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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, 2003 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
    
    (IRS Employerincorporation or organization)
    
    Identification No.)4690 Millennium DriveBelcamp, Maryland
    
    21017(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code: (410) 931-7500 Securities registered under Section 12 (b) of the Exchange Act: NONE Securities registered under Section 12 (g) of the Exchange Act: Name of eachTitle of each class
    
    exchange on which registeredCommon Stock, $.01 par value
    
    NASDAQ National Market
 Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes þ No o Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. o Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Rule 12b-2). Yes þ No o 1




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The aggregate market value of the Common Stock issued and outstanding and
held by non-affiliates of the Registrant, based upon the closing price for the
Common Stock on the NASDAQ National Market on June 30, 2003 was approximately
$289,000,000. All executive officers and directors of the registrant have been
deemed, solely for the purpose of this calculation, to be affiliates of the
registrant. This determination of the affiliate status is not necessarily
conclusive. The number of shares of the registrants Common Stock outstanding as of
March 5, 2004 was 13,423,645. DOCUMENTS INCORPORATED BY REFERENCE Part III incorporates information by reference from the registrants proxy
statement for the Annual Meeting of Stockholders, which proxy statement in
definitive form will be filed no later than 120 days after the close of the
registrants fiscal year ended December 31, 2003.    2




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INFORMATION REGARDING FORWARD-LOOKING STATEMENTS Certain statements in this Annual Report on Form 10-K, the exhibits hereto
and the information incorporated by reference herein are considered
forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended. These statements involve known and unknown risks,
uncertainties and other factors that may cause our or our industrys actual
results, levels of activity, performance or achievements to be materially
different from any future results, levels of activity, performance or
achievements expressed or implied by such forward-looking statements. These
risks, uncertainties and other factors include, among others, the risk factors
discussed in this Annual Report on Form 10-K. As a general matter, you can
identify forward-looking statements by terminology such as may, will,
should, expect, plan, anticipate, believe, estimate, predict,
potential, continue or the negative of such terms or other comparable
terminology. We expressly disclaim any obligation or undertaking to publicly
release any revisions to forward looking statements to reflect events or
circumstances after the date that this report is filed with the Securities and
Exchange Commission or to reflect the occurrence of anticipated events. 
 PART I. 
 ITEM 1. BUSINESS Overview We develop, market, sell and support a portfolio of hardware and software
network security products and services that enable secure communications and
data services. Our products and services are used to create secure wide area
networks (WANs) and virtual private networks over the Internet (VPNs) to
prevent security breaches that could result in unauthorized access to
confidential data, invasion of privacy and financial loss. Our security
solutions allow our customers to lower the cost of deploying and managing
secure, reliable private networks and enable the use of the Internet for secure
business communications and transactions with customers, suppliers and
employees. Our products and services address a wide range of customer and market
needs. Through our Enterprise Security Division, we sell high-performance
security solutions to address the needs of our government, financial
institutions and other security-sensitive commercial customers. We also
provide, through our Embedded Security Division, a broad range of security
products, including silicon chips, accelerator cards, licensed intellectual
property and software products, to original equipment manufacturers (OEMs) that
embed them into their own network and wireless products. We believe that our
relationships with both enterprises and OEMs allow us to provide security
products to a broad spectrum of end-users. Our products are based on industry standard encryption algorithms and
communication protocols that allow for integration into large networks and
interoperability with other network devices and applications. Our solutions
incorporate our security technologies, including our silicon chips, appliances,
client software and management software, to provide a vertically integrated
solution that addresses the stringent security needs of our customers. Our
products enable our customers to expand their existing WANs efficiently and to
integrate these networks with lower-cost VPNs. Our security products are
centrally managed with our management software, which enables policy management
and the secure, scalable monitoring of network devices, applications, network
traffic and security events. We are currently engaged in VPN product
development for the National Security Agency, which is the U.S. government
agency responsible for coordinating, directing and performing highly
specialized activities to protect U.S. information systems. Founded in 1983, we are headquartered in Belcamp, Maryland. We have a
long history of technology and security innovation and dedication to continuous
product improvement. In 1995, we developed our first Internet VPN solution for
a major financial institution. Through business relationships with end-user
customers, such as the U.S. Department of Defense, the Internal Revenue
Service, the U.S. Department of Homeland Security,  Citigroup, and various
OEMs, such 3




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as Cisco Systems and Texas Instruments, we have considerable experience
developing and deploying network security solutions. On November 18, 2003 we completed the acquisition of the OEM Products
Group of SSH Communications Security Corp (SSH), a company based in Finland.
The business acquired includes SSHs VPN client software and security and
networking toolkits. On October 22, 2003, we entered into an agreement to acquire Rainbow
Technologies, Inc., a provider of information security solutions for
mission-critical data and applications used in business, organization and
government computing environments, in a stock for stock transaction.
Consummation of the transaction is subject to customary closing conditions,
including the approval of Rainbows stockholders and our stockholders and
regulatory approvals. The Company expects the merger, if consummated, to close
during the first quarter of 2004. If this merger is consummated, it will have
a significant impact on our business operations going forward. In February 2003, we acquired the assets of Raqia Networks, Inc., a
development stage company, consisting primarily of technology-related
intangible assets. In February 2003, we also acquired Cylink Corporation, which expanded our
customer base and our product offerings to include security solutions for WANs,
such as our ATM, Frame and Link encryptor products. Operations of Cylink were
integrated into the Enterprise Security Division. Industry Background Enterprises increasingly require secure and reliable networks to conduct
electronic commerce, collaborate with customers and provide remote access for
employees. The pervasive use of WANs and the Internet is substantially
increasing the volume of electronic communications and transactions and the
demand for network security products and services. Today, large networks contain numerous points of vulnerability, which can
make passwords, network architecture and other critical information vulnerable
to attack. Communications may pass through dozens of countries, over
satellites, through numerous operating systems in computers and routers, and
through a variety of organizations or communications providers and their
premises. Consequently, multiple parties have access, or can acquire access,
to proprietary data within these networks. Because of this exposure,
enterprises must have access to secure paths of communication. Secure electronic communications and transactions have traditionally
required costly private networks and dedicated leased lines. Over time,
enterprises have invested heavily in WANs (ATM, frame relay and link) to
conduct secure communications and transactions, resulting in a significant
installed base of these networks. However, there are several limitations that
exist with traditional leased-line WANs. Their proprietary, fixed nature
results in significant costs and reduced flexibility and scalability. The need
for dedicated leased lines and excess capacity to meet peak load requirements
results in networks that are significantly more expensive to maintain and
administer. Additionally, providing network access is made difficult and
expensive by the need to add another dedicated leased-line for each new
location, partner and employee that needs to be connected to the network. In
the future, we expect that most networks will utilize both WANs and the
Internet, but will increasingly depend on the Internet as they expand to
support a much larger number of users. As a result, these enterprises will
require solutions that seamlessly manage both types of network technologies. The adoption of VPNs and, more recently, the Internet Protocol Security
(IPSec), a widely used industry protocol to enable secure transmissions over
the Internet, has enabled the secure transfer of information and data over the
Internet. A VPN is a communications system using encryption technology that
creates a private tunnel through the Internet and other communications
systems, assuring authentication of users and privacy of information.
Increased availability of VPN services has allowed a secure alternative to
traditional WANs. VPNs allow organizations to use 4




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public networks for their communications backbone. Because the Internet is
less expensive to use than private networks, enterprises can generally achieve
substantial cost savings by using VPNs while taking advantage of the global
availability and access to the Internet. VPNs have three key uses:  
    
    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. Some network security products emphasize one or more forms of security
technology other than VPNs, such as firewalls, intrusion detection and
anti-virus. Firewalls use filtering technology to control external access to
an enterprise network. Intrusion detection, or intrusion prevention, is
intended to alert network operators of attempts to penetrate customers
networks. Similarly, anti-virus products address the prevalence of virus
attacks that proliferate through the Internet, and migrate into private
networks through their users computers. We believe that encryption and
authentication should be the first line of defense in the networks security
strategy, with firewalls, intrusion detection and anti-virus solutions
providing additional defense for communications received from remaining,
unsecured sources. We further believe that encryption, by protecting the
privacy of the information, ensuring the integrity of the data and
authenticating the source and destination of the communication, is the
foundation technology upon which a secure network can be built. The SafeNet Solution We develop, market, sell and support a portfolio of hardware and software
network security products and services that provide secure communications and
data services over WANs and the Internet. Our products and services address a
wide range of customer and market needs. Through our Enterprise Security
Division, we sell high-performance security solutions to address the high-level
security needs of our government, financial institution and other
security-sensitive commercial customers. By providing a solution that
incorporates our security technologies, including our silicon chips,
appliances, client software and management software, we are able to provide a
vertically integrated solution that addresses the stringent security needs of
these customers. We also provide, through our Embedded Security Division, a
broad range of security solutions, including silicon chips, accelerator cards,
licensed intellectual property and software products, to OEMs that embed them
into their own network and wireless products. Our enterprise solutions have the following benefits:  
    
    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 institution and other commercial customers. We currently are
engaged in product development for the National Security Agency, which
includes products that protect classified defense information. We have
also 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 5




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security requirements of critical infrastructure, such as banks and
utilities, as required by the Department of Homeland Security.
    
    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.
    
    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.Our embedded solutions, in addition to some of the benefits discussed
above, have the following benefits:
    
    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 Our objective is to be the leading provider of products and services that
enable secure communications and data services over WANs and the Internet. To
achieve this objective, we continue to pursue the following strategies:  
    
    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 2004. For example in 2003, we
introduced a content inspection chip and expect to introduce other
content inspection products designed for intrusion detection and
prevention, application firewalls and anti-virus protection. 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 institution and
other commercial enterprises. The strategic 6




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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 acquisition of Cylink will continue to provide us with an opportunity
to sell new products and services into the larger combined customer base,
including selling our VPN solutions to customers with WAN-based
technology.
    
    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 and software products. We currently have OEM
relationships with major companies, such as Cisco Systems, Texas
Instruments, ARM, Advanced Micro Devices and Samsung. We offer
comprehensive training and marketing programs to support our OEMs. We
intend to further develop our relationships with system integrators for
the government sector and value added resellers for international
markets.
    
    Target the Government and Financial Institution Markets.We
continue to target government agencies and financial institutions.
We believe these markets represent, over the long-term, a significant
growth opportunity for sales of high-end network security products.
Governmental agencies as well as financial institutions have
increasingly focused on enhancing the security of their networks,
especially after the September 11, 2001 terrorist attacks. We intend
to expand our position in these markets and leverage this position to
target new high growth market opportunities as they arise.
    
    Target the Wireless Market.We have recently targeted the
wireless communications market. We are currently in the process of
developing additional security technology that will address the
growing need for secure wireless communication. For example, Texas
Instruments has licensed our encryption technology for use in their
next generation of chips for wireless products.
    
    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 Our Enterprise products and services are typically sold to government
agencies, financial institutions and other commercial customers. Our Embedded
products are typically sold to OEM customers as components, such as silicon
chips, accelerator cards, licensed intellectual property and software. Enterprise Solutions SafeEnterpriseSecurity System.In 2003, we introduced our
SafeEnterprise Security System, which provides security solutions for
government and financial institutions that require a high level of security to
protect their networks from unauthorized access and to protect sensitive
information as it travels over both WANs and the Internet. This solution,
which includes both appliances and software that can be sold as an integrated
turnkey solution or separately as discreet hardware and software products,
consists of network gateways, backbone encryptors, remote access, client
software and our management software. The SafeEnterprise system provides
management functionality, including policy creation, policy enforcement,
network monitoring, activity auditing 7




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and troubleshooting. SafeEnterprise provides a secure solution for both WANs
(ATM, frame relay and link) and the Internet. Appliances.The SafeEnterprise Security System includes HighAssurance
Gateways that employ the U.S. government endorsed Triple Data Encryption
Standard (3DES) and Data Encryption Standard (DES) algorithms and Advanced
Encryption Standard (AES) algorithms. In addition, the SafeEnterprise
Security System also includes ATM, Frame and Link Encryptors that employ 3DES
and DES algorithms.  
    
    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: Product
    
    IPSec Throughput
    
    IPSec Tunnels(1)HighAssurance 500 Gateway
    
    1.5 Mbps
    
    
    500HighAssurance 1000 Gateway
    
    10 Mbps
    
    
    1,000HighAssurance 2000 Gateway
    
    100 Mbps
    
    
    10,000HighAssurance 4000 Gateway
    
    1 Gbps
    
    
    1,024
  (1)
    
    A tunnel is an encrypted link between two devices.  
    
    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. In 2003, we entered into an exclusive marketing and sales agreement with
CTAM PTY Ltd., an Australian company, under which we have acquired exclusive
worldwide marketing and production rights, with the exception of Australia and
New Zealand, to CTAMs encryption appliances. We began offering the CTAM
product line as part of our SafeEnterprise Security System in 2003. 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. 8




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
    
    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 federal information processing standards
(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. 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. Embedded Solutions. Hardware Solutions.We provide OEMs with the following portfolio of
silicon chips and accelerator cards:  
    
    SafeXcel:SafeXcel is our line of silicon chips
that addresses the needs of OEMs for embedded, accelerated
security. This product line includes high-performance
integrated circuits and privacy products for both IPSec and
Secured Socket Layer, or SSL, encryption. Our SafeXcel product
line includes the following series:  
    
    SafeXcel Momentum Series.The
SafeXcel Momentum Series of silicon chips is developed
for the consumer and small office/home office, or SOHO,
markets. These chips are designed for low cost
applications, such as broadband access, SOHO routers,
wireless access devices, VPN gateways and firewalls.
The Momentum Series includes the following silicon
chips with the indicated IPSec throughputs:  
    
    SafeXcel-1140, 50 Mbps; 9




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
    
    SafeXcel-1141, 135 Mbps; and
    
    SafeXcel-1741, 260 Mbps.  
    
