the next generation in digital rights
management software with Sentinel Hardware Keys. We have also broadened our reach in this
market through the
acquisitions of DMDsecure and MediaSentry, which are focused on the protection of content
through online distribution. Additionally, we introduced Sentinel RMS, a rights management
solution that reduces or eliminates many of the costs normally associated with
license management by automating this process and integrating it with back-office systems.
 9




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
    
    Expand Strategic OEM Relationships and Other Distribution Channels.We intend to
continue to focus on our OEM relationships and to expand distribution channels to develop
new markets. We believe that these relationships allow us to provide our security
solutions to the largest number of end-user customers. We sell a variety of security
products to OEMs, including silicon chips, accelerator cards, licensed intellectual
property, servers, and software products. For example, we teamed our Luna Series of
products with Adobes document services to help customers deploy more secure documents on
the Adobe Intelligent Document Platform. We offer comprehensive training and marketing
programs to support our OEMs and channel partners. We intend to further develop our
relationships with system integrators for the government sector and value added resellers
for international markets.
    
    Target the Wireless Market.We continue to target the wireless communications
market, expanding our reach from semiconductor companies to handset and cell phone
manufacturers. We are currently in the process of developing additional security
technology that will address the growing need for secure wireless communication.
    
    Pursue Strategic Acquisitions on a Selective Basis.We explore acquisitions from time
to time to acquire businesses, products or technologies that we believe will enhance and
expand our current product offerings and our customer base.
 Products, Services and Technology
  Enterprise Solutions
 SafeEnterprise  Security System.
 Appliances.
 
    
    HighAssurance Gateways:Our HighAssurance Gateway line provides a portfolio of IPSec
VPN gateways covering small, medium and large network requirements. The gateways are
differentiated by the performance needs of the network and where they are placed in the
network. Our gateways integrate advanced features, such as load balancing and fail-over,
secure multi-casting, firewalls and routing, and are all IPSec standards-compliant.
HighAssurance Gateways include the HighAssurance 500 Gateway, the HighAssurance 1000
Gateway, HighAssurance 2000 Gateway, and the HighAssurance 4000 Gateway.
 10




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
    
    SafeEnterprise iGate SSL Appliance:SafeEnterprise iGate SSL Appliance gives users the
ability to access their core applications through any high-speed Internet connection
without a VPN client. Applications that were not available before through a browser
because of security concerns can now be pushed out to remote users easily.
    
    ATM Encryptor:The SafeEnterprise ATM Encryptor provides data privacy and access
control for connections over public and private ATM networks and protects all
workstations, servers and other end nodes connected to a local area network. This product
allows the flexibility to choose desired interface modules across a range of speeds up to
OC-12.
    
    Frame Encryptor:SafeEnterprise Frame Encryptor provides security for frame relay
networks at speeds up to 52 Mbps. This product is used across a wide range of frame relay
networks and applications.
    
    Link Encryptor:SafeEnterprise Link Encryptor secures sensitive data transmitted over
high-speed, point-to-point, or dial-up communication links at speeds up to 52 Mbps. The
Link Encryptor is designed for organizations that rely heavily on close-looped secure
networks for the transport of highly sensitive data.
    
    SONET Encryptor:The SafeEnterprise SONET Encryptor has been designed to integrate
transparently and simply into one SONET/SDH network architecture. High-speed throughput
and extremely low latency make it ideal for high-speed data and time-sensitive voice and
video applications. It supports both path and line SONET/SDH encryption at various rates
and distances.
 Digital Identity and PKI Solutions
 
    
    iKey: Personal Two-Factor USB Authentication Token is a USB-based
two-factor authentication token that provides a cost-effective and easy-to-use
control for multiple applications and network services, as in VPNs, and controls Intranet,
Extranet, and Internet access. The iKey can also be used in Public Key Infrastructure
(PKI).
    
    SafeNet Smart Cards: SafeNet designs all of its smart cards and tokens with security,
interoperability, convenience and performance in mind. Our smart cards and tokens are
validated for FIPS 140-2 Level 2, an important
U.S. government certification that demonstrates the card/tokens cryptographic strength
and security.
    
    SafeNet Axis: This is a complete software and smart card solution that delivers simplified
and secure Single Sign-On (SSO) for a full range of enterprise applications and network
resources.
    
    SafeNet CMS (Card Management System):This is a Web-based smart card/token and digital
credential management solution for enterprises that is used to issue, manage, and support
SafeNet cryptographic smart cards and SafeNet iKey USB tokens for identity-based
applications throughout the organization. SafeNet CMS gives enterprise customers a
powerful, interoperable, and secure system that reduces the cost of deploying and
supporting smart cards and iKeys.
    
    The SafeNet Luna®family of products comprises a complete range of hardware security
solutions for digital identity applications. Luna products feature true hardware key
management to maintain the integrity of encryption keys. Sensitive keys are created,
stored, and used exclusively within the secure confines of the Luna hardware security
module to prevent compromise.
 
    
    Luna SAFlexible, scalable, high-performance network-attached hardware security module
    
    Luna SPJava application security appliance
 11




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
    
    Luna
CA3LA PKI Root Key hardware security module
 Software.The SafeEnterprise Security System includes the following software products:
    
    Security Management Center:Our Security Management Center product provides security
management for our VPN and WAN appliances and software clients, including authentication,
definition and enforcement of security policy, configuration, monitoring and audit
capabilities. The Security Management Center allows customers to manage all aspects of
their VPN and WAN networks and allows for easy migration from WAN to VPN technology. The
Security Management Center is a Java-based management platform.
    
    Luna PKI Toolkit:The Luna PKI Toolkit features robust APIs, proven hardware, and
expert support to speed development of custom PKI-enabled applications without requiring
specialized security knowledge or lengthy development cycles.
    
    SoftRemote:SoftRemote allows for remote access to corporate networks. This product
provides VPN access capabilities for desktops and portable computers for all versions of
Microsoft® Windows®, including Windows XP®. The client software provides secure
client-to-client or client-to-gateway communications over the Internet, dial-up
connections and wireless local area networks. Key features include personal firewall
capabilities and support for strong two-factor authentication through industry-standard
smart cards. SoftRemote additionally includes policy protection and support for browser
certificates. We also sell versions of our SoftRemote VPN client software to OEMs who are
able to co-brand the client and offer it as part of their overall solution.
    
    HighAssurance Remote:The HighAssurance Remote client is based on SoftRemote, which
contains additional security features for the U.S. government and other agencies. The
Department of Defense has purchased a two-year license for HighAssurance Remote for
government-wide use. HighAssurance Remote is FIPS certified.
    
    SoftRemoteLT:SoftRemoteLT is a streamlined version of SoftRemote that offers all the
features of SoftRemote except for personal firewall capabilities.
    
    SoftRemotePDA:SoftRemotePDA is based on SoftRemote and designed specifically to extend
VPN access to mobile devices, such as personal digital assistants, or PDAs. SoftRemotePDA
is designed to combat the vulnerabilities in wireless communications by applying the IPSec
technologies utilized by SoftRemote to handheld portable devices. It allows PDA users to
securely communicate over wireless links to retrieve email, access corporate information
from a network or browse the Internet. SoftRemotePDA is available for both Palm OS® and
Pocket PC® handheld devices.
    
    Protect family of data encryption products:These data encryption products are designed
for medium to large organizations to address the need to protect the integrity of data
through encryption on laptops, desktops, servers and mobile devices.Services.The SafeEnterprise Security System includes the following service:
    
    SafeNet Trusted Services:SafeNet Trusted Services provides a complete outsourced VPN
solution. Our managed services allow organizations to implement our VPNs without the
investment in equipment, facilities and security expertise. SafeNet Trusted Services
provides system availability in excess of 99.9% and our primary network operations center,
located in Belcamp, Maryland, has been approved by several U.S. government security
organizations.
Qualified security specialists perform around-the-clock functions necessary to maintain VPN
security, including providing help desk services and other maintenance functions. SafeNet
Trusted Services specialists work closely with the customer to define and implement its
security policy.
 12




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Borderless Security
  
  Mykotronx Products
  Space Communications Security:
 
    
    The MYK-42 Centurion VLSI, and MYK-41 DES VLSI microcircuits, for commercial applications.
    
    In the Caribou category, the U-TXZ microcircuit.
 13




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
    
    In the Pegasus category, the KGV-227 VLSI microcircuit.
    
    In the KI-23 category, the MYK-1 microcircuit.
    
    In the KG-28/46 category, the MYK-11 VLSI microcircuit.
    
    And in the KG-44 and KG-29/57 categories, the KG-44 LSI microcircuit.
 Cryptographic Cards: tm tm
 tm tm tm
 Network Security:
  Embedded Solutions.
  14




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Integrated Security Solutions
  
 QuickSec Security Software Toolkits
  
 
   SafeXcel Security Processors
  
 
   15




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SafeXcel Security PCI Cards
  
 
   SafeXcel Semiconductor IP
  
 
   Wireless Security Solutions
  
 
   Rights Management Solutions
 Sentinel Rights Management Suite
  
    
    Sentinel Hardware Keys: are a software rights management solution that protects
software vendors from unauthorized use or distribution of their products. The Keys are
hardware tokens which, when attached to a computer or network, monitor and enforce the
licensing of protected applications.
    
    SentinelTMRMS: is a comprehensive system that reduces or
eliminates many of the costs normally associated with license management through
automation and integration with back-office systems.
    
    Unified Software Protection: is a comprehensive solution for
protecting software products throughout the entire product lifecycle. Unified Software
Protection is comprised of a suite of products and services that work together to protect
and manage the assets of software vendors. It consists of the following products and
services:
 
    
    SafeNet MediaSentry Serviceshelp software vendors monitor the continually
evolving threat of software piracy and mitigate unauthorized distribution of their
products.
 
    
    Investigation: Monitors the Internet for pirated software and
copyright infringements.
 16




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
    
    Interdiction: Combines a solid technology foundation with
effective countermeasure techniques to minimize the availability
of pirated software online.
    
    Early Leak Detection: Monitors piracy forums to quickly
identify first leak file uploads and downloads files for
investigation and source identification.
    
    Auction Services:Identify and initiate removal of infringing
auctions on popular domestic and international sites.
    
    Takedowns:Enforce copyrights using legal takedown
notification to stop unauthorized online distribution.
    
    Litigation Support:Help prosecute those who engage in illegal
and unauthorized online distribution of property.
 Technology
 TM
 Customers and Customer Support
    Government:
  Financial Institutions:
  
   17




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Sales and Marketing
   
    
    Direct marketing efforts through Web marketing programs and website, as well as email
and direct-mail promotions;
    
    Programs to ascertain the requirements of existing and prospective end-user and OEM
customers;
    
    Trade-shows and seminars to increase the visibility of our solutions and generate leads
for our sales force;
    
    European brand awareness through various exhibitions and the addition of new European
sales offices;
    
    Increased coverage of our technology and products in leading trade publications; and
    
    Public relations efforts and joint marketing and co-branding arrangements with our partners.
  Product Development
   
    
    Enhancing our rights management products that protect software and online content,
and help vendors with their dynamic licensing needs and distributed upgrade models;
    
    Expanding our products addressing infrastructure security including the enhancement
of our encryptors that serve multiple protocols, and Borderless Security offerings
including management platforms, remote access, and HSMs;
    
    Expanding our OEM offerings that allow vendors to add increased capabilities in a
more timely and efficient manner;
    
    Further incorporating in our product lines high assurance security techniques derived
from joint development initiatives with U.S. government agencies.
 18




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Backlog
  Contract Manufacturing
  Competition
   19




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
  
 Patents and Intellectual Property
     Employees
  ITEM 1A. RISK FACTORS
 Set forth below are the risks that we believe are material to our investors. This section
contains forward-looking statements. You should refer to the explanation of the qualifications and
limitations on forward-looking statements set forth at the beginning of Item 1 of this Annual
Report on Form 10-K.
 20




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Risks Related to Our Business
 We have a history of losses and if we fail to execute our growth strategy, our business could be
materially and adversely affected.
  The loss of significant customers could have a material adverse effect on our business and results
of operations.
  We may not be able to successfully execute our growth strategy through acquisitions
  
    
    our failure to identify suitable acquisition targets or, once identified, our
failure to consummate the acquisition;
    
    increased competition for targets resulting in increased acquisition costs;
    
    a reduced number of acquisition targets due to consolidation in our industry;
    
    the unavailability of acquisition financing on acceptable terms or at all; and
    
    competition laws and regulations that may prevent us from making certain acquisitions.
  21