    SafeXcel Velocity Series.The
SafeXcel Velocity Series of silicon chips is designed
for higher performing networking appliances, such as
routers, firewalls, gateways and remote access servers.
The Velocity Series includes the following silicon
chips:  
    
    SafeXcel-2010, which supports 50 Mbps of IPSec throughput; and
    
    SafeXcel-ISES, an SSL accelerator used in SSL appliances.  
    
    SafeXcel Transaction Series.The
SafeXcel Transaction Series of silicon chips is
designed for point-of-sale terminals, keyboards and
smart cards, which may be used in e-commerce, financial
and medical applications.
    
    SafeXcel Content Inspection
Series.This is our newest line of silicon chips,
targeted at content inspection applications such as
intrusion detection and prevention, application
firewalls and anti-virus protection. The first product
in this series is the SafeXcel-4850 silicon chip, which
we developed using technology acquired from Raqia. Our
Content Inspection Series enables deep packet
inspection, allowing pattern matching at all layers of
a communication protocol stack, including the
application layer, at wire speeds.  
    
    SafeXcel Cards. SafeXcel Cards are accelerator PCI
cards that provide cryptographic throughput and acceleration for
operations such as encryption, hashing, public key computations,
key negotiation, signatures and random number generation.
SafeXcel Cards include SafeXcel 140-PCI, SafeXcel 141-PCI,
SafeXcel 171-PCI and SafeXcel 241-PCT. Also available is a PCI
card based on SafeXcel-4850. EmbeddedIP.EmbeddedIP is the delivery of our technology in a form that
allows OEMs to embed security in their silicon chips, including products
designed specifically for the wireless market. EmbeddedIP is available for
license in intellectual property cores or blocks, whereby selected elements of
the VPN encryption technology can be adapted in single or multiple
implementations. This allows OEMs to incorporate selective blocks in their own
silicon chips to allow for cost-effective, high throughput, low power-consuming
designs. EmbeddedlP can be licensed in the following blocks:  
    
    Encryption Engines:
DES/3DES, AES;
    
    Hash Engines: SHA-1, MD5;
    
    Packet Engines: IPSec, SSL;
    
    Public Key Accelerators: RSA, DSA, and
Diffie-Hellman; and
    
    Entropy based True Random Number Generator
(RNG). We also license our CGX (CryptoGraphic eXtensions) Library, a library of
more than 60 cryptographic commands, which allows OEMs to deploy applications
with reduced development time. Technology Our portfolio of VPN security products is based on SecureIP Trademarked
Technology. SecureIP Technology is the intellectual property underlying the
building blocks of security applications that enable 10




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entities to securely use the Internet and other shared networks. SecureIP
Trademarked Technology is implemented in our CGX Library, a library of more
than 60 cryptographic commands, processes and interfaces that provides a
flexible and secure application that is portable across many processors and
operating systems. The CGX Library is embedded in our chips, accelerator cards
and software clients forming a seamless suite of readily embeddable products
for our OEM customers. In addition, we apply our security technologies at each
layer of the enterprise; not only the embedded technologies, but also in the
designs of the gateways and the systems resulting in integrated enterprise
security systems with high level performance. Customers and Customer Support The majority of our customers are U.S. government agencies, financial
institutions and many of the leading OEMs. Our significant end-user (Enterprise) customers include:  
    
    Government:the U.S. Department of Defense, the National Security
Agency, the U.S. Department of State, the U.S. Department of the
Treasury, including the Internal Revenue Service, and the U.S. Department
of Homeland Security including the U.S. Customs Service and Immigration
and Naturalization Service.
    
    Financial Institutions:Citigroup, UBS, JPMorgan Chase and SWIFT.Our significant OEM (Embedded) customers include:
    
    Network Infrastructure:Cisco Systems, Microsoft, WatchGuard and
NetScreen.
    
    Wireless/Semiconductor:Advanced Micro Devices, Texas
Instruments and ARM. We provide customer support through a staff of support engineers
knowledgeable in both our network security systems and products, and complex
computer networks. In addition to supporting customers, this group of
engineers performs system level quality assurance testing of new products and
product enhancements. We provide customer telephone support, including 24 hour
a day hot line support. In addition, we offer on-site training, installation
and trouble-shooting services, generally on a fee basis. We provide limited warranties on our hardware products for one year upon
delivery of the product. After warranty expiration, clients may purchase an
extended warranty support contract. This contract extends warranty service for
an additional one-year period, providing repair or replacement of defective
products and telephone support. We also offer support on a time and materials
basis. Sales and Marketing We sell our products and services primarily through direct sales
personnel dedicated to both enterprise and OEM markets and internationally
primarily through value added resellers. The unique requirements of our
customers require us to maintain specialized sales personnel. Our
Enterprise Security Division sales group, which includes a federal sales
group and a commercial sales group, specifically targets government
organizations and worldwide financial entities and utilizes federal
government systems integrators to fulfill customer purchase orders as a
contract vehicle for our federal customers. The Embedded Security Division
sales organization is responsible for pursuing and managing sales to OEMs
who embed our technology and products into their own network and wireless
products. We have sales offices in 11




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the United States, the United Kingdom, the Netherlands, Switzerland,
Finland, Singapore, Taiwan, South Korea and Japan. Our marketing department is dedicated to marketing communications,
developing sales tools and sales support programs, public relations, product
launch support, events and partner programs. Our marketing efforts focus on
building brand recognition and developing leads for our sales force. To achieve these objectives, our marketing program includes:  
    
    Direct marketing efforts through a Web marketing program 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, such as the RSA
Security Conference in San Jose, California and E-Gov conference in
Washington, DC;
    
    European brand awareness through exhibitions such as CEBIT in
Hanover, Germany and 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. Some of our network security products contain encryption algorithms that
are subject to the export restrictions administered by the Bureau of Industry
and Security, U.S. Department of Commerce. These restrictions permit the
export of encryption products based on country, algorithm and class of
end-user. They prohibit the export of encryption products to some countries
and to business entities that are not included in a range of end-users. Product Development We have assembled a team of engineers with experience in the fields of
computing, network systems design, Internet routing protocols, security
standards and software. Our engineering team has experience in developing and
delivering hardware, software, encryption and authentication technology,
accelerator cards and integrated custom silicon chips. We believe strong product development capabilities are essential to our
strategy of enhancing our core technology, developing additional product
functionality and maintaining the competitiveness of our products. Our current
initiatives include:  
    
    Developing wireless security products;
    
    Expanding our products to address the firewall, intrusion detection
and prevention and anti-virus markets through the release of a content
inspection product; and
    
    Further incorporating in our product lines high assurance security
techniques derived from joint development initiatives with U.S.
government agencies. For example, we have entered into a contract with
the Department of Defense to develop a classified level software
client. 12




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We will continue to devote resources to the latest security technology and
to meet the increasing demands of our customers and the market. Our internal
research and development expenses were $14.7 million on a historical basis for
the year ended December 31, 2003, $8.5 million for the year ended December 31,
2002 and $6.1 million on a historical basis for the year ended December 31,
2001. Backlog Orders for our products are usually placed by customers on an as-needed
basis and we typically ship products within five days to 10 weeks of receipt of
a customers firm purchase order. Our backlog consists of all orders received,
where the anticipated shipping date is typically within six months. Because of
the possibility of customer changes in delivery schedules or cancellations of
orders, our backlog as of any particular date may not be indicative of sales in
any future period. We seldom maintain long-term contracts with our customers
that require them to purchase our products. Our backlog as of December 31,
2003 was approximately $1.5 million, which we expect to realize in 2004. Contract Manufacturing We design and develop all key components of our appliances, software and
silicon chips, which are fabricated by contract foundries. Our silicon chips
are primarily manufactured by Analog Devices and Samsung. We outsource the
manufacturing of our other products primarily to a small privately-held
manufacturer. The outsourced operations include engineering prototypes,
pre-production runs, full turnkey boxbuilds and product drop shipments. We
also design, specify and monitor all the testing required to meet our internal
and external quality control guidelines. Outsourcing allows us to reduce fixed
overhead and personnel costs and provides greater flexibility to match product
and market demands. However, the unavailability of the contract manufacturers
and foundries we utilize could substantially decrease our control of the cost,
quality and timeliness of the manufacturing process. Competition The network security market is highly competitive and subject to rapid
technological changes. We expect to face increasing competitive pressures from
competitors as network security becomes more prevalent. We currently compete
against companies that have substantially greater financial resources, sales
and marketing organizations, market penetration and research and development
capabilities, as well as broader product offerings and greater market presence
and name recognition. There are also a number of other hardware and software
data encryption methods and security technologies on the market that compete
with our products. We believe that the principal competitive factors affecting the network
security market include standards compliance, product quality and reliability,
technical features, network compatibility, ease of use, client service and
support, distribution and price. Although we believe our technology and
products currently compete favorably with respect to such factors, there can be
no assurance that we can maintain our competitive position against current and
potential competitors. We face numerous competitors. Our key OEM competitive threat comes from
potential customers electing to develop internal capabilities similar to those
provided by our products rather than buying solutions from us or another
outside vendor. The key enterprise competitive threat is that customers select
vendors with greater financial, research and marketing resources. Competitors for our Enterprise Security Division include:  
    
    NetScreen, Checkpoint, Cisco Systems and Nortel Networks. 13




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Competitors for our Embedded Security Division include:  
    
    Broadcom, HiFn, Cavium and Certicom. Patents and Intellectual Property Our success and ability to compete is dependent, in part, upon our ability
to maintain the proprietary nature of our technologies. We rely on a
combination of patent, trade secret, copyright and trademark law, and
nondisclosure agreements to protect our intellectual property. We own 21
United States patents and 9 foreign patents. We have 24 additional pending
foreign and domestic patent applications. These patents cover our SafeXcel
chips, CGX Security Platform, SafeNet Dial and the AX400. We seek to protect the source codes to our computer software programs,
which are essential elements of our products, by means of copyright and trade
secrets laws. The protection of our intellectual property and information we
develop will be limited to such protection as we may be able to secure pursuant
to trade secret or copyright laws or under any confidentiality agreements into
which we may enter. We own federally registered trademarks for the SafeNet
name and for certain of our products. However, we cannot make assurances as to
the validity, enforceability or lack of infringement of these trademarks. At present, we have confidentiality agreements with our officers,
directors and employees. There can be no assurance that the scope of any such
protection we are able to secure will be adequate to protect our intellectual
property or that we will have the financial resources to engage in litigation
against parties who may infringe such intellectual property. In addition, we
cannot assure that others will not develop similar technology independent of
us. We believe that our products do not infringe the proprietary rights of
third parties. There can be no assurance, however, that third parties will not
assert infringement claims in the future. Employees As of December 31, 2003, we had 238 employees, of whom 16 are engaged in
production and quality control, 28 in administration and financial control, 128
in engineering, development, and client support, and 66 in sales and marketing.
We employ 175 employees in the United States and 63 employees internationally. 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. We have experienced substantial net losses, as reported in accordance with
generally accepted accounting principles in the United States (GAAP), in four
of the last five years, including 2002 and 2003. As of December 31, 2003, we
had an accumulated deficit of $26.3 million. We intend to maintain or increase
our expenditures in all areas in order to execute our business plan. As a
result, we may continue to incur substantial net losses in the future. The
likelihood of our success must be considered in light of the problems, expenses
and delays frequently encountered in connection with new technologies, the
design and manufacture of information technology security solutions, and the
competitive environment in which we operate. You should not consider our
historical results and recent growth as being indicative of future revenue
levels or operating results. We can neither give assurance that we will
operate profitably in the future nor that profitability will be sustained if it
is achieved. 14




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We may not be able to successfully integrate companies we acquire in the
future. There has been substantial consolidation in the security industry, and we
expect this consolidation to continue in the near future. As a result of this
consolidation, we expect to increasingly compete against larger competitors
with broader product offerings and greater resources, including software
vendors, network providers and manufacturers of networking and computer
equipment and communications devices. In order to remain competitive, we may
from time to time pursue acquisitions of businesses that complement or expand
our existing business, including acquisitions that could be material in size
and scope. Any future acquisitions will involve various risks, including:  
    
    difficulties in integrating the operations, technologies
and products of the acquired company, which can be particularly
challenging when dealing with complex security technologies;
    
    the risk of diverting managements attention from normal
daily operations of the business;
    
    risks of entering markets in which we have no or limited
direct prior experience and where competitors in such markets have
stronger market positions;
    
    insufficient revenues to offset increased expenses associated with the acquisition; and
    
    the potential loss of key employees of the acquired company. We cannot assure you that our acquisitions will be successful and will not
materially adversely affect our business, operating results, or financial
condition. We must also manage any growth resulting from such acquisitions
effectively. Failure to manage growth effectively and successfully integrate
the acquired companys operations could have a material adverse effect on our
business and operating results. Our quarterly operating results may fluctuate and our future revenues and
profitability are uncertain. We have experienced significant fluctuations in our quarterly operating
results during the last five years and anticipate continued substantial
fluctuations in our future operating results. A number of factors have
contributed to these quarterly fluctuations including:  
    