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Growing our business through acquisitions involves the risk that we may not successfully integrate
the business or assets acquired or that we may not achieve the expected benefits from the
acquisition.
  
    
    we may experience difficulties integrating the technologies and products of
the acquired businesses, which can be particularly challenging when dealing with complex
security technologies;
    
    synergies, economies of scale and cost reductions may not occur as expected;
    
    expected revenues may not be sufficient to offset increased expenses
associated with the acquisition;
    
    management may be distracted from overseeing existing operations by the need
to integrate acquired businesses;
    
    we may acquire or assume unexpected liabilities;
    
    unforeseen difficulties may arise in integrating operations, including
accounting, financial, managerial, back-office and other information systems;
    
    we may fail to retain key employees of the acquired business;
    
    we may experience problems in retaining customers and integrating customer bases; and
    
    problems may arise in entering and competing in new markets in which we may
have little or no experience and where competitors in such markets have stronger market
positions.
  Our quarterly operating results may fluctuate and our future revenues and profitability are
uncertain.
  
    
    introduction and market acceptance of new products and product enhancements by
us or our competitors;
    
    budgeting cycles of customers, including the U.S. government;
    
    timing and execution of individual contracts;
    
    changes in the percentage of revenues attributable to OEM license fees and royalties;
    
    length of time required by OEMs to embed our products into their products that
will generate future royalties;
 22




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
    
    competitive conditions in the highly competitive and increasingly consolidated
information security industry;
    
    changes in general economic conditions; and
    
    shortfall of revenues in relation to expectations that formed the basis for
the calculation of fixed expenses.
  If our subsidiary, Mykotronx, Inc., were to lose its eligibility as a small business under the
rules of the Small Business Administration, it would incur additional costs and charges relating to
disclosure, accounting and reporting to the U.S. government.
  Our industry is highly competitive and becoming increasingly consolidated, which may result in our
losing customers and declining revenue.
   
    
    standards compliance;
    
    product quality and reliability;
    
    technical features;
    
    network compatibility;
    
    product ease of use;
    
    client service and support;
    
    distribution; and
    
    price.
  23




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We may not be able to protect our proprietary technologies.
   Due to the nature of the information security industry and our products, our products and
technologies could infringe on the intellectual property rights of others, which may cause us to
engage in costly litigation and, if we are not successful, could cause us to pay substantial
damages and prohibit us from selling our products.
  We may not be able to maintain effective product distribution channels, which could result in
decreased revenue.
  24




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Delays in product development could adversely affect market acceptance of our products.
  We may be subject to product liability or other claims that could adversely affect our reputation
with existing and potential customers and expose us to significant liability.
    We rely on single or limited sources for the manufacture and supply of our products.
  25




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We rely on key technical and management employees and if such employees become unavailable, our
business could be adversely affected.
   Management has identified a material weakness in our internal control over financial reporting that
will require significant resources to remediate and could adversely affect our ability to report
our financial results accurately.
    Our future success will depend upon our ability to anticipate and keep pace with technological
changes and introduce new products and services in a timely manner.
  26




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Prolonged economic weakness in the Internet infrastructure, network security and related markets
may decrease our revenues and margins.
  If our products and services do not interoperate with our end-users networks, installations could
be delayed or cancelled, which could significantly reduce our revenues.
  A decrease of average selling prices for our products and services could adversely affect our
business.
  27




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We face risks associated with our international business activities.
   A breach of network security could harm public perception of our products and services, which could
cause us to lose revenue.
  Because a significant portion of
our net assets is represented by goodwill that is subject to
mandatory annual impairment evaluations, we could be required to
write-off some or all of this
goodwill, which may adversely affect our financial condition and results of operations.
 Goodwill and Other Intangible Assets
 28




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##### 



The conversion of our 2.50% convertible subordinated notes could adversely affect our available
cash.
  RISKS RELATED TO OUR COMMON STOCK
 Anti-takeover provisions in our charter documents and under Delaware law and certain provisions of
our 2.50% convertible subordinated notes could discourage an acquisition of us by a third
party.
   The price of our common stock may be volatile.
  
    
    our operating and financial performance and prospects;
    
    quarterly variations in key financial performance measurer, such as earnings
per share, net income and revenue;
    
    changes in revenue or earnings estimates or publication of research reports by
financial analysts;
    
    announcements of technological innovations or new products by us or our competitors;
    
    speculation in the press or investment community;
    
    strategic actions by us or our competitors, such as acquisitions or restructurings;
 29




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
    
    sales of our common stock or other actions by investors with significant shareholdings;
    
    general market conditions for security and other technology companies; and
    
    domestic and international economic, legal, political and regulatory factors
unrelated to our performance.
  ITEM 2. PROPERTIES
      ITEM 3. LEGAL PROCEEDINGS
  ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 30




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PART II


ITEM 5  MARKET FOR COMMON EQUITY AND RELATED MATTERS




High
    
    Low2005Fourth Quarter
    
    $
    37.20
    
    
    $
    31.57Third Quarter
    
    
    38.15
    
    
    
    29.70Second Quarter
    
    
    34.68
    
    
    
    25.55First Quarter
    
    
    36.63
    
    
    
    28.872004Fourth Quarter
    
    $
    37.68
    
    
    $
    26.46Third Quarter
    
    
    30.23
    
    
    
    22.19Second Quarter
    
    
    38.90
    
    
    
    20.61First Quarter
    
    
    41.80
    
    
    
    30.66 
 Issuer Purchases of Equity Securities
  (c) Total number
    
    (d) Maximumof shares
    
    number of sharespurchased as part
    
    that may yet be(a) Total number
    
    
    
    
    
    of publicly
    
    purchased underof shares
    
    (b) Average price
    
    announced plans
    
    the plans orPeriod
    
    purchased
    
    paid per share
    
    or programs
    
    programsDecember 7, 2005
    
    
    1,513,000
    
    
    $
    33.04
    
    
    
    
    
 31




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##### 



ITEM 6  SELECTED FINANCIAL DATA
  December 31,2005 (1)
    
    
    2004 (1)
    
    
    2003 (1)
    
    
    2002 (1)
    
    
    2001(Dollars in thousands, except per share data)Revenues
    
    $
    263,061
    
    
    $
    201,600
    
    
    $
    66,194
    
    
    $
    32,235
    
    
    $
    16,462Cost of revenues
    
    
    136,005
    
    
    
    99,753
    
    
    
    16,837
    
    
    
    8,963
    
    
    
    4,525Gross profit
    
    
    127,056
    
    
    
    101,847
    
    
    
    49,357
    
    
    
    23,272
    
    
    
    11,937Research and development expenses
    
    
    31,191
    
    
    
    23,771
    
    
    
    14,664
    
    
    
    8,504
    
    
    
    6,118Sales and marketing expenses
    
    
    49,782
    
    
    
    28,974
    
    
    
    14,929
    
    
    
    7,341
    
    
    
    5,061General and administrative expenses
    
    
    21,028
    
    
    
    16,216
    
    
    
    6,716
    
    
    
    3,852
    
    
    
    2,203Write-off of in-process research and
development
    
    
    1,196
    
    
    
    
    
    
    
    9,681
    
    
    
    3,375
    
    
    
    Costs of integration of acquired companies
    
    
    7,422
    
    
    
    15,908
    
    
    
    3,934
    
    
    
    256
    
    
    
    Amortization of acquired intangible assets
    
    
    9,175
    
    
    
    8,676
    
    
    
    4,710
    
    
    
    1,488
    
    
    
    Amorization of unearned compensation
    
    
    4,725
    
    
    
    5,925
    
    
    
    
    
    
    
    
    
    
    
    Restructuring charges
    
    
    2,391
    
    
    
    1,300
    
    
    
    
    
    
    
    
    
    
    
    Total operating expenses
    
    
    126,910
    
    
    
    100,770
    
    
    
    54,634
    
    
    
    24,816
    
    
    
    13,382Operating income (loss)
    
    
    146
    
    
    
    1,077
    
    
    
    (5,277
    )
    
    
    (1,544
    )
    
    
    (1,445
    )Investment income and other expenses, net
    
    
    5,861
    
    
    
    2,687
    
    
    
    807
    
    
    
    669
    
    
    
    1,336Income (loss) from continuing operations
before income taxes
    
    
    6,007
    
    
    
    3,764
    
    
    
    (4,470
    )
    
    
    (875
    )
    
    
    (109
    )Income tax expense (benefit)
    
    
    2,979
    
    
    
    1,581
    
    
    
    1,618
    
    
    
    (90
    )
    
    
    Income (loss) from continuing operations
    
    $
    3,028
    
    
    $
    2,183
    
    
    $
    (6,088
    )
    
    $
    (785
    )
    
    $
    (109
    )Income (loss) from continuing operations per
common share:Basic
    
    $
    0.12
    
    
    $
    0.10
    
    
    $
    (0.54
    )
    
    $
    (0.10
    )
    
    $
    (0.01
    )Diluted
    
    $
    0.12
    
    
    $
    0.10
    
    
    $
    (0.54
    )
    
    $
    (0.10
    )
    
    $
    (0.01
    )Shares used in computation:Basic
    
    
    24,751
    
    
    
    21,816
    
    
    
    11,350
    
    
    
    7,730
    
    
    
    7,057Diluted
    
    
    25,659
    
    
    
    22,637
    
    
    
    11,350
    
    
    
    7,730
    
    
    
    7,057Balance Sheet Data:Working capital
    
    $
    380,709
    
    
    $
    202,509
    
    
    $
    111,630
    
    
    $
    31,987
    
    
    $
    32,385Intangible assets
    
    
    475,989
    
    
    
    446,852
    
    
    
    67,988
    
    
    
    13,900
    
    
    
    727Total assets
    
    
    954,152
    
    
    
    723,978
    
    
    
    208,156
    
    
    
    55,319
    
    
    
    39,877Long-term debt
    
    
    250,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Stockholders equity
    
    
    583,131
    
    
    
    612,586
    
    
    
    178,997
    
    
    
    48,378
    
    
    
    35,459
 
 (1)
    
    During 2005, 2004, 2003 and 2002, the Company completed significant acquisitions as discussed further in
Note 3 to the consolidated financial statements. 32




---



##### 



QUARTERLY RESULTS OF OPERATIONS
  (Unaudited  Amounts in thousands, except per share data)
 2005 Quarter EndedAs reported
    
    
    As adjusted
    
    
    As reported
    
    
    As adjusted
    
    
    As reported
    
    
    As adjustedMarch 31
    
    
    March 31
    
    
    June 30
    
    
    June 30
    
    
    September 30 *
    
    
    September 30
    
    
    December 31Revenues (2)
    
    $
    59,812
    
    
    $
    59,712
    
    
    $
    63,498
    
    
    $
    63,142
    
    
    $
    62,899
    
    
    $
    62,945
    
    
    $
    77,262Cost of revenues
    
    
    28,560
    
    
    
    28,462
    
    
    
    32,998
    
    
    
    32,907
    
    
    
    34,489
    
    
    
    34,539
    
    
    
    40,097Gross profit
    
    
    31,252
    
    
    
    31,250
    
    
    
    30,500
    
    
    
    30,235
    
    
    
    28,410
    
    
    
    28,406
    
    
    
    37,165Operating income (loss) (1)
    
    
    1,428
    
    
    
    1,327
    
    
    
    (5,898
    )
    
    
    (6,898
    )
    
    
    (1,179
    )
    
    
    (1,133
    )
    
    
    6,850Net income (loss)
    
    $
    1,238
    
    
    $
    1,173
    
    
    $
    (3,811
    )
    
    $
    (4,895
    )
    
    $
    178
    
    
    $
    235
    
    
    $
    6,515Earnings (loss) per share, basic:Net (loss) income per share
    
    $
    0.05
    
    
    $
    0.05
    
    
    $
    (0.15
    )
    
    $
    (0.20
    )
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.26Income (loss) per share, diluted:Net (loss) income
    
    $
    0.05
    
    
    $
    0.05
    
    
    $
    (0.15
    )
    
    $
    (0.20
    )
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.25Shares used in calculation:Basic
    
    
    24,486
    
    
    
    24,486
    
    
    
    24,652
    
    
    
    24,652
    
    
    
    25,009
    
    
    
    25,009
    
    
    
    24,846Diluted
    
    
    25,439
    
    
    