    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 generate royalties;
    
    competitive conditions in the highly competitive and
increasingly consolidated security industry; and 15




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
    
    changes in general economic conditions; and
    
    shortfall of revenues in relation to expectations that
formed the basis for the calculation of fixed expenses. It is likely that our operating results will fall below our expectations
and the expectations of securities analysts or investors in some future quarter
and the market price of our common stock could be materially adversely
affected. The loss of significant customers could have a material adverse effect on our
business and results of operations. We were dependent on 12 customers for a majority of our consolidated
revenues for the year ended December 31, 2003. We have one enterprise
customer, SAIC, that accounted for 12% of our consolidated revenues for 2003.
We have one OEM customer, Cisco Systems, that accounted for 13% of our revenues
for 2003. In 2002, Cisco Systems announced the selection of a different vendor
for some of its next generation chip technology, which began to impact our
revenues in the second quarter of 2003. While Cisco Systems continues to be a
major revenue source for us, it is not under any obligation to continue to
purchase products and services from us. If our sales to this customer or to
our other significant customers decline, our business, financial condition and
results of operations could suffer. In addition, contracts with or for
governmental entities accounted for approximately 5% of our consolidated
revenues for 2003, and we expect this percentage to increase for 2004. Any
loss of governmental customers could have a material adverse effect on our
business and prospects. In addition, we regularly license some of our products
to customers who compete with us in other product categories. This potential
conflict may deter existing and potential future customers from purchasing or
licensing some of our products. Our industry is highly competitive and becoming increasingly consolidated,
which may result in our losing customers and declining revenue. Our industry is relatively new, highly competitive and subject to rapid
technological changes. Our future financial performance will depend, in large
part, on our ability to establish and maintain an advantageous market position
in the increasingly consolidated security industry. We currently compete with
companies that have substantially greater financial resources, sales and
marketing organizations, market penetration and research and development
capabilities, as well as broader product offerings and greater market presence
and name recognition. For example, current competitors of our Enterprise
Security Division include NetScreen, Checkpoint, Cisco Systems and Nortel
Networks. Current competitors of our Embedded Security Division include
Broadcom, HiFn, Cavium and Certicom. The competitive risk will increase to the extent that competitors begin to
include software vendors, network providers, and manufacturers of networking
and computer equipment and communications devices who may be in a better
position to develop security products in anticipation of developments in their
products and networks. Competitive factors in the network security industry
include:  
    
    standards compliance;
    
    product quality and reliability;
    
    technical features;
    
    network compatibility;
    
    product ease of use;
    
    client service and support; 16




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
    
    distribution; and
    
    price. We may not be able to protect our proprietary technologies. Our success and ability to compete is dependent, in part, upon our ability
to maintain the proprietary nature of our technologies. We rely on a
combination of patent, trade secret, copyright and trademark law and
nondisclosure agreements to protect our intellectual property. We own 30
United States and foreign patents and have additional pending foreign and
domestic patent applications. Our patents and patent applications protect
various aspects of our network security technology and have expiration dates
ranging from 2007 to 2018. Although we hold several patents and have several
pending patent applications that cover aspects of our technology, these patents
and patent applications do not protect some of our security products and
services. In addition, patents may not issue under our current and future
patent applications. Confidentiality, other non-disclosure agreements and other methods on
which we rely to protect our trade secrets, proprietary information and rights
may not be adequate to protect such proprietary rights. Litigation to defend
and enforce our intellectual property rights could result in substantial costs
and diversion of resources and could have a material adverse effect on our
financial condition and results of operations regardless of the final outcome
of such litigation. Despite our efforts to safeguard and maintain our
intellectual property, we may not be successful in doing so or the steps taken
by us in this regard may not be adequate to deter misappropriation of our
technology or prevent an unauthorized third party from copying or otherwise
obtaining and using our products, technology or other information that we
regard as proprietary. Our trade secrets or non-disclosure agreements may not
provide meaningful protection of our proprietary information. In addition,
others may independently develop similar technologies or duplicate any
technology developed by us. We may also be subject to additional risks as we
enter into transactions in countries where intellectual property laws are not
well developed or are poorly enforced. Legal protections of our rights may be
ineffective in such countries, and technology developed in such countries may
not be protected in jurisdictions where protection is ordinarily available.
Our inability to protect our intellectual property would have a material
adverse effect on our results of operations and financial condition. Due to the nature of the network security market 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. The network security products we sell are complex by nature and
incorporate a variety of technologies and methods. The use of these
technologies and methods increases the risk that third parties may challenge
the patents issued or licensed to us and the risk that third parties may claim
our products infringe that third partys intellectual property rights. We may
not be able to successfully challenge these infringement claims or defend the
validity of our patents and could have to pay substantial damages, possibly
including treble damages, for past infringement if it is ultimately determined
that our products infringe a third partys patents. Further, we may be
prohibited from selling our products before we obtain a license, which, if
available at all, may require us to pay substantial royalties. Even if
infringement claims against us are without merit, or if we challenge the
validity of issued patents, lawsuits take significant time, may be expensive
and may divert management attention from other business concerns. We may not be able to maintain effective product distribution channels, which
could result in decreased revenue. We rely on both our direct sales force and an indirect channel
distribution strategy for the sale and marketing of our products. Our sales
and marketing organization may be unable to successfully compete 17




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against more extensive and well-funded sales and marketing operations of
certain of our competitors. Additionally, we may be unable to attract
integrators and resellers that can market our legacy products effectively and
provide timely and cost-effective customer support and service. Further, our
distributors, integrators and resellers may carry competing lines of products.
The loss of important sales personnel, distributors, integrators or resellers
could adversely affect us. Delays in product development could adversely affect market acceptance of our
products. We may experience schedule overruns in product development triggered by
factors such as insufficient staffing or the unavailability of
development-related software, hardware or technologies. Further, when
developing new network security products, our development schedules may be
altered as a result of the discovery of software bugs, performance problems or
changes to the product specification in response to customer requirements,
technology market developments or self-initiated changes. All of these factors
can cause a product to enter the market behind schedule, which may adversely
affect market acceptance of the product or place it at a disadvantage to a
competitors product that has already gained market share or market acceptance
during the delay. 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. The sale and installation of our systems and products and the operation of
our facility entails a risk of product failure, product liability or other
claims. An actual or perceived breach of network or data security, regardless
of whether such breach is attributable to our products or services, could
adversely affect our reputation and financial condition or results of
operations. The complex nature of our products and services can make the
detection of errors or failures difficult during the development process. If
errors or failures are subsequently discovered, this may result in delays and
lost revenues during the correction process. In addition, a malfunction or the
inadequate design of our products could result in product liability claims. We attempt to reduce the risk of such losses through warranty disclaimers
and liability limitation clauses. However, we may not have obtained adequate
contractual protection in all instances or where otherwise required under
agreements we have entered into with others. We currently maintain product liability insurance. However, our insurance
coverage may not be adequate and any product liability claim for damages
resulting from security breaches could be substantial. In the event of product
liability litigation, insufficient insurance coverage could have a material
adverse effect on our results of operations and financial condition. Further,
some of our customers and future customers may require minimum product
liability insurance coverage as a condition to purchasing our products.
Failure to satisfy these insurance requirements could impede our ability to
sell products and services to these customers, which could have a material
adverse effect on our financial condition and results of operations. We cannot
assure you that that insurance will be available to us at a reasonable cost or
will be sufficient to cover all possible liabilities. We rely on single or limited sources for the manufacture and supply of our
products. We rely upon a single or a limited number of sources for the manufacture
and supply of our products. Our silicon chips are primarily manufactured by
Analog Devices and Samsung. We outsource the manufacturing of our other
products primarily to a small, privately-held manufacturer. Because we depend
on third party manufacturers and suppliers, we do not directly control product
delivery schedules or product quality. We place orders on a purchase order
basis and do not have long-term volume purchase agreements with any of our
manufacturers or suppliers. As a result, our manufacturers and suppliers may
allocate production capacity to other products while reducing deliveries to our
customers on short notice. In addition, we cannot assure you that we will be
able to maintain satisfactory contractual relations with our manufacturers and
suppliers. A significant delay in delivering products to our customers,
whether from unforeseen events such as natural disasters or otherwise, could
have a material adverse effect on our results of operations and 18




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financial condition. If we lose any of our manufacturers or suppliers, we
expect that it would take from three to six months for a new manufacturer or
supplier to begin full-scale production of one of our products. The delay and
expense associated with qualifying a new manufacturer or supplier and
commencing production could result in a material loss of revenue and reduced
operating margins and harm our relationships with customers. While we have not
experienced any significant supply problems or problems with the quality of the
manufacturing process of our suppliers and there have been no materially late
deliveries of components or parts, it is possible that in the future we may
encounter problems in the manufacturing process or shortages in parts,
components, or other elements vital to the manufacture, production and sale of
our products. We rely on key technical and management employees and if such employees become
unavailable, our business could be adversely affected. The network security industry is highly specialized and the competition
for qualified employees is intense. We expect this to remain so for the
foreseeable future. We believe our success depends upon a number of key
employees, such as our Chairman, Chief Executive Officer and President and key
technical personnel, and upon our ability to retain and hire additional key
personnel. Several members of our management team have joined us in the last
12 months. It may be difficult for us to integrate these new employees into
our existing management team. Further additions of new employees and
departures of existing employees, particularly in key positions, can be
disruptive and can result in further departures of our personnel. The loss of
the services of key personnel or the inability to attract additional qualified
personnel could materially and adversely affect our results of operations and
product development efforts. We may be unable to achieve our revenue and
operating performance objectives unless we can attract and retain technically
qualified and highly skilled engineers, sales, technical, marketing, and
management personnel. In 2001, we entered into a five-year employment agreement with Anthony A.
Caputo, our Chairman, Chief Executive Officer and President. However, we have
not historically entered into employment agreements with our other employees.
This may adversely impact our ability to attract and retain the necessary
technical, management and other key personnel to successfully run our business. Our recent growth has required us to improve our internal systems and may
require substantial management efforts. We have experienced a period of recent growth and expansion. To
accommodate this growth, we are implementing a variety of new and upgraded
operational and financial systems, procedures and controls, including the
improvement of our accounting and other internal management systems.
Implementation of these new systems, procedures and controls may require
substantial management effort, and our efforts to do so may not be successful.
If we fail to improve our operational, financial and management information
systems, or to hire, train, motivate or manage our employees, our business
condition and results of operations could suffer. In addition, the merger with Rainbow Technologies, if consummated, will
result in a significant growth and expansion of our business. During the
integration process, we will identify changes that may be required in our
operational and financial systems, procedures and controls as a result of this
transaction. If we fail to respond to this growth and expansion effectively,
our business and results of operations could suffer. 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. The network security industry is characterized by rapid changes, including
evolving industry standards, frequent introduction of new products and
services, continuing advances in technology and changes in customer
requirements and preferences. We expect technological developments to continue
at a rapid pace in our industry. Accordingly, we cannot assure you that 19




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technological changes implemented by competitors, developers of operating or
networking systems or persons seeking to breach network security will not cause
our technology to be rendered obsolete or non-competitive. Technology changes,
software bugs, performance problems or customer requirements may also cause the
development cycle for our new products to be significantly longer than our
historical product development cycle, resulting in higher development costs or
a loss in market share. Failure to develop and introduce new products and services and improve
current products and services in a timely fashion could adversely affect us.
Because of the complexity of our products and services or shortages of
development personnel, we have from time to time experienced delays in
introducing new and enhanced products and services. In May 2003, we introduced
a number of new products for the VPN and WAN markets, and to date we have made
only limited commercial shipments of these products. These products may
require additional development work, enhancement and testing to achieve
commercial success. If these or other new or recently introduced products have
performance, reliability, quality or other shortcomings, such products could
fail to achieve adequate market acceptance. The failure of our new or existing
products to achieve or enjoy market acceptance, whether for these or other
reasons, could cause us to experience reduced orders, which in each case could
have a material adverse effect on our business, financial condition and results
of operations Prolonged economic weakness in the Internet infrastructure, network security
and related markets may decrease our revenues and margins. The market for our products and services depends on economic conditions
affecting the broader Internet infrastructure, network security and related
markets. Prolonged weakness in these markets has caused in the past and may
cause in the future enterprises and carriers to delay or cancel security
projects, reduce their overall or security-specific information technology
budgets or reduce or cancel orders for our products. In this environment, our
customers may experience financial difficulty, cease operations and fail to
budget or reduce budgets for the purchase of our products and services. This,
in turn, may lead to longer sales cycles, delays in purchase decisions, payment
and collection, and may also result in price pressures, causing us to realize
lower revenues and operating margins. In addition, general economic
uncertainty caused by potential hostilities involving the United States,
terrorist activities and the general decline in capital spending in the
information technology sector make it difficult to predict changes in the
network security requirements of our customers and the markets we serve. We
believe that, in light of these events, some businesses may curtail or
eliminate capital spending on information technology. These factors may cause
our revenues and operating margins to decline. 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. Our products are designed to interface with our end-users existing
networks, each of which has different specifications and utilizes multiple
protocol standards. Many of our end-users networks contain multiple
generations of products that have been added over time as these networks have
grown and evolved. Our products and services must interoperate with all of the
products and services within these networks as well as with future products and
services that might be added to these networks to meet our end-users
requirements. If we find errors in the existing software used in our
end-users networks, we may elect to modify our software to fix or overcome
these errors so that our products will interoperate with their existing
software and hardware. If our products do not interoperate with those within
our end-users networks, customer installations could be delayed or orders for
our products could be cancelled, which could significantly reduce our revenues. A decrease of average selling prices for our products and services could
adversely affect our business. 20