    25,439
    
    
    
    24,652
    
    
    
    24,652
    
    
    
    25,935
    
    
    
    25,935
    
    
    
    25,759
 
 *
    
    As reported in Amendment No. 1 to the Companys Quarterly Report on Form 10-Q for the
quarterly period ended September 30, 2005, filed on February 27, 2006.  (1)
    
    Includes an adjustment to correct the accounting for the exit
of a leased facility in accordance with FASB Statement No. 146, Accounting for
Costs Associated with Exit or Disposal Activities. Under
Statement 146, net costs related to operating leases are accrued when
the lease no longer benefits operations or at the cease-use date. There was an
error in the Companys calculation of sublease income related to
the facility, which resulted in a $642 increase in restructuring expense for the three and six month periods ended June 30, 2005
and the nine months ended September 30, 2005.(2)
    
    Includes an adjustment to correct an error made in the
Companys calculation of the percent of completion for a contract accounted
for under SOP 81-1 Accounting for Performance of Construction-Type and Certain
Production-Type Contracts.The adjustment resulted in a decrease in revenue
of $356 for the three and six month periods ended June 30, 2005. This correction also
resulted in adjustments to the three-month periods ended March 31, 2005 and
September 30, 2005, of $100 and $47, respectively. There was no significant
impact on the revenue recognized for the year ended December 31, 2005.Other adjustments, all deminimus in amount, were also made.
 33




---



##### 



2004 Quarter Ended(Unaudited - Amounts in thousands, except per share data)March 31
    
    
    June 30
    
    
    September 30
    
    
    December 31Revenues
    
    $
    24,016
    
    
    $
    54,345
    
    
    $
    59,450
    
    
    $
    63,789Cost of revenues
    
    
    9,022
    
    
    
    28,760
    
    
    
    30,430
    
    
    
    31,541Gross profit
    
    
    14,994
    
    
    
    25,585
    
    
    
    29,020
    
    
    
    32,248Operating income (loss)
    
    
    (855
    )
    
    
    (485
    )
    
    
    1,642
    
    
    
    775Income (loss) from continuing operations
    
    
    (456
    )
    
    
    408
    
    
    
    996
    
    
    
    1,235Net income (loss)
    
    $
    (456
    )
    
    $
    408
    
    
    $
    996
    
    
    $
    1,235Earnings (loss) per share, basic:Income (loss) from continuing operations
    
    $
    (0.03
    )
    
    $
    0.02
    
    
    $
    0.04
    
    
    $
    0.05Net (loss) income per share
    
    $
    (0.03
    )
    
    $
    0.02
    
    
    $
    0.04
    
    
    $
    0.05Income (loss) per share, diluted:Income (loss) from continuing operations
    
    $
    (0.03
    )
    
    $
    0.02
    
    
    $
    0.04
    
    
    $
    0.05Net (loss) income
    
    $
    (0.03
    )
    
    $
    0.02
    
    
    $
    0.04
    
    
    $
    0.05Shares used in calculation:Basic
    
    
    15,183
    
    
    
    23,801
    
    
    
    23,976
    
    
    
    24,252Diluted
    
    
    15,183
    
    
    
    25,653
    
    
    
    24,558
    
    
    
    25,277
 ITEM 7
 MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 Forward-Looking Statements
  Overview
   34




---



##### 



10-K
         35




---



##### 



Recent
Development
    36




---



##### 



RESULTS OF OPERATIONS OF SAFENET
  2005
    
    2004
    
    2003Revenues
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Cost of revenues
    
    
    52
    %
    
    
    49
    %
    
    
    25
    %Gross profit
    
    
    48
    %
    
    
    51
    %
    
    
    75
    %Research and development expenses
    
    
    12
    %
    
    
    12
    %
    
    
    22
    %Sales and marketing expenses
    
    
    19
    %
    
    
    14
    %
    
    
    23
    %General and administrative expenses
    
    
    8
    %
    
    
    8
    %
    
    
    10
    %Costs of integration of acquired companies
    
    
    3
    %
    
    
    8
    %
    
    
    6
    %Write-off of in-process research and development
    
    
    0
    %
    
    
    0
    %
    
    
    15
    %Restructuring charge
    
    
    1
    %
    
    
    1
    %
    
    
    0
    %Amortization of intangibles
    
    
    3
    %
    
    
    4
    %
    
    
    7
    %Amortization of deferred compensation
    
    
    2
    %
    
    
    3
    %
    
    
    0
    %Total operating expenses
    
    
    48
    %
    
    
    50
    %
    
    
    83
    %Operating income (loss)
    
    
    0
    %
    
    
    1
    %
    
    
    (8
    %)Investment income and other expenses, net
    
    
    2
    %
    
    
    1
    %
    
    
    1
    %Income (loss) before income taxes
    
    
    2
    %
    
    
    2
    %
    
    
    (7
    %)Income tax expense
    
    
    1
    %
    
    
    1
    %
    
    
    2
    %Net income (loss)
    
    
    1
    %
    
    
    1
    %
    
    
    (9
    %)
 37




---



##### 



Year ended December 31, 2005 Compared to Year ended December 31, 2004
 Revenues and Gross Margins
 Variance2005
    
    
    2004
    
    
    $
    
    
    %(Dollars in thousands)Revenues by typeLicense and royalties
    
    $
    17,544
    
    
    $
    9,677
    
    
    $
    7,867
    
    
    
    81
    %Products
    
    
    217,078
    
    
    
    172,145
    
    
    
    44,933
    
    
    
    26
    %Service and maintenance
    
    
    28,439
    
    
    
    19,778
    
    
    
    8,661
    
    
    
    44
    %Total
    
    $
    263,061
    
    
    $
    201,600
    
    
    $
    61,461
    
    
    
    30
    %Revenues by segmentEmbedded Security Division
    
    $
    75,103
    
    
    $
    56,009
    
    
    $
    19,094
    
    
    
    34
    %Enterprise Security Division
    
    
    187,958
    
    
    
    145,591
    
    
    
    42,367
    
    
    
    29
    %Total
    
    $
    263,061
    
    
    $
    201,600
    
    
    $
    61,461
    
    
    
    30
    %Revenue mix by typeLicense and royalties
    
    
    7
    %
    
    
    5
    %Products
    
    
    82
    %
    
    
    85
    %Service and maintenance
    
    
    11
    %
    
    
    10
    %Total
    
    
    100
    %
    
    
    100
    %Revenue mix by segmentEmbedded Security Division
    
    
    29
    %
    
    
    28
    %Enterprise Security Division
    
    
    71
    %
    
    
    72
    %Total
    
    
    100
    %
    
    
    100
    %Gross margins by typeLicense and royalties
    
    
    99
    %
    
    
    97
    %
    
    
    
    
    
    
    2
    %Products (1)
    
    
    41
    %
    
    
    45
    %
    
    
    
    
    
    
    -4
    %Service and maintenance
    
    
    73
    %
    
    
    79
    %
    
    
    
    
    
    
    -6
    %Total
    
    
    48
    %
    
    
    51
    %
    
    
    
    
    
    
    -3
    %Gross margins by segmentEmbedded Security Division
    
    
    68
    %
    
    
    64
    %
    
    
    
    
    
    
    4
    %Enterprise Security Division
    
    
    40
    %
    
    
    46
    %
    
    
    
    
    
    
    -6
    %Total
    
    
    48
    %
    
    
    51
    %
    
    
    
    
    
    
    -3
    %
 
 (1)
    
    Includes amortization of acquired intangibles ($14,188 in 2005 and $11,104 in 2004)
and amortization of unearned compensation ($390 in 2005, $516 in 2004).  38




---



##### 



Operating Expenses
 Variance2005
    
    
    2004
    
    
    $
    
    
    %(Dollars in thousands)Operating expensesResearch and development
    
    $
    31,191
    
    
    $
    23,771
    
    
    $
    7,420
    
    
    
    31
    %Sales and marketing
    
    
    49,782
    
    
    
    28,974
    
    
    
    20,808
    
    
    
    72
    %General and administrative
    
    
    21,028
    
    
    
    16,216
    
    
    
    4,812
    
    
    
    30
    %Write-off of acquired in-process
research and development costs
    
    
    1,196
    
    
    
    
    
    
    
    1,196
    
    
    
    100
    %Cost of integration of
acquired companies
    
    
    7,422
    
    
    
    15,908
    
    
    
    (8,486
    )
    
    
    -53
    %Restructuring charge
    
    
    2,391
    
    
    
    1,300
    
    
    
    1,091
    
    
    
    84
    %Amortization of intangible assets
    
    
    9,175
    
    
    
    8,676
    
    
    
    499
    
    
    
    6
    %Amortization of unearned compensation
    
    
    4,725
    
    
    
    5,925
    
    
    
    (1,200
    )
    
    
    -20
    %Total
    
    $
    126,910
    
    
    $
    100,770
    
    
    $
    26,140
    
    
    
    26
    %
 39




---



##### 



40




---



##### 



Interest and Other Income, Net
 Variance2005
    
    2004
    
    $
    
    %(Dollars in thousands)Interest income, net
    
    $
    4,075
    
    
    $
    2,035
    
    
    $
    2,040
    
    
    
    100
    %Foreign exchange gain (loss), net
    
    
    724
    
    
    
    (232
    )
    
    
    956
    
    
    
    -412
    %Other income
    
    
    1,062
    
    
    
    884
    
    
    
    178
    
    
    
    20
    %Total
    
    $
    5,861
    
    
    $
    2,687
    
    
    $
    3,174
    
    
    
    118
    %
  Income Tax Expense
 Variance2005
    
    2004
    
    $
    
    %(Dollars in thousands)Income tax expense
    
    $
    2,979
    
    
    $
    1,581
    
    
    $
    1,398
    
    
    
    88
    %
  41




---



##### 



Year ended December 31, 2004 Compared to Year ended December 31, 2003
 Revenues and Gross Margins
 Variance2004
    
    
    2003
    
    
    $
    
    
    %(Dollars in thousands)Revenues by typeLicense and royalties
    
    $
    9,677
    
    
    $
    16,464
    
    
    $
    (6,787
    )
    
    
    -41
    %Products
    
    
    172,145
    
    
    
    38,797
    
    
    
    133,348
    
    
    
    344
    %Service and maintenance
    
    
    19,778
    
    
    
    10,933
    
    
    
    8,845
    
    
    
    81
    %Total
    
    $
    201,600
    
    
    $
    66,194
    
    
    $
    135,406
    
    
    
    205
    %Revenues by segmentEmbedded Security Division
    
    $
    56,009
    
    
    $
    19,269
    
    
    $
    36,740
    
    
    
    191
    %Enterprise Security Division
    
    
    145,591
    
    
    
    46,925
    
    
    
    98,666
    
    
    
    210
    %Total
    
    $
    201,600
    
    
    $
    66,194
    
    
    $
    135,406
    
    
    
    205
    %Revenue mix by typeLicense and royalties
    
    
    5
    %
    
    
    25
    %Products
    
    
    85
    %
    
    
    59
    %Service and maintenance
    
    
    10
    %
    
    
    16
    %Total
    
    
    100
    %
    
    
    100
    %Revenue mix by segmentEmbedded Security Division
    
    
    28
    %
    
    
    29
    %Enterprise Security Division
    
    
    72
    %
    
    
    71
    %Total
    
    
    100
    %
    
    
    100
    %Gross margins by typeLicense and royalties
    
    
    97
    %
    
    
    95
    %
    
    
    2
    %Products (1)
    
    
    45
    %
    
    
    62
    %
    
    
    -17
    %Service and maintenance
    
    
    79
    %
    
    
    88
    %
    
    
    -9
    %Total
    
    
    51
    %
    
    
    75
    %
    
    
    -24
    %Gross margins by segmentEmbedded Security Division
    
    
    64
    %
    
    
    75
    %
    
    
    -11
    %Enterprise Security Division
    
    
    46
    %
    
    
    75
    %
    
    
    -29
    %Total
    
    
    51
    %
    
    
    75
    %
    
    
    -24
    %
 
 (1)
    
    Includes amortization of acquired intangibles ($11,104 in 2004 and $2,652 in 2003) and
amortization of unearned compensation ($516 in 2004, $0 in 2003).  42




---



##### 



Operating Expenses
 Variance2004
    
    
    2003
    
    
    $
    
    
    %(Dollars in thousands)Operating expensesResearch and development
    
    $
    23,771
    
    
    $
    14,664
    
    
    $
    9,107
    
    
    