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The average selling prices for our products and services may decline due
to product introductions by our competitors, price pressures from significant
customers and other factors. The market for our embedded products is dominated
by a few large OEM vendors, who have considerable pricing power over our
company. In addition, with the general economic slowdown and decrease of
information technology capital spending budgets, our customers often seek the
lowest price for their security needs. To sell our products and services at
higher prices, we must continue to develop and introduce new products and
services that incorporate new technologies or high-performance features. If we
experience pricing pressures or fail to develop new products, our revenues and
gross margins could decline, which could harm our business, financial condition
and results of operations. We face risks associated with our international business activities. International sales accounted for approximately 13% of our consolidated
revenues for the year ended December 31, 2003. International sales are subject
to risks related to imposition of governmental controls, export license
requirements, restrictions on the export of critical technology, general
economic conditions, fluctuations in currency values, translation of foreign
currencies into U.S. dollars, foreign currency exchange controls, tariffs,
quotas, trade barriers and other restrictions, compliance with applicable
foreign laws and other economic and political uncertainties. Some of our network security products contain encryption algorithms that
are subject to the export restrictions administered by the Bureau of Industry
and Security, U.S. Department of Commerce. These restrictions permit the
export of encryption products based on country, algorithm and class of
end-user. They prohibit the export of encryption products to some countries
and to business entities that are not included in a range of end-users. These
restrictions may provide a competitive advantage to foreign competitors facing
less stringent controls on their products and services. In addition, the list
of countries, products and users for which export approval is required, and
regulatory policies with respect thereto, could become more restrictive, and
laws limiting the domestic use of encryption could be enacted. Our foreign
distributors may also be required to secure licenses or formal permission
before encryption products can be imported. A breach of network security could harm public perception of our products and
services, which could cause us to lose revenue. If an actual or perceived breach of network security occurs in one of our
end-users network systems, regardless of whether the breach is attributable to
our products or services, the market perception of the effectiveness of our
products and services could be harmed. Because the techniques used by computer
hackers to access or sabotage networks change frequently and generally are not
recognized until launched against a target, we may be unable to anticipate
these techniques. Failure to anticipate new techniques or otherwise prevent
breaches of network security could cause us to lose current and potential
customers and revenues. RISKS RELATED TO OUR COMMON STOCK Our stock price has been volatile. Market prices for our common stock and the securities of other network
security companies have been volatile. For example, the reported sale price of
our common stock was as low as $15.60 and as high as $32.48 in the first
quarter of 2003, as low as $19.42 and as high as $31.75 in the second quarter
of 2003, as low as $27.42 and as high as $40.43 in the third quarter of 2003
and as low as $29.75 and as high as $44.50 in the fourth quarter of 2003.
Also, after the announcement of the merger with Rainbow Technologies, the price
of our common stock dropped from a closing price of $41.02 per share on October
22, 2003 to a closing price of $30.07 per share by October 24, 2003, a decline
of over 26%, before recovering to a closing price of $38.62 per share on March
5, 2004. Factors such as announcements of 21




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technological innovations or new products by us or our competitors and market
conditions for network security company and other technology stocks in general
can have a significant impact on the market for our common stock, which could
reduce our stock price regardless of our operating performance. We
periodically consider acquisitions of companies and capital-raising
transactions, which events may also affect the market price for our common
stock regardless of our operating performance. Anti-takeover provisions in our charter documents and Delaware law could
prevent or delay a change in control. Our certificate of incorporation may discourage, delay or prevent a merger
or acquisition that a stockholder may consider favorable by authorizing the
issuance of blank check preferred stock. In addition, the provisions of the
Delaware General Corporation Law restricting business combinations between a
corporation and an owner of 15% or more of the outstanding voting stock of the
corporation for a three-year period may discourage, delay or prevent a third
party from acquiring or merging with us, even if such action were beneficial to
some, or even a majority, of our stockholders. We have not paid dividends and do not intend to pay dividends in the
foreseeable future. We have never paid nor declared any cash or other dividends on our common
stock since our inception and we do not presently anticipate that dividends
will be paid on our common stock in the foreseeable future. Because of the
highly competitive and increasingly consolidated network security industry, we
need to retain resources in order to fund the continued growth of our business. RISKS RELATED TO THE MERGER WITH RAINBOW TECHNOLOGIES, INC. If SafeNet and Rainbow Technologies are not successful in integrating their
organizations, the anticipated benefits of the merger may not be realized. Achieving the anticipated benefits of the merger will depend in part on
the integration of technology, operations and personnel of SafeNet and Rainbow
Technologies. The integration of companies is a complex, time-consuming and
expensive process that, without proper planning and implementation, could
significantly disrupt our business and the business of Rainbow Technologies.
In addition, as of October 22, 2003, Rainbow had approximately 570 employees
while we had approximately 213 employees. The management and administration of
the combined company will be conducted primarily by our current personnel, who
are currently managing a business much smaller than the combined company. We
cannot assure you that the integration will be successful, that the anticipated
benefits of the merger will be fully realized, that there will not be
substantial costs associated with the integration process, that integration
activities will not result in a decrease in revenues or a decrease in the value
of our common stock, or that there will not be other material adverse affects
from our integration efforts. The challenges involved in this integration
include the following:  
    
    satisfying the needs of the combined companys customers in a
timely and efficient manner and maintaining SafeNets and Rainbow
Technologies customer relationships;
    
    combining two business cultures and retaining the combined
companys key personnel;
    
    maintaining the dedication of SafeNets and Rainbow Technologies
management resources to integration activities without distracting
attention from the day-to-day business of the combined company;
    
    preserving distribution, marketing, key supplier or other important
relationships of both SafeNet and Rainbow Technologies; 22




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##### 




    
    consolidating manufacturing operations;
    
    combining product offerings;
    
    coordinating sales and marketing efforts;
    
    integrating purchasing and procurement;
    
    consolidating corporate IT and administrative infrastructures; and
    
    developing uniform standards, controls and procedures. The merger may be completed even though there has been a material adverse
effect on SafeNet. In general, each party can refuse to complete the merger if there is a
material adverse effect affecting the other party between the date of the
signing of the merger agreement, October 22, 2003, and the closing of the
merger. However, certain types of changes will not prevent the merger from
going forward, even if they would have a material adverse effect on us,
including:  
    
    any effect arising from or relating to general economic conditions;
    
    any effect relating to, affecting, or with respect to, conditions
affecting the industries as a whole in which SafeNet or Rainbow
Technologies has material operations;
    
    any effect arising from the transactions contemplated by the merger
agreement or the public announcement of the merger;
    
    any decline in trading prices in financial markets generally or in
the trading price of shares of SafeNet or Rainbow Technologies common
stock; or
    
    the failure of SafeNet or Rainbow Technologies to meet earnings
expectations published in analysts reports. If an adverse change occurs but we must still complete the merger, our
stock price may suffer. Customer uncertainty related to the merger could harm the combined company. SafeNet and Rainbow Technologies each operate in the security market,
which requires their products and services to be consistently secure and
reliable. SafeNets and Rainbow Technologies high-assurance security
customers, such as government agencies and financial institutions in
particular, demand high-performance, reliable and complex security products and
services to protect highly confidential networks and information. The
announcement and pendency of the merger may cause uncertainty among SafeNets
or Rainbow Technologies customers about the effect of the transaction on their
security systems. For example, SafeNets and Rainbow Technologies customers
may be concerned that the attention of employees will be diverted during the
integration of the businesses, that products they have used for their security
networks might be discontinued, or that the integration of different
technologies might compromise the reliability of the combined companys
products. As a result, in response to the announcement and pendency of the
merger, SafeNets or Rainbow Technologies customers may delay or defer
purchasing decisions. Any delay or deferral in purchasing decisions by
SafeNets or Rainbow Technologies customers could seriously harm the business
of the combined company. 23




---



##### 



We expect to incur significant costs associated with the merger. We estimate that we will incur direct transaction and related
costs of approximately
$12.0 million associated with the merger, including direct costs of the
acquisition as well as liabilities to be accrued in connection with the
acquisition, including severance and related costs. We believe the combined
entity may incur charges to operations, which are not currently reasonably
estimable, in the quarter in which the merger is completed or the following
quarters, to reflect costs associated with integrating the two companies.
There is no assurance that the combined company will not incur additional
material charges in subsequent quarters to reflect additional costs associated
with the merger. We anticipate that the combination will require significant
cash outflows for acquisition and integration related costs. We expect cash
requirements will be funded by current cash reserves and cash flows from
operations. If the benefits of the merger do not exceed the costs of
integrating the businesses of SafeNet and Rainbow Technologies, the combined
companys financial results may be adversely affected. If the merger is not completed, our stock price and future business and
operations could be harmed. There are many conditions to SafeNets and Rainbow Technologies
obligations to complete the merger. Many of these conditions are beyond
SafeNets and Rainbow Technologies control. These conditions include
obtaining requisite regulatory and stockholder approval, and SafeNet and
Rainbow Technologies may be unable to obtain these approvals on a timely basis,
if at all. If the merger is not completed, we may be subject to the following
material risks, among others:  
    
    The price of our common stock may change to the extent that the
current market price of our common stock reflects an assumption that
the merger will be completed;
    
    Our costs related to the merger, such as legal, accounting and some
of the fees of our financial advisors, must be paid even if the merger
is not completed;
    
    Under specified circumstances, we may be required to pay Rainbow
Technologies a termination fee of $15.0 million in connection with the
termination of the merger agreement; and
    
    If the merger is not completed, we would fail to derive the
benefits expected to result from the merger. Because a significant portion of our total assets will be 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. We will account for the acquisition of Rainbow Technologies using the
purchase method of accounting. A portion of the purchase price for this
business will be allocated to identifiable tangible and intangible assets and
assumed liabilities based on estimated fair values at the date of consummation.
Any excess purchase price, which is very likely to constitute a significant
portion of the purchase price, will be allocated to goodwill. In accordance
with the Financial Accounting Standards Boards Statement No. 142, Goodwill and
Other Intangible Assets, goodwill is not amortized but is reviewed annually, or
more frequently if impairment indicators arise, for impairment. We have
estimated that the goodwill to be recorded in connection with this acquisition
will total approximately $275.0 million. When we perform future impairment
tests, it is possible that the carrying value of our goodwill could exceed its
implied fair value and therefore would require adjustment. Such adjustment
would result in a charge to operating income in that period. Once adjusted,
there can be no assurance that there will not be further adjustments for
impairment in future periods. 24




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##### 



ITEM 2. PROPERTIES We lease approximately 40,000 square feet at 4690 Millennium Drive,
Belcamp, Maryland, for our corporate and administrative facilities. This space
is used for our executive headquarters, enterprise research and development and
SafeNet Trusted Services facility. The lease, which expires in 2013, has an
initial annual lease commitment of approximately $0.5 million with annual
increases. We assumed Cylinks lease of approximately 47,000 square feet in Santa
Clara, California. The lease, which expires in August 2009, requires annual
rent payments of approximately $1.2 million. We do not operate out of the
Santa Clara facility and will make attempts to sublease the facility. The real
estate market values in the Santa Clara market are extremely poor and we expect
that it will take a long time to find a sublease tenant, if at all, and that we
will only be able to receive a fraction of the current rent commitment in a
sublease situation. We also lease the former Cylink ATM Center, comprising
approximately 10,000 square feet in Raleigh, North Carolina, which expired in
June 2003. We recently renewed this lease for an additional three-year term.
Also, we lease facilities for sales offices in New Jersey, Virginia, the United
Kingdom and Singapore. The combined annual rent payments for these facilities
will be approximately $0.3 million in 2004. We believe our current facilities
are well maintained and are adequate for the foreseeable future. Our subsidiary, SafeNet BV, leases approximately 13,700 square feet for
its operations in Vught, The Netherlands. The lease, which expires in March,
2007, requires annual rental of approximately $0.2 million. Our Finnish subsidiary leases approximately 5,900 square feet for its
operations in Helsinki, Finland. The lease, which expires in December, 2009
requires annual rental of approximately $0.1 million. Our Japanese subsidiary leases approximately 900 square feet for its
operations in Tokyo, Japan. The lease, which expires in December, 2009
requires annual rental of under $0.1 million. We also lease office space in Danvers, Massachusetts with annual rent of
approximately $0.1 million. ITEM 3. LEGAL PROCEEDINGS In 1998, Cylink filed with the Securities and Exchange Commission, or SEC,
amendments to periodic reports, reflecting restated financial results for the
first and third quarters of 1998, and for the fourth quarter of 1997. Between
November 6, 1998 and December 14, 1998, several securities class action
complaints were filed against Cylink and certain of its then current and former
directors and officers in U.S. federal courts in California. These complaints
alleged, among other things, that Cylinks previously issued financial
statements were materially false and misleading and that the defendants knew or
should have known that these financial statements caused Cylinks common stock
price to rise artificially. The actions variously alleged violations of
Section 10(b) of the Securities Exchange Act of 1934, as amended, and SEC Rule
l0b-5 promulgated thereunder, and Section 20 of the Exchange Act. The
securities class action lawsuits were ordered consolidated into a single action
pending in the United States District Court for the Northern District of
California, captioned In Re Cylink Securities Litigation, No. C98-4292 (VRW).
On October 16, 2002,Cylink entered into an agreement with all plaintiffs in
the securities class action lawsuit to settle all claims in the class action
for $6.4 million. The United States District Court for the Northern District
of California preliminarily approved the settlement agreement on November 12,
2002, and on July 23, 2003, the court issued an order granting final approval
of the settlement and entering final judgment in accordance with the terms of
the settlement agreement. 25