    62
    %Sales and marketing
    
    
    28,974
    
    
    
    14,929
    
    
    
    14,045
    
    
    
    94
    %General and administrative
    
    
    16,216
    
    
    
    6,716
    
    
    
    9,500
    
    
    
    141
    %Write-off of acquired in-process
research and development costs
    
    
    
    
    
    
    9,681
    
    
    
    (9,681
    )
    
    
    -100
    %Cost of integration of
acquired companies
    
    
    15,908
    
    
    
    3,934
    
    
    
    11,974
    
    
    
    304
    %Restructuring charge
    
    
    1,300
    
    
    
    
    
    
    
    1,300
    
    
    
    100
    %Amortization of intangible assets
    
    
    8,676
    
    
    
    4,710
    
    
    
    3,966
    
    
    
    84
    %Amortization of unearned compensation
    
    
    5,925
    
    
    
    
    
    
    
    5,925
    
    
    
    100
    %Total
    
    $
    100,770
    
    
    $
    54,634
    
    
    $
    46,136
    
    
    
    84
    %
  43




---



##### 



Interest and Other Income, Net
 Variance2004
    
    2003
    
    $
    
    %(Dollars in thousands)Interest and other income, net
    
    $
    2,687
    
    
    $
    807
    
    
    $
    1,880
    
    
    
    233
    %
 44




---



##### 



Income Tax Expense (Benefit)
 Variance2004
    
    2003
    
    $
    
    %(Dollars in thousands)Income tax expense (benefit)
    
    $
    1,581
    
    
    $
    1,618
    
    
    $
    (37
    )
    
    
    2
    %
  Liquidity and Capital Resources
     45




---



##### 



Future Contractual Obligations
  Less than
    
    
    1 - 3
    
    
    3 - 5
    
    
    More thanTotal
    
    
    One Year
    
    
    Years
    
    
    Years
    
    
    5 Years(In thousands)Convertible subordinated notes (1)
    
    $
    250,000
    
    
    $
    
    
    
    $
    
    
    
    $
    250,000
    
    
    $
    Interest on convertible
subordinated notes (2)
    
    
    30,990
    
    
    
    6,250
    
    
    
    12,500
    
    
    
    12,240
    
    
    
    Operating leases(3)
    
    
    36,149
    
    
    
    8,029
    
    
    
    13,610
    
    
    
    9,378
    
    
    
    5,132Other obligations
    
    
    763
    
    
    
    403
    
    
    
    316
    
    
    
    44
    
    
    
    Total
    
    $
    317,902
    
    
    $
    14,682
    
    
    $
    26,426
    
    
    $
    271,662
    
    
    $
    5,132
 
 (1)
    
    The convertible subordinated notes are convertible prior to their stated maturity upon the occurrence of
certain events beyond our control. Upon conversion, the principal is payable in cash.(2)
    
    The interest obligation on our long-term debt assumes that our convertible notes will bear
interest at their stated rates until maturity.(3)
    
    The operating leases are for the multiple facilities that we lease for our
operations, sales and headquarters. 46




---



##### 



Inflation and Seasonality
  Critical Accounting Policies
   Allowance for Doubtful Accounts
  Inventory and Reserve for Obsolescence
   Software Development Costs
   47




---



##### 



Goodwill and Other Intangible Assets
  Applicability of FASB Statement
No. 2 to Business Combinations Accounted for by the Purchase Method
 Goodwill and Other Intangible Assets,
  48




---



##### 



Product Warranties
  Revenue Recognition
  Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain
Transactions
    49




---



##### 



Income Taxes
 Accounting for Income
Taxes  Special Areas
    ITEM 7A  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 Market Risk
  Foreign Currency Risk
  50




---



##### 



Interest Rate Risk
   Equity Price Sensitivity
  51




---



##### 



SAFENET, INC.
AND SUBSIDIARIES
 ITEM 8  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 INDEX TO FINANCIAL STATEMENTS
 PAGEReport of Independent Registered Public Accounting Firm
    
    
    53Consolidated Balance Sheets as of December 31, 2005 and 2004
    
    
    54Consolidated Statements of Operations for the years ended
December 31, 2005, 2004 and 2003
    
    
    55Consolidated Statements of Comprehensive Income (Loss) for
the years ended December 31, 2005, 2004 and 2003
    
    
    56Consolidated Statements of Stockholders Equity for the years
ended December 31, 2005, 2004 and 2003
    
    
    57Consolidated Statements of Cash Flows for the years ended
December 31, 2005, 2004, and 2003
    
    
    58Notes to Consolidated Financial Statements
    
    
    59
 52




---



##### 



Report of Independent Registered Public Accounting Firm
 
    Internal Control-
Integrated Framework
 /s/ Ernst & Young LLP
 
 53




---



##### 



SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
 December 31,2005
    
    
    2004AssetsCurrent assets:Cash and cash equivalents
    
    $
    63,934
    
    
    $
    74,751Short-term investments
    
    
    278,785
    
    
    
    93,310Accounts receivable, net of allowance for doubtful accounts
of $2,278 in 2005 and $2,264 in 2004
    
    
    67,722
    
    
    
    55,286Inventories, net of reserve of $2,227 in 2005 and $726 in 2004
    
    
    22,176
    
    
    
    18,168Unbilled costs and fees
    
    
    4,025
    
    
    
    1,259Deferred income taxes
    
    
    9,575
    
    
    
    9,694Prepaid expenses and other current assets
    
    
    5,874
    
    
    
    4,190Total current assets
    
    
    452,091
    
    
    
    256,658Property and equipment, net
    
    
    17,904
    
    
    
    18,313Computer software development costs, net of accumulated
amortization of $2,278 in 2005 and $2,619 in 2004
    
    
    3,886
    
    
    
    2,349Goodwill
    
    
    339,785
    
    
    
    305,311Other intangible assets, net of accumulated amortization of $52,179 in 2005
and $28,223 in 2004
    
    
    132,318
    
    
    
    139,192Other assets
    
    
    8,168
    
    
    
    2,155Total assets
    
    $
    954,152
    
    
    $
    723,978Liabilities and Stockholders EquityCurrent liabilities:Accounts payable
    
    $
    19,770
    
    
    $
    11,615Accrued compensation and related costs
    
    
    14,007
    
    
    
    13,046Advance payments and deferred revenue
    
    
    11,009
    
    
    
    11,319Accrued warranty costs
    
    
    4,443
    
    
    
    3,192Unfavorable lease liability
    
    
    1,521
    
    
    
    1,270Other accrued expenses
    
    
    11,247
    
    
    
    6,889Accrued income taxes
    
    
    9,385
    
    
    
    6,818Total current liabilities
    
    
    71,382
    
    
    
    54,149Long-term debt
    
    
    250,000
    
    
    
    Unfavorable lease liability, less current portion
    
    
    4,347
    
    
    
    4,653Deferred income taxes
    
    
    43,599
    
    
    
    50,922Other liabilities
    
    
    1,693
    
    
    
    1,668Total liabilities
    
    
    371,021
    
    
    
    111,392Commitments 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,
25,343 and 24,401 shares issued at December 31, 2005 and 2004,
respectively; 23,830 and 24,401 shares outstanding at December 31,
2005 and 2004, respectively
    
    
    253
    
    
    
    244Additional paid-in capital
    
    
    654,167
    
    
    
    633,882Treasury stock, 1,513 shares at December 31, 2005, at cost
    
    
    (49,990
    )
    
    
    Unearned compensation
    
    
    (2,422
    )
    
    
    (6,719
    )Accumulated other comprehensive income
    
    
    2,225
    
    
    
    9,309Accumulated deficit
    
    
    (21,102
    )
    
    
    (24,130
    )Total stockholders equity
    
    
    583,131
    
    
    
    612,586Total liabilities and stockholders equity
    
    $
    954,152
    
    
    $
    723,978
 54




---



##### 



SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
 Year ended December 31,2005
    
    
    2004
    
    
    2003Revenues:Licenses and royalties
    
    $
    17,544
    
    
    $
    9,677
    
    
    $
    16,464Products
    
    
    217,078
    
    
    
    172,145
    
    
    
    38,797Service and maintenance
    
    
    28,439
    
    
    
    19,778
    
    
    
    10,933Total revenues
    
    
    263,061
    
    
    
    201,600
    
    
    
    66,194Cost of revenues:Licenses and royalties
    
    
    167
    
    
    
    325
    
    
    
    812Products
    
    
    113,703
    
    
    
    83,660
    
    
    
    12,106Service and maintenance
    
    
    7,557
    
    
    
    4,148
    
    
    
    1,267Amortization of acquired intangible assets
    
    
    14,188
    
    
    
    11,104
    
    
    
    2,652Amortization of unearned compensation*
    
    
    390
    
    
    
    516
    
    
    
    Total cost of revenues
    
    
    136,005
    
    
    
    99,753
    
    
    
    16,837Gross profit
    
    
    127,056
    
    
    
    101,847
    
    
    
    49,357Operating expenses:Research and development expenses
    
    
    31,191
    
    
    
    23,771
    
    
    
    14,664Sales and marketing expenses
    
    
    49,782
    
    
    
    28,974
    
    
    
    14,929General and administrative expenses
    
    
    21,028
    
    
    
    16,216
    
    
    
    6,716Write-off of acquired in-process research and development costs
    
    
    1,196
    
    
    
    
    
    
    
    9,681Restructuring charges
    
    
    2,391
    
    
    
    1,300
    
    
    
    Costs of integration of acquired companies
    
    
    7,422
    
    
    
    15,908
    
    
    
    3,934Amortization of acquired intangible assets
    
    
    9,175
    
    
    
    8,676
    
    
    
    4,710Amortization of unearned compensation*
    
    
    4,725
    
    
    
    5,925
    
    
    
    Total operating expenses
    
    
    126,910
    
    
    
    100,770
    
    
    
    54,634Operating income (loss)
    
    
    146
    
    
    
    1,077
    
    
    
    (5,277
    )Foreign exchange gain (loss)
    
    
    724
    
    
    
    (232
    )
    
    
    (5
    )Interest income, net
    
    
    4,075
    
    
    
    2,035
    
    
    
    812Other income, net
    
    
    1,062
    
    
    
    884
    
    
    
    Income (loss) before income taxes
    
    
    6,007
    
    
    
    3,764
    
    
    
    (4,470
    )Income tax expense
    
    
    2,979
    
    
    
    1,581
    
    
    
    1,618Net income (loss)
    
    $
    3,028
    
    
    $
    2,183
    
    
    $
    (6,088
    )Basic income (loss) per common share
    
    $
    0.12
    
    
    $
    0.10
    
    
    $
    (0.54
    )Diluted income (loss) per common share
    
    $
    0.12
    
    
    $
    0.10
    
    
    $
    (0.54
    )*Composition of amortization of unearned compensation:Cost of revenues
    
    $
    390
    
    
    $
    516
    
    
    $
    Research and development
    
    
    905
    
    
    
    1,225
    
    
    
    Sales and marketing
    
    
    1,000
    
    
    
    1,102
    
    
    
    General and administrative
    
    
    750
    
    
    
    1,303
    
    
    
    Costs of integration
    
    
    2,070
    
    
    
    2,295
    
    
    
    Total
    
    $
    5,115
    
    
    $
    6,441
    
    
    $
    
  55




---



##### 



SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(In thousands)
 Year ended December 31,2005
    
    
    2004
    
    
    2003Net income (loss)
    
    $
    3,028
    
    
    $
    2,183
    
    
    $
    (6,088
    )Other comprehensive income (loss):Foreign currency translation adjustment
    
    
    (7,253
    )
    
    
    4,196
    
    
    
    2,535Reclassification adjustment  realization of foreign
currency translation adjustment upon settlement
of intercompany loan
    
    
    216
    
    
    
    
    
    
    
    Unrealized loss on available-for-sale securities
    
    
    (47
    )
    
    
    (281
    )
    
    
    Total other comprehensive income (loss)
    
    
    (7,084
    )
    
    
    3,915
    
    
    
    2,535Comprehensive income (loss)
    
    $
    (4,056
    )
    
    $
    6,098
    
    
    $
    (3,553
    )
  56




---



##### 



SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
(In thousands)
 AccumulatedAdditional
    
    
    
    
    
    
    
    
    
    
    Other
    
    
    
    
    