---



##### 



The settlement amount was paid entirely from insurance proceeds under
insurance policies held by Cylink. On June 25, 2003, we were served with a motion and complaint in a lawsuit
filed by Thales E-Security, Inc. and Thales Communications, Inc. (together,
Thales) in the 17th Judicial Circuit Court of Broward County, Florida. The
court granted our motion to dismiss this lawsuit on jurisdictional grounds on
July 3, 2003 and entered a final order to that effect on July 14, 2003. On
July 22, 2003, Thales filed a motion and complaint for preliminary injunction
in the Circuit Court for Montgomery County, Maryland. The motion and complaint
alleged that, among other things, we and a former Thales employee hired by us
misappropriated trade secrets concerning one of the Thales governmental
customers, interfered with Thales business and contractual relationships with
a former supplier, CTAM PTY Ltd. SafeNet and Thales have entered into a
stipulation of dismissal of this lawsuit with prejudice against Thales, dated
October 6, 2003. The Circuit Court dismissed the lawsuit with prejudice on
October 30, 2003. We are not aware of any other material litigation or proceeding, pending
or threatened, to which we are or may become a party. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None.  PART II
 ITEM 5  MARKET FOR COMMON EQUITY AND RELATED MATTERS SafeNets Common Stock is listed on the NASDAQ National Market under the
symbol SFNT. The following table sets forth the quarterly range of per share
high and low closing prices for SafeNets Common Stock as reported by the
NASDAQ National Market for the periods indicated. High
    
    Low2003Fourth Quarter
    
    $
    42.95
    
    
    $
    30.07Third Quarter
    
    
    39.85
    
    
    
    28.46Second Quarter
    
    
    30.94
    
    
    
    19.70First Quarter
    
    
    32.21
    
    
    
    16.472002Fourth Quarter
    
    
    29.00
    
    
    
    13.75Third Quarter
    
    
    21.48
    
    
    
    14.05Second Quarter
    
    
    16.16
    
    
    
    10.80First Quarter
    
    
    18.65
    
    
    
    9.89
 On March 5, 2004, the last reported per share sale price of SafeNets Common
Stock on the NASDAQ National Market was $38.62. As of that date, there were
approximately 250 holders of record of the Common Stock. We have not paid
dividends on our Common Stock and intend for the near future to retain
earnings, if any, to finance the expansion and development of our business. 26




---



##### 



ITEM 6  SELECTED FINANCIAL DATA The selected financial data set forth below as of and for each of the five
years ended December 31, 2003 is derived from our audited financial statements.
The selected financial data is qualified by and should be read in conjunction
with the Consolidated Financial Statements and Managements Discussion and
Analysis of Financial Condition and Results of Operations included elsewhere
herein. The accompanying financial data has been restated to reflect the net
assets of the disposed operations of SafeNet Systems AG  (GDS) as current
assets, non-current assets, and current liabilities of discontinued operations.
The following data should be read in conjunction with Note 3 to the
Consolidated Financial Statements. December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999(Dollars in thousands, except per share data)Revenues
    
    $
    66,194
    
    
    $
    32,235
    
    
    $
    16,462
    
    
    $
    25,278
    
    
    $
    10,565Cost of revenues
    
    
    16,837
    
    
    
    8,963
    
    
    
    4,525
    
    
    
    5,834
    
    
    
    4,352Gross profit
    
    
    49,357
    
    
    
    23,272
    
    
    
    11,937
    
    
    
    19,444
    
    
    
    6,213Research and development expenses
    
    
    14,664
    
    
    
    8,504
    
    
    
    6,118
    
    
    
    6,342
    
    
    
    4,580Sales and marketing expenses
    
    
    14,929
    
    
    
    7,341
    
    
    
    5,061
    
    
    
    4,756
    
    
    
    5,251General and administrative expenses
    
    
    6,716
    
    
    
    3,852
    
    
    
    2,203
    
    
    
    2,681
    
    
    
    2,227Write-off of in-process research and
development
    
    
    9,681
    
    
    
    3,375
    
    
    
    
    
    
    
    
    
    
    
    Costs of integration of acquired companies
    
    
    3,934
    
    
    
    256
    
    
    
    
    
    
    
    
    
    
    
    Amortization of intangibles
    
    
    4,710
    
    
    
    1,488
    
    
    
    
    
    
    
    
    
    
    
    Recovery of Cyberguard advance
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (275
    )
    
    
    (375
    )Total operating expenses
    
    
    54,634
    
    
    
    24,816
    
    
    
    13,382
    
    
    
    13,504
    
    
    
    11,683Operating (loss) income
    
    
    (5,277
    )
    
    
    (1,544
    )
    
    
    (1,445
    )
    
    
    5,940
    
    
    
    (5,470
    )Investment income and other expenses, net
    
    
    807
    
    
    
    669
    
    
    
    1,336
    
    
    
    1,320
    
    
    
    95(Loss) income from continuing operations
before income taxes
    
    
    (4,470
    )
    
    
    (875
    )
    
    
    (109
    )
    
    
    7,260
    
    
    
    (5,375
    )Income tax expense (benefit)
    
    
    1,618
    
    
    
    (90
    )
    
    
    
    
    
    
    
    
    
    
    (Loss) income from continuing operations
    
    $
    (6,088
    )
    
    $
    (785
    )
    
    $
    (109
    )
    
    $
    7,260
    
    
    $
    (5,375
    )(Loss) income from continuing operations
per
common shareBasic
    
    $
    (0.54
    )
    
    $
    (0.10
    )
    
    $
    (0.01
    )
    
    $
    1.08
    
    
    $
    (0.98
    )Diluted
    
    $
    (0.54
    )
    
    $
    (0.10
    )
    
    $
    (0.01
    )
    
    $
    1.01
    
    
    $
    (0.98
    )Shares used in computationBasic
    
    
    11,350
    
    
    
    7,730
    
    
    
    7,057
    
    
    
    6,751
    
    
    
    5,504Diluted
    
    
    11,350
    
    
    
    7,730
    
    
    
    7,057
    
    
    
    7,195
    
    
    
    5,504Balance Sheet Data:Working capital
    
    $
    111,630
    
    
    $
    31,987
    
    
    $
    32,385
    
    
    $
    33,695
    
    
    $
    23,035Intangible assets
    
    
    67,988
    
    
    
    13,900
    
    
    
    727
    
    
    
    1,516
    
    
    
    2,107Total assets
    
    
    208,156
    
    
    
    55,319
    
    
    
    39,877
    
    
    
    43,106
    
    
    
    31,896Stockholders equity
    
    
    178,997
    
    
    
    48,378
    
    
    
    35,459
    
    
    
    37,723
    
    
    
    27,636
 (1) During 2003 and 2002, the Company completed significant acquisitions as discussed further in
note 4 to the consolidated financial statements. 27




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##### 



QUARTERLY RESULTS OF OPERATIONS The following is a summary of the quarterly results of operations for the
years ended December 3l, 2003 and 2002. (Unaudited  Amounts in thousands, except per share data): 2003 Quarter EndedAs Reported
    
        As Adjusted
    
    As Reported
    
        As Adjusted
    
    As Reported
    
        As AdjustedMarch 31
    
    March 31
    
    June 30
    
    June 30
    
    Sept. 30
    
    Sept. 30
    
    Dec. 31Revenues (1) (4)
    
    $
    14,014
    
    
    $
    13,563
    
    
    $
    15,425
    
    
    $
    16,511
    
    
    $
    17,593
    
    
    $
    17,385
    
    
    $
    18,735Cost of revenues (2) (4)
    
    
    4,455
    
    
    
    4,444
    
    
    
    4,243
    
    
    
    4,898
    
    
    
    4,428
    
    
    
    4,289
    
    
    
    3,206Gross Profit
    
    
    9,559
    
    
    
    9,119
    
    
    
    11,182
    
    
    
    11,613
    
    
    
    13,165
    
    
    
    13,096
    
    
    
    15,529Operating (loss) income (3) (4)
    
    
    (9,092
    )
    
    
    (9,182
    )
    
    
    (1,992
    )
    
    
    (2,200
    )
    
    
    2,095
    
    
    
    2,183
    
    
    
    3,922(Loss) income from continuing operations
    
    
    (9,656
    )
    
    
    (9,734
    )
    
    
    (2,243
    )
    
    
    (2,443
    )
    
    
    1,719
    
    
    
    1,821
    
    
    
    4,268Net (loss) income
    
    $
    (9,656
    )
    
    $
    (9,734
    )
    
    $
    (2,243
    )
    
    $
    (2,443
    )
    
    $
    1,719
    
    
    $
    1,821
    
    
    $
    4,268(Loss) income per common share, Basic:(Loss) income from continuing operations
    
    $
    (1.06
    )
    
    $
    (1.07
    )
    
    $
    (0.22
    )
    
    $
    (0.24
    )
    
    $
    0.13
    
    
    $
    0.14
    
    
    $
    0.32Net (loss) income per share
    
    $
    (1.06
    )
    
    $
    (1.07
    )
    
    $
    (0.22
    )
    
    $
    (0.24
    )
    
    $
    0.13
    
    
    $
    0.14
    
    
    $
    0.32(Loss) income per common share, Diluted:(Loss) income from continuing operations
    
    $
    (1.06
    )
    
    $
    (1.07
    )
    
    $
    (0.22
    )
    
    $
    (0.24
    )
    
    $
    0.13
    
    
    $
    0.13
    
    
    $
    0.31Net (loss) income per share
    
    $
    (1.06
    )
    
    $
    (1.07
    )
    
    $
    (0.22
    )
    
    $
    (0.24
    )
    
    $
    0.13
    
    
    $
    0.13
    
    
    $
    0.31Shares used in computation:Basic
    
    
    9,083
    
    
    
    9,083
    
    
    
    10,232
    
    
    
    10,232
    
    
    
    12,769
    
    
    
    12,769
    
    
    
    13,281Diluted
    
    
    9,083
    
    
    
    9,083
    
    
    
    10,232
    
    
    
    10,232
    
    
    
    13,546
    
    
    
    13,546
    
    
    
    13,987
 During
    the fourth quarter of fiscal year 2003 and subsequent to December 31, 2003,
    the Company identified certain adjustments to its financial statements that
    impacted the results of operations that were previously reported in its quarterly
    reports on Forms 10-Q. While the Company does not believe these adjustments
    are material to the previously announced results for the year ended December
    31, 2003, the Company has decided to take the opportunity to reflect these
    adjustments in this filing. The results of operations for the previously reported
    quarters have been adjusted and are reflected in the as adjusted
    amounts above. A summary of the significant adjustments are as follows:  (1)
    
    Includes adjustments to correct the timing of revenue recognition
in accordance with AICPA Statement of Position 97-2, Software Revenue
Recognition, and SOP 81-1, Accounting for Performance of
Construction-Type and Certain Production-Type Contracts. These
corrections yielded a decrease in revenue of $425 during the three
months ended March 31, 2003, an increase in revenue of $598 during the
three months ended June 30, 2003, and a decrease of revenues of $173
during the three months ended September 30, 2003.(2)
    
    Includes adjustments to correct the elimination of profit in
intercompany sales, to correct the recognition of cost of goods sold in
connection with certain types of inventory transactions and to correct
the timing of cost recognition in accordance with SOP 81-1, Accounting
for Performance of Construction-Type and Certain Production-Type
Contracts. These corrections yielded an increase in cost of revenues
of $87 during the three months ended March 31, 2003, an increase in
cost of revenues of $412 during the three months ended June 30, 2003,
and a decrease in cost of revenues of $139 during the three months
ended September 30, 2003. 28




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##### 



(3)
      
      Includes adjustments to operating expenses to correct the timing of
        recognition of certain estimated tooling costs and the under-capitalization
        of software development costs. These corrections yielded a decrease in
        operating expenses of $350 during the three months ended March 31,
        2003, an increase in operating expenses of $350 during the three months
        ended June 30, 2003, and a decrease in operating expenses of $128
        during the three months ended September 30, 2003.(4)
      
      Includes adjustments to revenue, cost of revenues and operating expenses
        for the incorrect consolidation of the results of operations of the Companys
        subsidiary in the United Kingdom during the three months ended June 30,
        2003. These corrections yielded an increase in revenue of $540, an increase
        in cost of revenues of $243, and an increase in operating expenses of
        $264. Other adjustments, all de minimus in amount, were also made. The effective income tax rate for the year ended December 31, 2003 was
(36%). The effective tax rate changed during each quarter of fiscal year 2003
as a result of events occurring during each quarter,
including purchase business combinations and a change in mix of earnings
and losses between domestic and foreign tax jurisdictions. If the Company had
been able to estimate the overall annual effective tax of (36%) at the
beginning of fiscal year 2003 and reported that effective tax rate throughout
2003, the impact on the reported income tax expense (benefit) would have been
as follows: Three Months EndedMarch 31,
    
    June 30,
    
    September 30,
    
    December 31,2003
    
    2003
    
    2003
    
    2003As reported
    
    $
    641
    
    
    $
    397
    
    
    $
    569
    
    
    $
    11Revised
    
    
    3,291
    
    
    
    741
    
    
    
    (865
    )
    
    
    (1,549
    )
 During the three months ended March 31, 2003, the Company recorded charges
of $3,317 and $4,583 related to the write-off of in process research and
development assets acquired in connection with the purchase of Cylink on
February 5, 2003 and Raqia Networks on February 27, 2003, respectively. During
the three months ended June 30, 2003, the Company recorded additional charges
of $34 and $1,747 in connection with the receipt of final valuations related to
the write-off of in process research and development assets acquired in
connection with the purchase of Cylink and Raqia Networks, respectively. 29




---



##### 



2002 Quarter EndedMarch 31
    
    June 30
    
    Sept. 30
    
    Dec. 31Revenues
    
    $
    6,154
    
    
    $
    7,428
    
    
    $
    8,827
    
    
    $
    9,826Cost of revenues
    
    
    1,953
    
    
    
    2,061
    
    
    
    2,580
    
    
    
    2,369Gross profit
    
    
    4,201
    
    
    
    5,367
    
    
    
    6,247
    
    
    
    7,457Operating (loss) income
    
    
    (4,016
    )
    
    
    222
    
    
    
    754
    
    
    
    1,496(Loss) income from continuing operations
    
    
    (3,742
    )
    
    
    246
    
    
    
    877
    
    
    
    1,834(Loss) income from discontinued
operations
    
    
    (3,784
    )
    
    
    (398
    )
    
    
    116
    
    
    
    112Net (loss) income
    
    $
    (7,526
    )
    
    $
    (152
    )
    
    $
    993
    
    
    $
    1,946(Loss) earnings per share, basic:(Loss) income from continuing operations
    
    $
    (0.49
    )
    
    $
    0.03
    
    
    $
    0.12
    
    
    $
    0.24(Loss) income from discontinued
operations
    
    $
    (0.49
    )
    
    $
    (0.05
    )
    
    $
    0.01
    
    
    $
    0.01Net (loss) income
    
    $
    (0.98
    )
    
    $
    (0.02
    )
    
    $
    0.13
    
    
    $
    0.25(Loss) earnings per share, diluted:(Loss) income from continuing operations
    
    $
    (0.49
    )
    
    $
    0.03
    
    
    $
    0.11
    
    
    $
    0.22(Loss) income from discontinued
operations
    
    $
    (0.49
    )
    
    $
    (0.05
    )
    
    $
    0.01
    
    
    $
    0.01Net (loss) income
    
    $
    (0.98
    )
    
    $
    (0.02
    )
    
    $
    0.12
    
    
    $
    0.23Shares used in calculation:Basic
    
    
    7,677
    
    
    
    7,689
    
    
    
    7,736
    
    
    
    7,824Diluted
    
    
    7,677
    
    
    
    7,932
    
    
    
    8,062
    
    
    
    8,625
 During the three months ended March 31, 2002, the Company recorded a
charge of $3,375 related to the write-off of in process research and
development assets acquired in connection with the purchase of Securealink on
January 2, 2002. During that quarter, the Company also recorded a charge of
$3,506 related to the loss on the disposal of the GDS business. 30




---



##### 



ITEM 7  MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS Forward-Looking Statements This Annual Report on Form 10-K contains forward-looking statements
within the meaning of the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. These statements involve known and unknown
risks, uncertainties and other factors that may cause our or our industrys
actual results, levels of activity, performance, or achievements to be
materially different from any future results, levels of activity, performance
or achievements expressed or implied by such forward-looking statements. These
risks and other factors include, among others, the risks described in
Item 1  Business. As a general matter, you can identify forward-looking
statements by terminology such as may, will, should, expect, plan,
anticipate, believe, estimate, predict, potential, continue or the
negative of such terms or other comparable terminology. Overview We develop, market, sell and support a portfolio of hardware and software
network security products and services. Our products and services are used to
create secure wide area networks (WANs) and virtual private networks over the
Internet (VPNs) to prevent security breaches that could result in unauthorized
access to confidential data, invasion of privacy and financial loss. We have two reportable business segments. Through our Enterprise Security
Division, we sell high-performance security solutions to address the needs of
our government, financial institution and other security-sensitive commercial
customers. We also provide, through our Embedded Security Division, a broad
range of network security products, including silicon chips, accelerator cards,
licensed intellectual property and software products, to OEMs that embed them
in their own network infrastructure and wireless products. These divisions are
managed separately because they offer different products and employ different
marketing strategies (See Note 13 to the accompanying notes to consolidated
financial statements). We periodically review and consider possible acquisitions of companies
that we believe will contribute to our long-term objectives and discuss such
acquisitions with the management of those companies. Such acquisitions, which
may be material, may be made from time to time. In January 2002, we acquired Pijnenburg Securealink, Inc., a Delaware
corporation primarily engaged in the manufacture of security chips for
e-commerce transactions through its European subsidiary. Securealink develops,
markets and sells security chips and intellectual property, primarily in Europe
and Asia. As a result of the acquisition, we broadened our market with the
addition of new technologies and a larger presence in Europe. We integrated
the operations of Securealink into our Embedded Security Division. In February 2002, our management decided to discontinue our Swiss
subsidiary operations at GretaCoder Data Systems (GDS), which was formerly our
European operations segment (see note 3 to our 2002 audited consolidated
financial statements). The decision to discontinue GDSs operations was based
on the amount of its operating and cash losses during 2000 and 2001, as well as
a significant downturn in its future business prospects. We transferred
certain employees from GDSs sales and marketing group to our sales group to
create a European sales office focused on selling our enterprise products and
services in Europe. The operating results of the discontinued businesses has
been reported in the discontinued operations section of the consolidated
statements of operations. In February 2003, we acquired Cylink Corporation, which expanded our
customer base and our product offerings to include security solutions for WANs.
Operations of Cylink were integrated into the Enterprise Security Division. 31




---



##### 



In February 2003, we also acquired the assets of Raqia Networks, Inc., a
development stage company that was developing content inspection technology.
This transaction consisted primarily of technology-related intangible assets. In November 2003, we acquired substantially all of the assets and
properties used in connection with the toolkit, IPVia VPN and VPN client
businesses of SSH Communications Security Corp. (SSH) for
approximately $13.6 million in cash. SSH is a world-leading supplier of managed security
middleware. In October 2003, we entered into an agreement to acquire Rainbow
Technologies, Inc., a provider of information security solutions for
mission-critical data and applications used in business, organization and
government computing environments, in a stock-for-stock transaction.
Consummation of the transaction is subject to customary closing conditions,
including the approval of Rainbows stockholders and our stockholders. Under
the terms of the agreement, each outstanding share of Rainbow common stock will
be exchanged for 0.374 of a share of SafeNet common stock. All outstanding
options to acquire Rainbow common stock will be assumed by us and converted
into options to purchase shares of our common stock using the same exchange
ratio. If the merger is consummated, the Company will issue in the transaction
approximately 11.1 million shares of SafeNet common stock on a fully-diluted
basis, which would represent approximately 43% of the outstanding stock of the
combined company as of October 23, 2003, the date the proposed merger was
announced. The Company has subsequently announced a special shareholder
meeting to be held on March 15, 2004 to approve the issuance of the shares of
SafeNet common stock pursuant to the merger. If this
    merger with Rainbow is consummated, it will have a significant impact on our
    operations going forward. While the impact of the proposed merger on our future
    results of operations and liquidity is uncertain at this time, the combined
    company is expected to add 4,000 new customers to SafeNets existing
    customer base, distribution channels in over 100 countries, and up to 570
    employees to SafeNets approximately 215 employees. We expect that revenues
    of the combined company will be significantly greater than our revenues. Pro
    forma revenues for the combined company as of December 31, 2003 are $208
    million compared to our revenues for the same period of $66.2 million. We
    expect that the gross margins for the combined company will be lower than
    our current gross margins as a result of Rainbow having a significant portion
    of its revenues under long-term contracts, which is accounted for using the
    percentage of completion method, as well as, the effect of amortization of
    acquired intangibles. This has the effect of including all significant costs,
    including allowable sales and marketing, research and development and general
    and administrative costs related to its long-term contracts in costs of sales
    instead of operating expenses. The pro forma results of operations of the
    combined company for the year ended December 31, 2003 result in gross margins
    of 38% as compared to SafeNets stand-alone gross margins of 75% for
    the same period. We expect our net loss to increase significantly as our reporting
    reflects the acquisition related charges, including amortization of acquired
    intangibles. In addition, we anticipate the proposed merger will result in cost savings
as a result of cost synergies and operating efficiencies after the integration
of our businesses. While the magnitude and timing of those benefits is
uncertain, we currently anticipate pre-tax annual cost savings of at least $4.0
million to $6.0 million, including anticipated savings of $1.8 million to $2.5
million in professional fees and insurance costs, $1.8 million to $2.5 million
in marketing costs, and $0.5 million to $1.0 million in management and board of
directors expenses. For a description of the proposed merger with Rainbow,
including the risks associated with the merger, please refer to our
Registration Statement on Form S-4, which is on file with the Securities and
Exchange Commission and available through the SECs website at www.sec.gov. Our historical operating results have been dependent on a variety of
factors including, but not limited to, the length of the sales cycle, the
timing of orders from and shipments to clients, product development expenses
and the timing of development and introduction of new products. Our expense
levels are based, in part, on expectations of future revenues. The size and
timing of our historical revenues have varied substantially from quarter to
quarter and year to year. Accordingly, the results of a particular 32




---



##### 



period, or period to period comparisons of recorded sales and profits may
not be indicative of future operating results. RESULTS OF OPERATIONS OF SAFENET The following table sets forth certain Consolidated Statement of
Operations data of SafeNet as a percentage of revenues for the years ended
December 31. 2003
    
    2002
    
    2001Revenues
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Cost of revenues
    
    
    25
    %
    
    
    28
    %
    
    
    27
    %Gross profit
    
    
    75
    %
    
    
    72
    %
    
    
    73
    %Research and development expenses
    
    
    22
    %
    
    
    26
    %
    
    
    37
    %Sales and marketing expenses
    
    
    23
    %
    
    
    23
    %
    
    
    31
    %General and administrative expenses
    
    
    10
    %
    
    
    13
    %
    
    
    13
    %Costs of integration of acquired companies
    
    
    6
    %
    
    
    0
    %
    
    
    0
    %Write-off of in-process research and development
    
    
    15
    %
    
    
    10
    %
    
    
    0
    %Amortization of intangibles
    
    
    7
    %
    
    
    5
    %
    
    
    0
    %Total operating expenses
    
    
    83
    %
    
    
    77
    %
    
    
    81
    %Operating loss
    
    
    (8
    )%
    
    
    (5
    )%
    
    
    (8
    )%Investment income and other expenses, net
    
    
    1
    %
    
    
    2
    %
    
    
    8
    %Loss from continuing operations before income
taxes
    
    
    (7
    )%
    
    
    (3
    )%
    
    
    0
    %Income tax expense
    
    
    2
    %
    
    
    0
    %
    
    
    0
    %Loss from continuing operations
    
    
    (9
    )%
    
    
    (3
    )%
    
    
    0
    %
 The Company has two reportable segments: products, chips and software
designed and manufactured for sale to companies that will embed the Companys
products into their products for ultimate sale to end-users (Embedded Security
Division), and network security products designed and manufactured for direct
sales to end-users and remote access software sold to OEMs (Enterprise
Security Division). The segments are strategic business units that offer
different products. The segments are managed separately because each segment
requires different technology and marketing strategies (see note 13 to the
audited consolidated financial statements). The
proposed merger with Rainbow Technologies, which is expected to close in March 2004, is expected
to have a significant impact on the Companys results of operations and
financial condition. Since the transaction is scheduled to close subsequent to
December 31, 2003, this merger has not been considered in the Companys
discussion of its results of operations and financial condition as of and for
the year ended December 31, 2003. 33




---



##### 



Year ended December 31, 2003 Compared to Year ended December 31, 2002 Revenues and Gross Margins Variance2003
    
    2002
    
    $
    
    %Revenues by typeLicense and royalties
    
    $
    16,464
    
    
    $
    7,398
    
    
    $
    9,066
    
    
    
    123
    %Products
    
    
    38,797
    
    
    
    21,588
    
    
    
    17,209
    
    
    
    80
    %Service and maintenance
    
    
    10,933
    
    
    
    3,249
    
    
    
    7,684
    
    
    
    237
    %Total
    
    $
    66,194
    
    
    $
    32,235
    
    
    $
    33,959
    
    
    
    105
    %Revenues by segmentEmbedded Security
Division
    
    $
    19,269
    
    
    $
    18,292
    
    
    $
    977
    
    
    
    5
    %Enterprise Security
Division
    
    
    46,925
    
    
    
    13,943
    
    
    
    32,982
    
    
    
    237
    %Total
    
    $
    66,194
    
    
    $
    32,235
    
    
    $
    33,959
    
    
    