    
    TotalCommon stock
    
    
    Paid-in
    
    
    Treasury
    
    
    Unearned
    
    
    Comprehensive
    
    
    Accumulated
    
    
    StockholdersShares
    
    
    Amount
    
    
    Capital
    
    
    Stock
    
    
    Compensation
    
    
    Income (Loss)
    
    
    Deficit
    
    
    EquityBalance at January 1, 2003
    
    
    7,894
    
    
    $
    79
    
    
    $
    65,665
    
    
    $
    
    
    
    $
    
    
    
    $
    2,859
    
    
    $
    (20,225
    )
    
    $
    48,378Issuance of common stock in
connection with:Secondary offering
    
    
    2,698
    
    
    
    27
    
    
    
    83,893
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    83,920Cylink Corporation acquisition
    
    
    1,680
    
    
    
    17
    
    
    
    31,067
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    31,084Asset acquisition of Raquia Networks
    
    
    354
    
    
    
    4
    
    
    
    6,094
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,098Employee Stock Purchase Plan
    
    
    7
    
    
    
    
    
    
    
    162
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    162Stock option exercises
    
    
    653
    
    
    
    6
    
    
    
    8,849
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,855Assumption of stock options in connection
with Cylink Corporation acquisition
    
    
    
    
    
    
    
    
    
    
    1,399
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,399Assumption of stock warrants in connection
with Cylink Corporation acquisition
    
    
    
    
    
    
    
    
    
    
    292
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    292Income tax benefit related to
stock option exercises
    
    
    
    
    
    
    
    
    
    
    2,362
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,362Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (6,088
    )
    
    
    (6,088
    )Other comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,535
    
    
    
    
    
    
    
    2,535Balance at December 31, 2003
    
    
    13,286
    
    
    
    133
    
    
    
    199,783
    
    
    
    
    
    
    
    
    
    
    
    5,394
    
    
    
    (26,313
    )
    
    
    178,997Costs in connection with registration
of common stock related to the
acquisitions of Raqia Networks and
Rainbow Technologies
    
    
    
    
    
    
    
    
    
    
    (1,034
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,034
    )Issuance of common stock in
connection with:Rainbow Technologies acquisition
    
    
    10,306
    
    
    
    103
    
    
    
    375,025
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    375,128Employee Stock Purchase Plan
    
    
    23
    
    
    
    
    
    
    
    553
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    553Stock option exercises
    
    
    766
    
    
    
    8
    
    
    
    11,558
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,566Stock warrant exercises
    
    
    20
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Assumption of stock options in
connection with:Rainbow Technologies acquisition
    
    
    
    
    
    
    
    
    
    
    44,600
    
    
    
    
    
    
    
    (13,160
    )
    
    
    
    
    
    
    
    
    
    
    31,440Datakey acquisition
    
    
    
    
    
    
    
    
    
    
    449
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    449Income tax benefit related to
stock option exercises
    
    
    
    
    
    
    
    
    
    
    2,948
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,948Amortization of unearned compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,441
    
    
    
    
    
    
    
    
    
    
    
    6,441Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,183
    
    
    
    2,183Other comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,915
    
    
    
    
    
    
    
    3,915Balance at December 31, 2004
    
    
    24,401
    
    
    
    244
    
    
    
    633,882
    
    
    
    
    
    
    
    (6,719
    )
    
    
    9,309
    
    
    
    (24,130
    )
    
    
    612,586Issuance of common stock in connection with:MediaSentry acquisition
    
    
    194
    
    
    
    2
    
    
    
    5,998
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,000Employee Stock Purchase Plan
    
    
    41
    
    
    
    
    
    
    
    1,058
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,058Stock option exercises
    
    
    707
    
    
    
    7
    
    
    
    11,178
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,185Assumption of stock options in
connection with MediaSentry acquisition
    
    
    
    
    
    
    
    
    
    
    626
    
    
    
    
    
    
    
    (334
    )
    
    
    
    
    
    
    
    
    
    
    292Issuance of stock options to employees
    
    
    
    
    
    
    
    
    
    
    705
    
    
    
    
    
    
    
    (484
    )
    
    
    
    
    
    
    
    
    
    
    221Income tax benefit related to
stock option exercises
    
    
    
    
    
    
    
    
    
    
    720
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    720Repurchase of 1,513 shares of common stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (49,990
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (49,990
    )Amortization of unearned compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,115
    
    
    
    
    
    
    
    
    
    
    
    5,115Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,028
    
    
    
    3,028Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (7,084
    )
    
    
    
    
    
    
    (7,084
    )Balance at December 31, 2005
    
    
    25,343
    
    
    $
    253
    
    
    $
    654,167
    
    
    $
    (49,990
    )
    
    $
    (2,422
    )
    
    $
    2,225
    
    
    $
    (21,102
    )
    
    $
    583,131
  57




---



##### 



SAFENET, INC
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 Year ended December 31,2005
    
    
    2004
    
    
    2003Cash flows from operating activities:Net income (loss)
    
    $
    3,028
    
    
    $
    2,183
    
    
    $
    (6,088
    )Adjustments to reconcile net income (loss) to net cash
provided by operating activities:Write-off of acquired in-process research and
development costs
    
    
    1,196
    
    
    
    
    
    
    
    9,681Depreciation and amortization of property and equipment
    
    
    5,611
    
    
    
    2,893
    
    
    
    1,318Amortization of computer software development costs
    
    
    1,145
    
    
    
    921
    
    
    
    183Amortization of other intangible assets
    
    
    23,363
    
    
    
    19,780
    
    
    
    7,362Amortization of unearned compensation
    
    
    5,335
    
    
    
    6,441
    
    
    
    Excess income tax benefit related to stock option exercises
    
    
    720
    
    
    
    2,948
    
    
    
    2,362Other non-cash items
    
    
    60
    
    
    
    
    
    
    
    Restucturing charges
    
    
    2,391
    
    
    
    1,300
    
    
    
    Deferred income taxes
    
    
    (3,439
    )
    
    
    (4,168
    )
    
    
    (2,445
    )Amortization of unfavorable lease liability
    
    
    (1,676
    )
    
    
    (1,311
    )
    
    
    (632
    )Gain on the sale of property and equipment, net
    
    
    (727
    )
    
    
    
    
    
    
    Changes in operating assets and liabilities:Accounts receivable, net
    
    
    (9,868
    )
    
    
    (21,994
    )
    
    
    (1,772
    )Inventories, net
    
    
    (2,741
    )
    
    
    (4,021
    )
    
    
    (230
    )Prepaid expenses and other current assets
    
    
    (5,465
    )
    
    
    (76
    )
    
    
    259Accounts payable
    
    
    7,583
    
    
    
    (2,221
    )
    
    
    1,890Accrued compensation and related costs
    
    
    (3,120
    )
    
    
    3,061
    
    
    
    (3,979
    )Accrued income taxes
    
    
    3,147
    
    
    
    2,453
    
    
    
    2,294Other accrued expenses
    
    
    662
    
    
    
    (5,263
    )
    
    
    (3,521
    )Advanced payments and deferred revenue
    
    
    (1,622
    )
    
    
    2,335
    
    
    
    489Net cash provided by operating activities
    
    
    25,583
    
    
    
    5,261
    
    
    
    7,171Cash flows from investing activities:Proceeds from maturities of held to maturity securities
    
    
    
    
    
    
    
    
    
    
    28,763Proceeds from sales of available for sale securities
    
    
    38,545
    
    
    
    89,857
    
    
    
    52,927Purchases of available for sale securities
    
    
    (224,023
    )
    
    
    (88,865
    )
    
    
    (145,207
    )Purchases of property and equipment
    
    
    (7,849
    )
    
    
    (6,795
    )
    
    
    (2,628
    )Proceeds from sale of property and equipment
    
    
    4,069
    
    
    
    
    
    
    
    Expenditures for computer software development
    
    
    (2,684
    )
    
    
    (1,285
    )
    
    
    (1,686
    )Cash paid for SSH, including restricted cash
    
    
    
    
    
    
    (197
    )
    
    
    (13,796
    )Cash received upon acquisition of Cylink, net of cash paid
    
    
    
    
    
    
    (277
    )
    
    
    703Cash paid for Raqia, net of cash acquired
    
    
    
    
    
    
    
    
    
    
    (1,390
    )Cash received upon acquisition of Rainbow, net of cash paid
    
    
    
    
    
    
    55,158
    
    
    
    Cash paid for Datakey, net of cash acquired
    
    
    (194
    )
    
    
    (10,993
    )
    
    
    Cash paid for MediaSentry, net of cash acquired
    
    
    (13,948
    )
    
    
    
    
    
    
    Cash paid for Eracom, net of cash acquired
    
    
    (23,139
    )
    
    
    
    
    
    
    Cash paid for DMDsecure, net of cash acquired
    
    
    (9,397
    )
    
    
    
    
    
    
    Change in other assets
    
    
    (289
    )
    
    
    (1,404
    )
    
    
    (46
    )Net cash provided by (used in) investing activities
    
    
    (238,909
    )
    
    
    35,199
    
    
    
    (82,360
    )Cash flows from financing activities:Repayment of line of credit assumed in MediaSentry acquisition
    
    
    (300
    )
    
    
    
    
    
    
    Proceeds from stock options exercised and issuance
of stock under Employee Stock Purchase Plan
    
    
    12,243
    
    
    
    12,119
    
    
    
    9,017Proceeds from secondary stock offering, net
    
    
    
    
    
    
    
    
    
    
    83,920Proceeds from issuance of debt, net of direct costs of $5,927
    
    
    244,073
    
    
    
    
    
    
    
    Registration costs for issuances of common stock in
in connection with acquisitions
    
    
    
    
    
    
    (1,034
    )
    
    
    Repurchase of company stock
    
    
    (49,990
    )
    
    
    
    
    
    
    Other financing cash flows
    
    
    (288
    )
    
    
    
    
    
    
    Net cash provided by financing activities
    
    
    205,738
    
    
    
    11,085
    
    
    
    92,937Effect of exchange rate changes on cash
    
    
    (3,229
    )
    
    
    1,555
    
    
    
    504Net increase (decrease) in cash and cash equivalents
    
    
    (10,817
    )
    
    
    53,100
    
    
    
    18,252Cash and cash equivalents at beginning of year
    
    
    74,751
    
    
    
    21,651
    
    
    
    3,399Cash and cash equivalents at end of year
    
    $
    63,934
    
    
    $
    74,751
    
    
    $
    21,651
  58




---



##### 



SAFENET, INC. AND SUBSIDIARIES
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005
 (Amounts in thousands, except per share amounts)
 (1) BUSINESS
     (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 Principles of Consolidation
  Use of Estimates
  Cash Equivalents
  Short-Term Investments
  59




---



##### 



Accounts Receivable and Allowance for Doubtful Accounts
  Inventories and Reserve for Obsolescence
   Property and Equipment
  Computer Software Development Costs
   60




---



##### 



Goodwill and Other Intangible Assets
 Goodwill and Intangible Assets
    Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of
  61




---



##### 



Debt Financing Fees
  Product Warranties
   2005
    
    2004
    

    2003Beginning
balance
    
    $
    3,192
    

    $
    259
    

    $
    50Costs
incurred for warranty claims
    
    
    (1,615
    )

    
    (521
    )

    
    Balance
acquired from Rainbow
    
    
    
    

    
    3,423
    

    
    Provision
    
    
    2,866
    

    
    31
    

    
    209Ending balance
    
    $
    4,443
    

    $
    3,192
    

    $
    259
 Unfavorable Lease Liabilities
  Revenue Recognition
  License and Royalties
 62




---



##### 



Modification of SOP 97-2, Software
Revenue Recognition, With Respect to Certain Transactions
 Products
    Maintenance and Other Services
 Software Revenue Recognition
  63




---



##### 



Shipping and Handling Costs
  Advertising Expense
  Costs of Integration of Acquired Companies
  Foreign Currency Translation
 Foreign Currency Translation Accounting for Income Taxes  Special Areas,
 Income Taxes
  64




---



##### 



Employee Stock-Based Compensation
 Accounting for Stock Issued to Employees
 Accounting for Stock-Based Compensation
 Year Ended December 31,2005
    
    
    2004
    
    
    2003(Restated)Net income (loss), as reported
    
    $
    3,028
    
    
    $
    2,183
    
    
    $
    (6,088
    )Add: Employee stock-based
            compensation expense included in net income (loss) as reported,
            net of taxes
    
    
    3,730
    
    
    
    3,736
    
    
    
    Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards, net
of taxes
    
    
    (7,608
    )
    
    
    (7,604
    )
    
    
    (4,178
    )Pro forma net loss
    
    $
    (850
    )
    
    $
    (1,685
    )
    
    $
    (10,266
    )Income (loss) per share:Basic  as reported
    
    $
    0.12
    
    
    $
    0.10
    
    
    $
    (0.54
    )Basic  pro forma
    
    $
    (0.03
    )
    
    $
    (0.08
    )
    
    $
    (0.90
    )Diluted  as reported
    
    $
    0.12
    
    
    $
    0.10
    
    
    $
    (0.54
    )Diluted  pro forma
    
    $
    (0.03
    )
    
    $
    (0.08
    )
    
    $
    (0.90
    )
   65




---



##### 



2005
    
    2004
    
    2003Risk-free interest rate
    
    
    3.48
    %
    
    
    3.86
    %
    
    
    3.11
    %Dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Option life
    
    3-5 years
    
    3-5 years
    
    3-5 yearsStock price volatility
    
    
    62
    %
    
    
    91
    %
    
    
    106
    %Weighted average fair value of granted options
    
    $
    15.04
    
    
    $
    14.77
    
    
    $
    16.74
  Comprehensive Income (Loss)
  Reclassifications
  Recent Accounting Pronouncements
   
    
    The modified prospective method which requires companies to recognize
compensation cost beginning with the effective date of adoption based on (a) the
requirements of Statement No. 123(R) for all share-based payments granted or modified after the
effective date of adoption and (b) the requirements of Statement No. 123 for all
unvested awards granted to employees prior to the effective date of adoption; or
    
    The modified retrospective method, which includes the requirements of the
modified prospective method described above, but also requires restatement of prior
period financial statements using amounts previously disclosed under the pro-forma
provisions of Statement 123.
  66




---



##### 



The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments Accounting for Certain
Investments in Debt and Equity Securities Accounting for Certain Investments Held by
Not-for-Profit Organizations The Equity Method of Accounting for
Investments in Common Stock
 (3) ACQUISITIONS
 2003 Acquisitions:
 Cylink Corporation
   67




---



##### 



Raqia Networks, Inc.
    SSH Communications Security Corp.
   68




---



##### 



2004 Acquisitions:
 Rainbow Technologies, Inc.
   Datakey Corporation
     69




---



##### 



Rainbow
    
    
    DatakeyCurrent assets
    
    $
    91,908
    
    
    $
    2,638Deferred income taxes
    
    
    4,182
    
    
    
    Property and equipment
    
    
    9,837
    
    
    
    66Goodwill
    
    
    252,573
    
    
    
    8,061Intangible assets subject to amortization
    
    
    117,277
    
    
    
    4,473Intangible assets not subject to amortization  trademarks
    
    
    13,520
    
    
    
    100Other assets
    
    
    512
    
    
    
    6Total assets acquired
    
    
    489,809
    
    
    
    15,344Current liabilities
    
    
    23,811
    
    
    
    1,591Other liabilities
    
    
    3,187
    
    
    
    420Accrued income taxes
    
    
    1,828
    
    
    
    1,738Deferred income taxes
    
    
    42,258
    
    
    
    Other current liabilities
    
    
    2,641
    
    
    
    Accrued warranty costs
    
    
    3,423
    
    
    
    Accrued restructuring costs
    
    
    436
    
    
    
    Total liabilities assumed
    
    
    77,584
    
    
    
    3,749Net assets acquired
    
    $
    412,225
    
    
    $
    11,595
 Rainbow
    
    
    DatakeyIntangible assets subject to amorization*:Developed technology
    
    $
    89,000
    
    
    $
    4,137Customer contracts
    
    
    16,890
    
    
    
    205Patents
    
    
    10,247
    
    
    
    Customer list, backlog, purchase orders
    
    
    1,140
    
    
    
    131$
    117,277
    
    
    $
    4,473
 
 *
    
    The average amortization period for the developed technology is 8  9 years, customer
contracts is 7  10 years, patents is 9 years and customer list is 5  10 years. Rainbow
    
    
    DatakeyAllocation
of goodwill by operating segmentEmbedded Security segment
    
    $
    94,202
    
    
    $
    Enterprise Security segment
    
    
    158,371
    
    
    
    8,061$
    252,573
    
    
    $
    8,061
   70




---



##### 



2004
    
    
    2003(In thousands, except per share data)Revenues
    
    $
    235,351
    
    
    $
    214,614Loss from continuing operations
    
    $
    (1,676
    )
    
    $
    (20,841
    )Loss from discontinued operations (GDS)
    
    $
    
    
    
    $
    (261
    )Net loss
    
    $
    (1,676
    )
    
    $
    (21,102
    )Loss per common share  basic and diluted:Loss from continuing operations
    
    $
    (0.07
    )
    
    $
    (0.98
    )Loss from discontinued operations (GDS)
    
    
    
    
    
    
    (0.01
    )Net loss
    
    $
    (0.07
    )
    
    $
    (0.99
    )
   2005 Acquisitions:
 DMDsecure, B.V.
   .
  71




---



##### 



MediaSentry, Inc
     Eracom Technologies AG
    72




---



##### 



DMDsecure
    
    
    MediaSentry
    
    
    EracomCurrent assets
    
    $
    319
    
    
    $
    2,027
    
    
    $
    3,563Property and equipment
    
    
    70
    
    
    
    1,207
    
    
    
    286Deferred income taxes
    
    
    92
    
    
    
    
    
    
    
    Acquired
in-process research and development
    
    
    1,196
    
    
    
    
    
    
    
    Other intangibles
    
    
    1,968
    
    
    
    7,100
    
    
    
    7,428Goodwill
    
    
    6,897
    
    
    
    13,494
    
    
    
    23,739Other
    
    
    
    
    
    
    
    
    
    
    116Total assets acquired
    
    
    10,542
    
    
    
    23,828
    
    
    
    35,132Current liabilities
    
    
    401
    
    
    
    716
    
    
    
    5,638Other liabilities
    
    
    
    
    
    
    360
    
    
    
    3,954Accrued income taxes
    
    
    
    
    
    
    8
    
    
    
    24Deferred income taxes
    
    
    
    
    
    
    54
    
    
    
    1,904Capital leases  short-term
    
    
    
    
    
    
    484
    
    
    
    Note payable
    
    
    
    
    
    
    300
    
    
    
    Deferred income taxes
    
    
    643
    
    
    
    1,035
    
    
    
    Capital leases  long-term
    
    
    
    
    
    
    389
    
    
    
    Total liabilities assumed
    
    
    1,044
    
    
    
    3,346
    
    
    
    11,520Net assets acquired
    
    $
    9,498
    
    
    $
    20,482
    
    
    $
    23,612
 73




---



##### 



DMDsecure
    
    
    MediaSentry
    
    
    EracomIntangible assets subject to amorization*:Developed technology
    
    $
    
    
    
    $
    2,000
    
    
    $
    Customer contracts
    
    
    1,675
    
    
    
    5,100
    
    
    
    6,013Patents
    
    
    293
    
    
    
    
    
    
    
    1,050Non-compete agreements
    
    
    
    
    
    
    
    
    
    
    365$
    1,968
    
    
    $
    7,100
    
    
    $
    7,428
 
 *
    
    The average amortization period for the developed technology is 8  9 years, customer
contracts is 7  10 years, patents is 9 years and non-compete agreements is 3 years. DMDsecure
    
    
    MediaSentry
    
    
    EracomAllocation of goodwill by operating segmentEmbedded Security segment
    
    $
    6,897
    
    
    $
    13,494
    
    
    $
    Enterprise Security segment
    
    
    
    
    
    
    
    
    
    
    23,739$
    6,897
    
    
    $
    13,494
    
    
    $
    23,739
  2005
    
    
    2004(In thousands, except per share data)Revenues
    
    $
    276,976
    
    
    $
    252,670Net loss
    
    $
    (7,590
    )
    
    $
    (4,433
    )Loss per common share  basic and diluted:
    
    $
    (0.30
    )
    
    $
    (0.18
    )
  (4) RESTRUCTURING CHARGE
 Accounting for Costs Associated
with Exit or Disposal Activities
 74




---



##### 



(5) INVENTORIES
  2005
    
    
    2004Raw materials
    
    $
    4,668
    
    
    $
    4,667Finished goods
    
    
    13,111
    
    
    
    8,462Inventoried costs relating to long-term contracts, net
of amounts attributable to revenues recognized
    
    
    6,624
    
    
    
    5,76524,403
    
    
    
    18,894Reserve for excess and obsolete inventory
    
    
    (2,227
    )
    
    
    (726
    )$
    22,176
    
    
    $
    18,168
 (6) PROPERTY AND EQUIPMENT
  2005
    
    
    2004Furniture and equipment
    
    $
    18,730
    
    
    $
    13,251Buildings
    
    
    1,639
    
    
    
    5,572Computer software
    
    
    4,533
    
    
    
    3,276Leasehold improvements
    
    
    3,526
    
    
    
    2,60228,428
    
    
    
    24,701Accumulated depreciation and amortization
    
    
    (10,524
    )
    
    
    (6,388
    )$
    17,904
    
    
    $
    18,313
 75




---



##### 



(7) GOODWILL
  Embedded
    
    
    EnterpriseSecurity
    
    
    SecuritySegment
    
    
    Segment
    
    
    TotalBalance as of January 1, 2004
    
    $
    18,086
    
    
    $
    24,321
    
    
    $
    42,407Goodwill recorded during the year:Acquisition of Rainbow
    
    
    158,256
    
    
    
    94,146
    
    
    
    252,402Acquisition of Datakey
    
    
    
    
    
    
    7,606
    
    
    
    7,606Purchase price allocation adjustments
    
    
    705
    
    
    
    785
    
    
    
    1,490Foreign currency translation adjustment
    
    
    1,406
    
    
    
    
    
    
    
    1,406Balance as of December
            31, 2004
    
    
    178,453
    
    
    
    126,858
    
    
    
    305,311Goodwill recorded during the year:Acquisition of MediaSentry
    
    
    13,494
    
    
    
    
    
    
    
    13,494Acquisition of DMDsecure
    
    
    6,897
    
    
    
    
    
    
    
    6,897Acquisition of Eracom
    
    
    
    
    
    
    23,739
    
    
    
    23,739Purchase price allocation adjustmentsRainbow
    
    
    (608
    )
    
    
    (867
    )
    
    
    (1,475
    )Datakey
    
    
    
    
    
    
    454
    
    
    
    454Recognition of tax benefit for acquired
net operating loss carryforwards
    
    
    (3,529
    )
    
    
    (2,890
    )
    
    
    (6,419
    )Reclassification*
    
    
    (46,886
    )
    
    
    46,886
    
    
    
    Foreign currency translation
            adjustments
    
    
    (2,186
    )
    
    
    (30
    )
    
    
    (2,216
    )Balance as of December 31, 2005
    
    $
    145,635
    
    
    $
    194,150
    
    
    $
    339,785
 
 *
    
    In 2005 there was a realignment of products acquired in the Rainbow acquisition and the
estimated related goodwill was reclassified from the Embedded segment to the Enterprise segments. (8) ACQUIRED INTANGIBLE ASSETS
  Weighted
    
    
    
    
    
    
    
    
    
    
    NetAverage Useful
    
    
    Gross Carrying
    
    
    Accumulated
    
    
    CarryingLife in Years
    
    
    Amount
    
    
    Amortization
    
    
    AmountIntangible assets subject to amortization:Customer contracts / relationships
    
    
    7.5
    
    
    $
    41,900
    
    
    $
    (12,870
    )
    
    $
    29,030Developed technology
    
    
    8.1
    
    
    
    104,896
    
    
    
    (28,098
    )
    
    
    76,798Patents and related technology
    
    
    7.2
    
    
    
    17,394
    
    
    
    (7,563
    )
    
    
    9,831Tradenames
    
    
    0.5
    
    
    
    100
    
    
    
    (100
    )
    
    
    Non-compete agreements
    
    
    2.1
    
    
    
    2,532
    
    
    
    (2,089
    )
    
    
    443Purchase orders and contract backlog
    
    
    0.9
    
    
    
    1,459
    
    
    
    (1,459
    )
    
    
    Total
    
    
    7.7
    
    
    
    168,281
    
    
    
    (52,179
    )
    
    
    116,102Intangible assets not subject to amortization:Trademarks
    
    
    N/A
    
    
    