    105
    %Revenue mix by typeLicense and royalties
    
    
    25
    %
    
    
    23
    %Products
    
    
    59
    %
    
    
    67
    %Service and maintenance
    
    
    16
    %
    
    
    10
    %Total
    
    
    100
    %
    
    
    100
    %Revenue mix by segmentEmbedded Security
Division
    
    
    29
    %
    
    
    57
    %Enterprise Security
Division
    
    
    71
    %
    
    
    43
    %Total
    
    
    100
    %
    
    
    100
    %Gross margins by typeLicense and royalties
    
    
    95
    %
    
    
    89
    %
    
    
    6
    %Products (1)
    
    
    62
    %
    
    
    64
    %
    
    
    (2
    )%Service and maintenance
    
    
    88
    %
    
    
    86
    %
    
    
    2
    %Total
    
    
    75
    %
    
    
    72
    %
    
    
    3
    %Gross margins by segmentEmbedded Security
Division
    
    
    75
    %
    
    
    72
    %
    
    
    3
    %Enterprise Security
Division
    
    
    75
    %
    
    
    74
    %
    
    
    1
    %Total
    
    
    75
    %
    
    
    72
    %
    
    
    3
    %
 (1) Includes amortization of acquired intangible assets. The increase in licenses and royalties from 2002 to 2003 was primarily
related to three items. The largest item was the execution of six new license
arrangements that accounted for $5.7 million in revenue. There were also $1.5
million of new intellectual property licenses during 2003. Finally, our
development revenue related to our long-term government contracts increased
approximately $0.8 million from 2002 to 2003. Product revenues increased from 2002 to 2003 due to the acquisition of
Cylink and its Wide Area Network (WAN) product line. The product revenue for
2003 that came from Cylink-based products was approximately $19.8 million.
Additional revenue came from sales of new products introduced in 2003 totaling
approximately $2.3 million. This additional revenue was offset by a decrease
in legacy product sales of approximately $2.4 million. The remaining decrease
in product revenue was related to the Embedded Security Divisions loss of a
significant contract with Cisco Systems early in 2003 that led to a $2.2
million reduction in revenues. 34




---



##### 



The increase in service and maintenance revenue from 2002 to 2003 is due
to two acquisitions. The first was the acquisition of Cylink in February 2003,
adding approximately $6.5 million of service and maintenance revenue in 2003.
The second was the acquisition of the OEM product line of SSH, Inc. (SSH) in
November 2003. In the period of SafeNet ownership, the maintenance contracts
acquired in the SSH transaction accounted for $0.3 million of incremental
revenue. Revenues from 2002 to 2003 for the Embedded Security Division increased
slightly as increased license and royalty revenue, including Intellectual
Property licenses, offset the loss of product revenue from the loss of a
significant contract with Cisco Systems early in 2003. The Enterprise Security
Division significantly increased revenues from 2002 to 2003 through the
acquisition of Cylink and its product lines and related maintenance contracts
as well as securing two significant license arrangements totaling $4.2 million. Gross margins increased slightly, 3%, from 2002 to 2003. The most
significant reason for this was the increase in license and royalty revenue, in
dollars and as a percentage of revenues. In 2003, the significant licenses and
intellectual property sales were software and technology-based, which
offer a higher percentage of gross margins in terms of dollars than SafeNets recurring royalty revenue stream or
development revenues from its long term government contracts. These higher
gross margins were also offset by decreasing product margins resulting from
higher component costs for the Wide Area Network products compared to SafeNets
legacy products. Due to several factors: competition, an unsteady economy, and
pricing sensitivity of high-end products (such as SafeNets WAN products), SafeNet
chose not to pass those increased costs through to our customers. SafeNet
believes that the 2003 product margin of 69% is reflective of its actual
product margin for the Companys current product offerings. Operating Expenses Variance2003
    
    2002
    
    $
    
    %Operating expensesResearch and development
    
    $
    14,664
    
    
    $
    8,504
    
    
    $
    6,160
    
    
    
    72
    %Sales and marketing
    
    
    14,929
    
    
    
    7,341
    
    
    
    7,588
    
    
    
    103
    %General and administrative
    
    
    6,716
    
    
    
    3,852
    
    
    
    2,864
    
    
    
    74
    %Write-off of acquired
in-process
research and development costs
    
    
    9,681
    
    
    
    3,375
    
    
    
    6,306
    
    
    
    187
    %Amortization of intangible
assets
    
    
    4,710
    
    
    
    1,488
    
    
    
    3,222
    
    
    
    217
    %Cost of integration of
acquired companies
    
    
    3,934
    
    
    
    256
    
    
    
    3,678
    
    
    
    1437
    %Total
    
    $
    54,634
    
    
    $
    24,816
    
    
    $
    29,818
    
    
    
    120
    %
 The increase in research and development expenses from 2002 to 2003 was
due to several factors. Headcount increased as a result of the Cylink
acquisition and the Raqia acquisition, both in February 2003, as well as the
SSH acquisition in late 2003. Several new products and technology offerings
were introduced, including two new chip designs within the Embedded Security
Division and the HighAssurance product line with SafeNets Security Management
Center from the Enterprise Security Division. SafeNet also continued
development related to our long-term government contracts. SafeNet also
expended significant efforts in 2003, that will continue through 2004, on
entering and subsequently expanding SafeNets technology and product offerings
into the wireless communication market. Sales and marketing expenses increased from 2002 to 2003, primarily as a
function of revenues. Sales and marketing expenses remained constant as a
percentage of sales, 23% in 2003 and 2002. The dollar increases from
2002 to 2003 are a function of increased headcount in the sales and product
marketing departments as SafeNet continues to introduce new products and expand
its presence and awareness within the government, financial institution and
Original Equipment Manufacturers sectors. SafeNet also invested significant
sales and marketing resources into its new and expanding presence in the 35




---



##### 



wireless communications markets. SafeNet will continue to market itself into
emerging markets, like wireless communications, as the need for secured
communications continues to expand. SafeNet also intends to expand its market
presence in EMEA (Europe, Middle East, and Asia) as well as APAC (Asia Pacific)
and the Americas. General and administrative expenses increased from 2002 to 2003 as the
result of increased headcount. SafeNets management and support infrastructure
increased by 9 new employees in 2003 (from 11 in 2002 to 28 in 2003). There
were additional expenses specific to 2003 related to the adoption of the
corporate governance requirements instituted for public companies by the
Sarbanes-Oxley Act. SafeNet will experience additional increases in these
costs for 2004 as more requirements are instituted. SafeNet believes, as a
percentage of sales, that 10% of revenues for 2003, is a reliable measure of
cost management. The write-off of acquired in-process research and development costs for
2003 was directly attributable to the acquisition of the Raqia assets
($6.3.million) and the acquisition of Cylink ($3.4 million). These write-offs
represent the estimated fair value of the in-process research and development
projects that had not yet reached technological feasibility at the acquisition
dates, and had no alternate future use. The values assigned to these acquired
in-process technologies relate entirely to three distinct projects: a specific
content inspection chip and compiler (Raqia); a specific gateway design for
security applications that included specific government certifications
(Cylink); and a fully-integrated policy and security manager for multiple
platforms and networks that use SafeNet technology (Cylink). The estimated
fair values of these projects were determined by the use of discounted cash
flow models, using discount rates that took into account the stage of
completion, and the risks surrounding the successful development and
commercialization of the technology and product. Subsequent to the
acquisitions, we incurred approximately $0.5 million in additional research and
development charges to complete the development of these technologies.
Completion of the development of these technologies occurred during the first
quarter of 2003, reaching both technological feasibility and general
availability. For 2002, the write-off of in- process research and development
costs amounted to $3.4 million, all of which related to the acquisition of
Securealink, which was for the in-process research and development of a new
application specific
integrated circuit that was completed and licensed to a customer in 2002.
SafeNet incurred an additional $0.8 million of costs to complete this project
during 2002. The amortization of acquired intangible assets for 2003 related to the
acquisitions of Cylink and the Raqia assets, as well as Securealink. We
acquired intangible assets, including developed technology, patents, customer
relationships/contracts, backlog, and non-compete agreements. The amortization
of developed technology and backlog is included in costs of revenues and the
remainder is included in amortization of intangible assets. The Cylink
intangible assets total $17.5 million and are being amortized over a weighted
average useful life of 2.7 years. The Raqia intangible assets total $1.2
million and are being amortized over three years. The Securealink intangible
assets total $0.6 million and are being amortized over estimated useful lives
ranging from one to five years. For 2002, the amortization of intangible
assets related only to the acquisition of Securealink and the appropriate
intangible assets. Costs of integration of acquired companies are costs specifically incurred
as a result of integrating the people, products, and technology of Cylink, the
Raqia and SSH assets, as well as some preliminary costs for the pending merger
with Rainbow Technologies. The integrations of Cylink and Raqia were
substantially completed during the second quarter of 2003. The integration of
SSH assets and people was substantially completed in the fourth quarter of
2003. These costs are primarily employee transition costs and professional
fees. We will incur additional integration expenses in connection with these
acquisitions, especially the Rainbow Technologies merger (see Liquidity and
Resources for further discussion related to the Rainbow Technologies merger). Interest and Other Income, Net Variance2003
    
    2002
    
    $
    
    %Interest and other
income, net
    
    $
    807
    
    
    $
    669
    
    
    $
    138
    
    
    
    21
    %
 36




---



##### 



The increase from 2002 to 2003 is attributable to higher cash balances in
2003 generating increased interest income of $0.4 million. In 2002, SafeNet,
through its Dutch subsidiary, received a grant from the Dutch government for
developing technology in the Netherlands of $0.3 million. There was no such
grant in 2003. Income Tax Expense (Benefit) Variance2003
    
    2002
    
    $
    
    %Income tax expense
(benefit)
    
    $
    1,618
    
    
    $
    (90
    )
    
    $
    1,708
    
    
    
    1898
    %
 The effective income tax rate for the year ended December 31, 2003 is
approximately (36%). This overall rate reflects the recognition of a tax
benefit related to the reduction in deferred tax liabilities established in
purchase accounting for non-deductible intangible assets, offset by the usage
of U.S. net operating loss carryforwards (NOLs) and current year deductions
related to the exercise of non-qualified stock options and the disqualified
disposition of incentive stock options for which the tax benefit is recorded as
a direct increase to stockholders equity rather than as a reduction of income
tax expense. During 2002, we incurred operating losses for which we recorded a
full valuation allowance, as we could not predict the ultimate realization of
the related deferred tax asset. We believe the issuance of shares in the
public offering we completed on July 15, 2003, when combined with the issuance
of shares in
connection with acquisitions in 2002 and 2003, may have resulted in a
change in control for purposes of Section 382 of the Internal Revenue Code of
1986, as amended, which would limit our ability to utilize a portion of these
NOLs. While we do not believe this limitation on the use of these NOLs would
have a significant impact on our business, we are not able to quantify the
amount of the limitation at this time. Loss from Discontinued Operations (GDS) Variance2003
    
    2002
    
    $
    
    %Loss from discontinued
operations
    
    $
    
    
    
    $
    (3,954
    )
    
    $
    3,954
    
    
    
    (100
    )%
 The loss for 2002 resulted from our decision to discontinue operations at
GretaCoder Data Systems (GDS), which was formerly our European operations
segment, in the first quarter of 2002. The discontinuation of operations was
completed in May 2002. There are no costs associated with this activity in
2003. 37




---



##### 



Year ended December 31, 2002 Compared to Year ended December 31, 2001 Revenues and Gross margins Variance2002
    
    2001
    
    $
    
    %Revenues by typeLicense and royalties
    
    $
    7,398
    
    
    $
    4,031
    
    
    $
    3,367
    
    
    
    84
    %Products
    
    
    21,588
    
    
    
    9,732
    
    
    
    11,856
    
    
    
    122
    %Service and maintenance
    
    
    3,249
    
    
    
    2,699
    
    
    
    550
    
    
    
    20
    %Total
    
    $
    32,235
    
    
    $
    16,462
    
    
    $
    15,773
    
    
    
    96
    %Revenues by segmentEmbedded Security
Division
    
    $
    18,292
    
    
    $
    5,477
    
    
    $
    12,815
    
    
    
    234
    %Enterprise Security
Division
    
    
    13,943
    
    
    
    10,985
    
    
    
    2,958
    
    
    
    27
    %Total
    
    $
    32,235
    
    
    $
    16,462
    
    
    $
    15,773
    
    
    
    96
    %Revenue mix by typeLicense and royalties
    
    
    23
    %
    
    
    25
    %Products
    
    
    67
    %
    
    
    59
    %Service and maintenance
    
    
    10
    %
    
    
    16
    %Total
    
    
    100
    %
    
    
    100
    %Revenue mix by segmentEmbedded Security
Division
    
    
    57
    %
    
    
    33
    %Enterprise Security
Division
    
    
    43
    %
    
    
    67
    %Total
    
    
    100
    %
    
    
    100
    %Gross margins by typeLicense and royalties
    
    
    89
    %
    
    
    84
    %
    
    
    5
    %Products (1)
    