    13,520
    
    
    
    
    
    
    
    13,520Domain names
    
    
    N/A
    
    
    
    2,696
    
    
    
    
    
    
    
    2,696Total acquired intangible assets
    
    
    
    
    
    $
    184,497
    
    
    $
    (52,179
    )
    
    $
    132,318
 76




---



##### 



Weighted
    
    
    
    
    
    
    
    
    
    
    NetAverage Useful
    
    
    Gross Carrying
    
    
    Accumulated
    
    
    CarryingLife in Years
    
    
    Amount
    
    
    Amortization
    
    
    AmountIntangible assets subject to amortization:Customer contracts / relationships
    
    
    7.4
    
    
    $
    29,140
    
    
    $
    (6,891
    )
    
    $
    22,249Developed technology
    
    
    8.3
    
    
    
    102,520
    
    
    
    (13,432
    )
    
    
    89,088Patents and related
    
    
    7.2
    
    
    
    15,842
    
    
    
    (4,472
    )
    
    
    11,370Non-compete agreements
    
    
    2.0
    
    
    
    2,066
    
    
    
    (1,980
    )
    
    
    86Tradenames
    
    
    0.5
    
    
    
    100
    
    
    
    (33
    )
    
    
    67Purchase orders and contract backlog
    
    
    0.9
    
    
    
    1,459
    
    
    
    (1,415
    )
    
    
    44Total
    
    
    7.8
    
    
    
    151,127
    
    
    
    (28,223
    )
    
    
    122,904Intangible assets not subject to amortization:Trademarks
    
    
    N/A
    
    
    
    13,520
    
    
    
    
    
    
    
    13,520Domain names
    
    
    N/A
    
    
    
    2,768
    
    
    
    
    
    
    
    2,768Total acquired intangible assets
    
    
    
    
    
    $
    167,415
    
    
    $
    (28,223
    )
    
    $
    139,192
  2006
        
        $
    19,7522007
    
    
    18,6762008
    
    
    16,8912009
    
    
    13,2012010
    
    
    11,3312011 and thereafter
    
    
    36,251
 (9) FAIR VALUE OF FINANCIAL INSTRUMENTS
  Cash and cash equivalents, accounts receivable, accounts payable and accrued expenses
 Long-term debt
 77




---



##### 



(10) LONG-TERM DEBT
     78
      (11) INCOME TAXES
  2005
    
    
    2004
    
    
    2003Current:Federal
    
    $
    844
    
    
    $
    3,140
    
    
    $
    3,662State
    
    
    240
    
    
    
    476
    
    
    
    523Foreign
    
    
    6,118
    
    
    
    2,133
    
    
    
    161Total current
    
    
    7,202
    
    
    
    5,749
    
    
    
    4,346Deferred (benefit):Federal
    
    
    (1,875
    )
    
    
    (3,771
    )
    
    
    (2,672
    )State
    
    
    (771
    )
    
    
    (648
    )
    
    
    Foreign
    
    
    (1,577
    )
    
    
    251
    
    
    
    (56
    )Total deferred
    
    
    (4,223
    )
    
    
    (4,168
    )
    
    
    (2,728
    )Total tax expense (benefit)
    
    $
    2,979
    
    
    $
    1,581
    
    
    $
    1,618
  79
      2005
    
    
    2004Deferred tax assets:Inventories
    
    $
    2,157
    
    
    $
    3,041Net operating loss carryforwards
    
    
        48,672
    
    
    
    49,229Tax credits
    
    
    12,815
    
    
    
    12,301Property and equipment
    
    
    394
    
    
    
    405Compensation and accrued reserves
    
    
    5,306
    
    
    
    4,314Other
    
    
        3,311
    
    
    
    2,872Total deferred tax assets
    
    
    72,655
    
    
    
    72,162Deferred tax liabilities:Deferred gain
    
    
    
    
    
    
    (1,398
    )Intangible assets
    
    
    (45,803
    )
    
    
    (49,524
    )Total deferred tax liabilities
    
    
    (45,803
    )
    
    
    (50,922
    )Net deferred tax asset
    
    
    26,852
    
    
    
    21,240Less: valuation allowance
    
    
    (60,876
    )
    
    
    (62,468
    )Total
    
    $
    (34,024
    )
    
    $
    (41,228
    )
  2005
    
    
    2004Tax benefit at U.S. statutory rate
    
    $
    2,043
    
    
    $
    1,280Effect of permanent differences:Non-deductible in-process research and
and development
    
    
    407
    
    
    
    Tax effect of international operations
    
    
    (2,228
    )
    
    
    (1,165
    )Non-deductible acquisition costs
    
    
    (565
    )
    
    
    676Non-deductible expenses related to foreign subsidiaries
    
    
    533
    
    
    
    559State income taxes, including effect of change
in state rate, net of federal benefit
    
    
    645
    
    
    
    (244
    )Change in valuation allowance, excluding change
related to stock option exercises
    
    
    1,799
    
    
    
    22Other non-deductible items, net
    
    
    345
    
    
    
    453Total
    
    $
    2,979
    
    
    $
    1,581
 80
      (12) LEASES
  2006
    
    $
    8,0292007
    
    
    7,1712008
    
    
    6,4392009
    
    
    5,4712010
    
    
    3,9072011 and thereafter
    
    
    5,132
  81
      2006
    
    $
    1,1782007
    
    
    1,3182008
    
    
    1,4802009
    
    
    1,3712010
    
    
    1,065
 (13) RETIREMENT PLAN
  (14) STOCK COMPENSATION PLANS
 Stock Option Plans
  82
      WeightedAverageNumber
    
    Range of
    
    Exerciseof Shares
    
    Exercise Prices
    
    PriceOutstanding as of January 1, 2003
    
    
    1,924
    
    
    $
    4.37 to $43.63
    
    
    $
    15.08Granted
    
    
    925
    
    
    $
    16.47 to $38.07
    
    
    $
    21.11Issued in connection with Cylink acquisition
    
    
    170
    
    
    $
    0.20 to $25.00
    
    
    $
    12.63Exercised
    
    
    (653
    )
    
    $
    4.63 to $24.13
    
    
    $
    13.69Cancelled / Forfeited
    
    
    (177
    )
    
    $
    0.20 to $33.63
    
    
    $
    17.78Outstanding as of December 31, 2003
    
    
    2,189
    
    
    $
    4.37 to $43.63
    
    
    $
    17.03Granted
    
    
    946
    
    
    $
    21.70 to $24.35
    
    
    $
    22.19Issued in connection
            with Rainbow and Datakey acquisitions
    
    
    1,999
    
    
    $
    8.83 to $43.32
    
    
    $
    20.58Exercised
    
    
    (766
    )
    
    $
    5.85 to $33.63
    
    
    $
    14.95Cancelled / Forfeited
    
    
    (167
    )
    
    $
    5.85 to $45.29
    
    
    $
    26.71Outstanding as of December 31, 2004
    
    
    4,201
    
    
    $
    4.37 to $45.29
    
    
    $
    19.88Granted
    
    
    1,269
    
    
    $
    21.70 to $35.11
    
    
    $
    30.48Issued in connection
            with MediaSentry acquisition
    
    
    35
    
    
    $
    0.03 to $29.96
    
    
    $
    20.01Exercised
    
    
    (703
    )
    
    $
    0.03 to $42.70
    
    
    $
    15.88Cancelled / Forfeited
    
    
    (395
    )
    
    $
    8.53 to $45.29
    
    
    $
    24.14Outstanding as of December 31, 2005
    
    
    4,407
    
    
    $
    0.03 to $45.29
    
    
    $
    23.19Exercisable as of December 31, 2005
    
    
    2,752
    
    
    $
    0.03 to $45.29
    
    
    $
    21.01
  Options Outstanding
    
    Options ExercisableWeighted
    
    Weighted
    
    
    
    
    
    WeightedAverage
    
    Average
    
    
    
    
    
    AverageRange of
    
    Number
    
    Remaining
    
    Exercise
    
    Number
    
    ExerciseExercise Prices
    
    of Shares
    
    Contractual Life
    
    Price
    
    of Shares
    
    Price$0.03
to   $11.17
    
    
    503
    
    
    
    5.84
    
    
    $
    8.61
    
    
    
    497
    
    
    $
    8.64$11.25 to $18.25
    
    
    1,011
    
    
    
    5.05
    
    
    $
    14.93
    
    
    
    879
    
    
    $
    14.83$18.50 to $26.00
    
    
    1,210
    
    
    
    7.85
    
    
    $
    22.67
    
    
    
    749
    
    
    $
    22.94$26.38 to $35.40
    
    
    1,380
    
    
    
    9.20
    
    
    $
    30.68
    
    
    
    324
    
    
    $
    31.86$35.43 to $45.29
    
    
    303
    
    
    
    4.87
    
    
    $
    42.91
    
    
    
    303
    
    
    $
    42.924,407
    
    
    
    
    
    
    
    
    
    
    
    2,752
 83
      Employee Stock Purchase Plan
  (15) SEGMENTS OF THE COMPANY AND RELATED INFORMATION
   84
      2005
    
    
    2004
    
    
    2003Revenue from external customers:Embedded security
    
    $
    75,103
    
    
    $
    56,009
    
    
    $
    19,269Enterprise security
    
    
    187,958
    
    
    
    145,591
    
    
    
    46,925Consolidated revenues
    
    $
    263,061
    
    
    $
    201,600
    
    
    $
    66,194Significant non-cash items other than depreciation
and amortization expense:Embedded security
    
    $
    4,167
    
    
    $
    5,119
    
    
    $
    6,330Enterprise security
    
    
    4,535
    
    
    
    2,622
    
    
    
    3,351Consolidated significant non-cash items
other than depreciation and amortization expense
    
    $
    8,702
    
    
    $
    7,741
    
    
    $
    9,681Operating income (loss):Embedded security
    
    $
    (2,713
    )
    
    $
    (12,326
    )
    
    $
    (6,711
    )Enterprise security
    
    
    2,859
    
    
    
    13,403
    
    
    
    1,434Consolidated operating income (loss)
    
    $
    146
    
    
    $
    1,077
    
    
    $
    (5,277
    )Depreciation and amortization:Embedded security
    
    $
    10,429
    
    
    $
    7,864
    
    
    $
    1,382Enterprise security
    
    
    19,690
    
    
    
    15,730
    
    
    
    7,481Consolidated depreciation and amortization
    
    $
    30,119
    
    
    $
    23,594
    
    
    $
    8,863Income (loss) before
            income taxes:Embedded security
    
    $
    751
    
    
    $
    (7,084
    )
    
    $
    (6,632
    )Enterprise security
    
    
    5,256
    
    
    
    10,848
    
    
    
    2,162Consolidated income (loss) before
            income taxes
    
    $
    6,007
    
    
    $
    3,764
    
    
    $
    (4,470
    )
   85
      2005
    
    
    2004
    
    
    2003Significant non-cash items other than depreciation
and amortization consist of the following:Restructuring charges
    
    $
    2,391
    
    
    $
    1,300
    
    
    $
    Amortization of unearned compensation
    
    
    5,115
    
    
    
    6,441
    
    
    
    Write-off of acquired in-process research and development
    
    
    1,196
    
    
    
    
    
    
    
    9,681Total
    
    $
    8,702
    
    
    $
    7,741
    
    
    $
    9,681
 2005
    
    
    2004
    
    
    2003Geographic InformationRevenues:United States
    
    $
    185,696
    
    
    $
    155,892
    
    
    $
    58,321All other countries
    
    
    77,365
    
    
    
    45,708
    
    
    
    7,873Total
    
    $
    263,061
    
    
    $
    201,600
    
    
    $
    66,194Long-lived assets:United States
    
    $
    16,867
    
    
    $
    11,975
    
    
    $
    5,478France
    
    
    
    
    
    
    4,922
    
    
    
    All other countries
    
    
    4,923
    
    
    
    3,765
    
    
    
    313Total
    
    $
    21,790
    
    
    $
    20,662
    
    
    $
    5,791
  (16) SIGNIFICANT CUSTOMERS AND CONCENTRATIONS OF CREDIT RISK
     86
      (17) INCOME (LOSS) PER SHARE
  2005
    
    
    2004
    
    
    2003Numerator  basic
            and diluted Net income (loss)
    
    $
    3,028
    
    
    $
    2,183
    
    
    $
    (6,088
    )Denominator:Weighted average number of shares outstanding  basic
    
    
    24,751
    
    
    
    21,816
    
    
    
    11,350Effect of dilutive stock options
    
    
    908
    
    
    
    821
    
    
    
    Weighted average number of shares outstanding  diluted
    
    
    25,659
    
    
    
    22,637
    
    
    
    11,350Basic income (loss) per share
    
    $
    0.12
    
    
    $
    0.10
    
    
    $
    (0.54
    )Diluted income (loss) per share
    
    $
    0.12
    
    
    $
    0.10
    
    
    $
    (0.54
    )
  (18) SUBSEQUENT EVENT
   87
      88
      SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS
Years Ended December 31, 2005, 2004 and 2003
 Balance at
    
    Charged to
    
    Charges
    
    
    
    
    
    
    
    
    
    BalanceBeginning
    
    Costs and
    
    to Other
    
    Deductions
    
    
    
    
    
    at Endof Period
    
    Expenses
    
    Accounts (a)
    
    (b)
    
    Recovery
    
    of PeriodAllowance for
doubtful accounts:2005
    
    $
    2,264
    
    
    $
    192
    
    
    $
    481
    
    
    $
    (694
    )
    
    $
    35
    
    
    $
    2,2782004
    
    
    940
    
    
    
    857
    
    
    
    715
    
    
    
    (248
    )
    
    
    
    
    
    
    2,2642003
    
    
    224
    
    
    
    24
    
    
    
    775
    
    
    
    (83
    )
    
    
    
    
    
    
    940Reserve for
obsolete inventory:2005
    
    
    726
    
    
    
    1,784
    
    
    
    
    
    
    
    (283
    )
    
    
    
    
    
    
    2,2272004
    
    
    1,275
    
    
    
    (307
    )
    
    
    
    
    
    
    (242
    )
    
    
    
    
    
    
    7262003
    
    
    958
    
    
    
    418
    
    
    
    
    
    
    
    (101
    )
    
    
    
    
    
    
    1,275Accrued warranty costs:2005
    
    
    3,192
    
    
    
    2,866
    
    
    
    
    
    
    
    (1,615
    )
    
    
    
    
    
    
    4,4432004
    
    
    259
    
    
    
    3,917
    
    
    
    
    
    
    
    (463
    )
    
    
    (521
    )
    
    
    3,1922003
    
    
    50
    
    
    
    
    
    
    
    209
    
    
    
    
    
    
    
    
    
    
    
    259Valuation allowance
for deferred tax
assets:2005
    
    
    62,468
    
    
    
    1,914
    
    
    
        9,293
    
    
    
    (6,377
    )
    
    
    (6,422
    )
    
    
    60,8762004
    
    
    39,570
    
    
    
    22
    
    
    
    22,876
    
    
    
    
    
    
    
    
    
    
    
    62,4682003
    
    
    8,141
    
    
    
    592
    
    
    
    30,837
    
    
    
    
    
    
    
    
    
    
    
    39,570
 
 (a)
    
    Represents reserves acquired through purchase business
combinations or established through charges to stockholders equity(b)
    
    Deductions represent write-offs of specifically identified accounts ITEM 9  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
  ITEM 9A  CONTROLS AND PROCEDURES
  EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
   CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
  MANAGEMENTS REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
 Internal
Control-Integrated Framework
  Internal Control  Integrated Framework
  89
      Report of Ernst & Young LLP,
Independent Registered Public Accounting Firm,
On Internal Control over Financial Reporting
  Internal Control-Integrated Framework
        
 PART III
 ITEM 10  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
  ITEM 11  EXECUTIVE COMPENSATION
  90
      ITEM 12  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS
  ITEM 13  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
  ITEM 14  PRINCIPAL ACCOUNTANT FEES AND SERVICES
  PART IV
 ITEM 15  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
 (a)
    
    
    1.
    
    
    The financial statements filed as part of this report are listed separately on the Index To Financial
Statements on page 52 of this Form 10-K.2.
    
    
    Financial Statement Schedules: Schedule II Valuation and Qualifying Accounts
  (b)
 2A
    
    
    Agreement and Plan of Reorganization dated June 1, 2005 by and among the Registrant, MediaSentry, Inc., Sidecast Merger
Corp. and certain shareholders of MediaSentry, Inc.
    
    I/B/R(1)2B
    
    
    Purchase Agreement dated November 14, 2005 by and among the Registrant, SafeNet Technologies B.V. and the holders of the share capital of Eracom Technologies AG
    
    I/B/R(2)3A
    
    
    Restated Certificate of Incorporation of Registrant, as filed with the Secretary of State of Delaware on May 23, 2001
    
    I/B/R(3)3B
    
    
    By-laws of Registrant
    
    I/B/R(4)4A
    
    
    Specimen of Common Stock Certificate of Registrant
    
    I/B/R(5)4B
    
    
    Indenture, dated as of December 13, 2005, by and between the Registrant and Citibank, N.A., as trustee
    
    I/B/R(6)4C
    
    
    Form of 2.50% Convertible Subordinated Note due 2010
    
    I/B/R(6)4D
    
    
    Registration Rights Agreement, dated as of December 13, 2005, by and between the Registrant and Merrill Lynch, Pierce, Fenner & Smith Incorporated
    
    I/B/R/(6)10A
    
    
    Office lease dated June 25, 2003 by and between Waters Edge Corporate Campus LLC and SafeNet, Inc.
    
    I/B/R(7)
 91
      10B
    
    
    Stock Option Plan of 1989
    
    I/B/R(8)10C
    
    
    1999 Employee Stock Option Plan
    
    I/B/R(9)10D
    
    
    1999 Stock Bonus Plan
    
    I/B/R(9)10E
    
    
    Non-Employee Director Stock Option Plan
    
    I/B/R(9)10F
    
    
    2000 Employee and Directors Stock Option Plan
    
    I/B/R(9)10G
    
    
    2001 Omnibus Stock Plan
    
    I/B/R(10)10H
    
    
    Employment Agreement with Anthony Caputo
    
    I/B/R(11)10I
    
    
    Employment Agreement with Carole D. Argo
    
    I/B/R(4)10J
    
    
    Employment Offer Letter with Shelley A. Harrison
    
    I/B/R(12)10K
    
    
    Employee Stock Purchase Plan
    
    I/B/R(13)10L
    
    
    Form of Indemnification Agreement for Directors and Officers
    
    I/B/R(7)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(14)10N
    
    
    First Amendment to Employment Agreement with Anthony Caputo
    
    I/B/R(4)10O
    
    
    Employment Agreement with Kenneth A. Mueller
    
    I/B/R(4)10P
    
    
    Lease for premises at 371 Van Ness Way, Torrence, California, dated
October 2, 1997, between Surf Management Associates and Mykotronx, Inc.
    
    I/B/R/(15)10Q
    
    
    Lease for premises at 8 Hughes, Irvine, California, between Alton Irvine
Partners, LLC and Rainbow Technologies, Inc.
    
    I/B/R/(16)10R
    
    
    Lease for premises at 50 Technology Drive, Irvine, California, dated
April 14, 2000, between The Irvine Company and Rainbow Technologies, Inc.
    
    I/B/R/(17)10S
    
    
    Lease for premises at 357 and 359 Van Ness Way, Torrenece, California,
dated May 1, 2002, between Surf Management Associates and Mykotronx, Inc.
    
    I/B/R/(18)10T
    
    
    Employment Agreement with Chris Fedde
    
    *10U
    
    
    Summary of Non-Employee Director Compensation
    
    I/B/R(19)21
    
    
    Subsidiaries of Registrant
    
    *23.1
    
    
    Consent of Ernst & Young LLP, independent registered public accounting firm
    
    *31.1
    
    
    Rule 13a-14(a)/15-d-14(a) Certification
    
    *31.2
    
    
    Rule 13a-14(a)/15-d-14(a) Certification
    
    *32.1
    
    
    Section 1350 Certification
    
    *
 92
      32.2
    
    
    Section 1350 Certification
    
    *
 
 *
    
    Filed herewith.(1)
    
    Included as an exhibit to the Registrants Current Report on Form 8-K filed on June 6, 2005 and incorporated herein by reference.(2)
    
    Included as an exhibit to the Registrants Current Report on Form 8-K filed on December 7, 2005 and incorporated herein by reference.(3)
    
    Included as an exhibit to the Registrants Quarterly Report on Form 10-Q for the quarter ended June 30, 2002 filed on August 14, 2002 and incorporated herein by reference.(4)
    
    Included as an exhibit to the Registrants Quarterly Report on Form 10Q for the quarter ended September 30, 2004 filed on November 9, 2004 and incorporated herein by
reference(5)
    
    Included as an exhibit to the Registration Statement on Form S-18 (File No. 33-28673) of the Registrant and incorporated herein by reference.(6)
    
    Included as an exhibit to the Registrants Current Report on Form 8-K filed on December 15, 2005 and incorporated herein by reference.(7)
    
    Included as an exhibit to the Registrants Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 filed on July 31, 2003 and incorporated herein by reference.(8)
    
    Included as an exhibit to the Registration Statement on Form S-1 (File No. 33-52066) of the Registrant and incorporated herein by reference.(9)
    
    Included as an attachment to the Registrants Definitive Proxy Statement on Schedule 14A filed on April 30, 1999 and incorporated herein by reference.(10)
    
    Included as an exhibit to the Registrants Current Report on Form 8-K filed on July 29, 2005 and incorporated herein by reference.(11)
    
    Included as an exhibit to the Registrants Quarterly Report on Form 10-Q for the quarter ended September 30, 2002 filed on November 7, 2002 and incorporated herein by
reference.(12)
    
    Included as an exhibit to the Registration Statement on Form S-3 (File No. 333-106084) of the Registrant filed on July 9, 2003 and incorporated herein by reference.(13)
    
    Included as an attachment to the Registrants Definitive Proxy Statement on Schedule 14A filed on June 4, 2002 and incorporated herein by reference.(14)
    
    Included as an exhibit to the Quarterly Report on Form 10-Q of Cylink Corporation (File No. 0-27742) for the quarter ended September 29, 2002 filed on November 13, 2002
and incorporated herein by reference.(15)
    
    Included as an exhibit to the Annual Report on Form 10-K of Rainbow Technologies, Inc. (File No. 0-16641) for the fiscal year ended December 31, 1999 filed on March 30,
2000 and incorporated herein by reference.(16)
    
    Included as an exhibit to the Annual Report on Form 10-K of Rainbow Technologies, Inc. (File No. 0-16641) for the fiscal year ended December 31, 2000 filed on April 2,
2001 and incorporated herein by reference. 93
      (17)
    
    Included as an exhibit to the Quarterly Report on Form 10-Q of Rainbow Technologies, Inc. (File No. 0-16641) for the quarter ended September 30, 2002 filed on November
12, 2002 and incorporated herein by reference.(18)
    
    Included as an exhibit to the Annual Report on Form 10-K of Rainbow Technologies, Inc. (File No. 0-16641) for the fiscal year ended December 31, 2002 filed on March 28,
2003 and incorporated herein by reference.(19)
    
    Included under the section titled Compensation of Directors in the Registrants Definitive Proxy Statement on Schedule 14A filed on July 6, 2005 and incorporated herein
by reference. 94
      SIGNATURES
  SAFENET, INC.
 By:
    
    /s/ Anthony A. CaputoAnthony A. CaputoChairman and Chief Executive OfficerDate: March 15, 2006
  Signature
    
    Title
    
    Date/s/ Anthony A. Caputo
    
    Chairman and Chief Executive Officer
    
    March 15, 2005Anthony A. CaputoSenior Vice President and Chief Financial Officer/s/ Kenneth A. Mueller
    
    (Principal Financial and Accounting
    
    March 15, 2006Kenneth A. Mueller
    
    Officer)/s/ Thomas A. Brooks
    
    Director
    
    March 15, 2006Thomas A. Brooks/s/ Shelley A. Harrison
    
    Director
    
    March 15, 2006Shelley A. Harrison/s/ Ira A. Hunt, Jr.
    
    Director
    
    March 15, 2006Ira A. Hunt, Jr./s/ Bruce R. Thaw
    
    Director
    
    March 15, 2006Bruce R. Thaw/s/ Andrew E. Clark
    
    Director
    
    March 15, 2006Andrew E. Clark/s/ Walter W. Straub
    
    Director
    
    March 15, 2006Walter W. Straub/s/ Arthur L. Money
    
    Director
    
    March 15, 2006Arthur L. Money
 95