    
    64
    %
    
    
    65
    %
    
    
    (1
    )%Service and maintenance
    
    
    86
    %
    
    
    83
    %
    
    
    3
    %Total
    
    
    72
    %
    
    
    73
    %
    
    
    (1
    )%Gross margins by segmentEmbedded Security
Division
    
    
    72
    %
    
    
    77
    %
    
    
    (5
    )%Enterprise Security
Division
    
    
    74
    %
    
    
    71
    %
    
    
    3
    %Total
    
    
    74
    %
    
    
    73
    %
    
    
    (1
    )%
 Revenues increased 96%, or $15.8 million, to $32.2 million for the period
ended December 31, 2002, from $16.5 million in 2001. The Embedded Security
Division revenues increased 234% or $12.8 million due to the full year presence
of the Securealink acquisition for 2002, which resulted in increased
revenues of approximately $2.2 million, as well as increased revenue from our
largest commercial customer, Cisco Systems, Inc. Cisco accounted for
41% of our consolidated revenues for the year ended December 31,
2002. The Enterprise Security Division segment
increased 27% or $3.0 million due primarily to revenues of
approximately $3.1 million earned under additional long-term
government contracts. These contracts are the result of the governments
approach to internet and communication security in light of the Homeland
Security Initiative. Gross margin remained consistent, 72% for the period ended December 31,
2002, from 73% in 2001. Gross margins in the Embedded Security Division
decreased to 72% in 2002 from 77% in 2001, due to the change in product mix
with the addition of Securealink delivering lower margin products. Enterprise
Security Division margins increased to 74% in 2002 from 71% in 2001 based on
increased customer base purchasing higher margin products as well changes in
product mix with higher volumes in higher margin products such as license
revenue. 38




---



##### 



Operating Expenses Variance2002
    
    2001
    
    $
    
    %Operating expensesResearch and development
    
    $
    8,504
    
    
    $
    6,118
    
    
    $
    2,386
    
    
    
    39
    %Sales and marketing
    
    
    7,341
    
    
    
    5,061
    
    
    
    2,280
    
    
    
    45
    %General and administrative
    
    
    3,852
    
    
    
    2,203
    
    
    
    1,649
    
    
    
    75
    %Write-off of acquired in-process
research and development costs
    
    
    3,375
    
    
    
    
    
    
    
    3,375
    
    
    
    100
    %Costs of integration of acquired
companies
    
    
    256
    
    
    
    
    
    
    
    256
    
    
    
    100
    %Amortization
of acquired intangible
assets
    
    
    1,488
    
    
    
    
    
    
    
    1,488
    
    
    
    100
    %Total
    
    $
    24,816
    
    
    $
    13,382
    
    
    $
    11,434
    
    
    
    85
    %
 Research and development expenses increased 39%, or $2.4 million to $8.5
million for the period ended December 31, 2002, from $6.1 million in 2001. The
increase is primarily related to the addition of the Securealink business, with
the main cost of that business being research and development costs. Research
and development expenses for the Embedded Security Division were focused on the
next generation products (chips), designed to be a very cost-effective, high
throughput, low power-consuming chips in the tradition of SafeNets other
silicon products. Research and development expenses for the Enterprise
Security Division were focused on SafeNets High Assurance product line,
including gateways, software, and other appliances. Some of these products
were made available in 2002 with the remaining products coming to market in
2003. Sales and marketing expenses increased 45%, or $2.3 million to $7.3
million for the period ended December 31, 2002, from $5.1 million in 2001. The
additional expense reflects increased headcount, higher commissions from higher
revenues, as well as additional promotional dollars spent on the branding of
the Securealink products and name. As a percentage of revenues, the expenses
were 23% and 31% in 2002 and 2001, respectively. General and administrative expenses increased 86%, or $1.9 million, to
$4.1 million for the period ended December 31, 2002, from $2.2 million in 2001.
The increase is due to the additional office space obtained with the
Securealink acquisition, additional corporate employees, increased bonus
expenses and additional professional fees incurred related to new corporate
governance requirements. As a percentage of revenues, the expenses were 12%
and 13% in 2002 and 2001, respectively. The write-off of acquired in-process research and development assets,
which totaled $3.4 million for the year ended December 31, 2002, relates to the
January 2002 acquisition of Securealink. This represents the estimated fair
value of the in-process research and development projects that had not yet
reached technological feasibility at the acquisition date, and had no
alternative future use. Accordingly, this amount was immediately expensed at
the acquisition date. The value assigned to the acquired in-process technology
relates entirely to the development of a new application specific integrated
circuit. The estimated fair value of this project was determined by the use of
a discounted cash flow model, using a
discount rate that took into account the stage of completion and the risks
surrounding the successful development and commercialization of the technology.
Subsequent to the acquisition, the Company incurred approximately $0.8 million
in additional research and development charges to complete the development of
the technology, which was licensed to a customer during fiscal year 2002. Amortization of intangible assets, which totaled $1.5 million for the year
ended December 31, 2002, also relates to the January 2002 acquisition of
Securealink. Intangible assets, which consist primarily of developed
technology and patents, are amortized over estimated useful lives ranging from
one to five years. 39




---



##### 



Interest and Other Income, Net Variance2002
    
    2001
    
    $
    
    %Interest and other
income, net
    
    $
    669
    
    
    $
    1,336
    
    
    $
    (667
    )
    
    
    (50
    )%
 Interest and other income decreased by $0.7 million, to $0.7 million for
the year ended December 31, 2002, from $1.4 million in 2001. Interest and
other income decreased primarily due to lower interest rates throughout 2002 as
compared to 2001. Income Tax Expense (Benefit) Variance2002
    
    2001
    
    $
    
    %Income tax expense
(benefit)
    
    $
    (90
    )
    
    $
    
    
    
    $
    (90
    )
    
    
    (100
    )%
 For the year ended December 31, 2002, the Company incurred operating
losses, however, the Company also experienced an income tax benefit related to
the amortization of acquired intangible assets from the Securealink
acquisition. For the year ended December 31, 2001, the Company incurred
operating losses and therefore, did not record income tax expense. The
Companys income tax benefit related to these losses has been offset by a
valuation allowance for the full amount of the net deferred tax assets since
the Companys ability to use the remaining net operating loss carryforward is
dependent upon future taxable income.   40




---



##### 



Liquidity and Capital Resources As of December 31, 2003, SafeNet had working capital of $111.6 million
including unrestricted cash and short-term investments of $113.9 million and
restricted cash of $2.8 million. On July 15, 2003, we completed a secondary
public offering pursuant to which we sold 2.7 million shares of our common
stock and received net proceeds of $83.9 million. SafeNet believes that its
current cash resources and future cash flow from operations will be
sufficient to meet its anticipated short-term and long-term needs. For the year ended December 31, 2003, compared to the same period in 2002,
cash provided by operating activities increased by $1.2 million.
Cash used in investing activities increased $63.7 million, primarily due an increase in
net purchases of investment securities of $50.7 million and cash paid for the acquisition of the OEM
assets of SSH, Inc. $13.8 million. Cash provided
by financing activities increased $92.2 million, which is mainly attributed to
cash proceeds from our July 2003 secondary offering of $83.9 million and an
increase in cash received from stock option exercises of $6.8 million. Material recurring uses of working capital include salaries and other
compensation, which accounted for approximately $22.2 million in 2003, sales
and marketing expenses, which accounted for approximately $4.7 million in 2003,
and research and development projects, which accounted for approximately $5.3
million in 2003. We have expended, and will continue to expend, significant amounts of cash
for acquisition and integration costs related to prior and future acquisitions.
During 2003, we completed the integrations of Cylink, Raqia, and SSH. During
2003, we also spent $0.8 million for integration costs for the pending Rainbow
Technology merger. Pursuant to the terms of the merger agreement related to the proposed
merger with Rainbow Technologies, we may be obligated to pay Rainbow
Technologies a termination fee of $15.0 million if the merger agreement is
terminated because our Board of Directors fails to support the merger in
certain ways or in other specified circumstances following the public
announcement of a competing acquisition proposal involving SafeNet. We expect
to incur costs associated with the merger which may aggregate $12.0 million
related to professional fees such as legal, due diligence, professional
integration advisory services and financial advisory fees. Additionally, we
would expect that there may be additional cash obligations, including
obligations related to possible severance, directors and officers liability
insurance for Rainbow ($1.0 million), and lease buy-outs. At this point, we
are unable to quantify the expected range, with the exception of the directors
and officers liability insurance. The following table sets forth, as of December 31, 2003, our commitments
and contractual obligations for the years indicated (amounts in thousands): Less than
    
    1 - 3
    
    3 - 5
    
    More thanTotal
    
    One Year
    
    Years
    
    Years
    
    5 YearsOperating Leases (1)
    
    $
    17,046
    
    
    $
    2,618
    
    
    $
    4,958
    
    
    $
    4,868
    
    
    $
    4,602Sales and Marketing
Agreement (2)
    
    
    500
    
    
    
    
    
    
    
    500
    
    
    
    
    
    
    
    Purchase
commitments (3)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    17,546
    
    
    $
    2,618
    
    
    $
    5,458
    
    
    $
    4,868
    
    
    $
    4,602
  (1)
    
    The operating leases are for the multiple facilities that we
lease for our operations, sales and headquarters.(2)
    
    This agreement requires certain payments to be made in the future to complete our acquisition of these
exclusive sales and marketing rights.(3)
    
    SafeNet generally does not make unconditional, non-cancelable
purchase commitments. SafeNet enters into purchase orders in the
normal course of business which are less than one year in term. 41




---



##### 



Inflation and Seasonality SafeNet does not believe that inflation will significantly impact its
business. We do not believe our business is seasonal. However, because we
generally recognize product revenues upon shipment and software revenues upon
establishing fair value of undelivered elements, recognition may be irregular
and uneven, thereby disparately impacting quarterly operating results and
balance sheet comparisons. Critical Accounting Policies The Companys accounting policies are more fully described in Note 2 of
the Notes to Consolidated Financial Statements. As discussed in this note, the
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
about future events that affect the amounts reported in the financial
statements and accompanying notes. Future events and their effects cannot be
determined with absolute certainty; therefore, the determination of estimates
requires the exercise of judgment. Actual results inevitably will differ from
those estimates, and such differences may be material to the financial
statements. SafeNet believes the following critical accounting policies affect its
more significant judgments and estimates used in the preparation of its
consolidated financial statements. SafeNet Senior Management has discussed
each of these critical accounting policies with the Companys audit committee. Allowance for Doubtful Accounts SafeNet maintains an allowance for doubtful accounts for estimated losses
resulting from the inability of its customers to make required payments. We
calculate the allowance based on a specific analysis of past due balances and
also consider historical trends of write-offs. If the financial condition of
our customers were to deteriorate, resulting in their inability to make required
payments, additional allowances may be required. Inventory SafeNet provides for its estimated inventory obsolescence or unmarketable
inventory equal to the difference between the cost of the inventory and the
estimated market value based upon assumptions about future demand and market
conditions. The Company utilizes projected sales by product to determine the
net realizable value of the inventory. If actual market conditions are less
favorable than those projected by management, additional inventory write-downs
may be required. Software Development Costs SafeNet calculates amortization of its capitalized software development
costs based on the greater of the amount computed using the ratio that current
gross revenues for a product bear to the total of current and anticipated
future gross revenues for that product or the straight-line method over the
remaining estimated economic life of the product including the period being
reported on. In addition, SafeNet assesses the recoverability of software
development costs by comparing the unamortized balance to the net realizable
value of the asset and writes off the amount by which the unamortized
capitalized costs exceed the net realizable value. These calculations require management to make assumptions about future
demand for its products, future revenues to be generated from the sale of its
products, as well as the estimated useful lives of developed technology. If
actual market conditions or product demand is different from those assumptions,
or if changes in technology limit the useful life of SafeNets core
technology, additional amortization or write-downs may be required. 42




---



##### 



Goodwill and Other Intangible Assets SafeNet accounts for acquired businesses using the purchase method of
accounting. A portion of the purchase price for each of these businesses is
allocated to identifiable tangible and intangible assets and assumed
liabilities based on estimated fair values at the dates of acquisitions. Any
excess purchase price is allocated to goodwill. The identified intangible assets include patents, developed technology,
purchase orders, contract backlog and acquired in-process research and
development assets. Research and development assets are written off at the
date of acquisition in accordance with Financial Accounting Standards Board
(FASB) Interpretation No. 4, Applicability of FASB Statement No. 2 to
Business Combinations Accounted for by the Purchase Method. The fair values
were determined by management, generally based upon information supplied by the
management of the acquired entities and valuations prepared by independent
valuation experts. The valuations have been based primarily upon future cash
flow projections for the acquired assets, discounted to present value using
risk-adjusted discount rates. For certain classes of intangible assets, the
valuations have been based upon estimated cost of replacement. The assigned
useful lives, which range from one to five years, are based upon periods of
estimated cash flows and other factors. If SafeNet used different assumptions
and estimates in the calculation of the fair value of identified intangible
assets and the estimation of the related useful lives, the amounts allocated to
these assets, as well as the related amortization expense, would have been
significantly different than the amounts recorded. Effective January 1, 2002, SafeNet adopted the provisions of FASB
Statement No. 142, Goodwill and Other Intangible Assets. Under Statement 142,
goodwill is no longer amortized but is reviewed annually for impairment, or
more frequently if impairment indicators exist. Impairment exists when the
carrying amount of goodwill exceeds its implied fair value using the impairment
testing methodology in Statement 142. Indicators of potential impairment
include operating losses, loss of a significant customer and adverse industry
developments. Impairment testing for goodwill is conducted annually. Our most
recent test was conducted as of October 1, 2003. The impairment test was based
upon a comparison of the estimated fair values of our reporting units, the
Embedded Security Division and the Enterprise Security Division, to the sums of
the carrying value of the assets and liabilities allocated to each reporting
unit. The fair values used in this evaluation were estimated based upon
discounted future cash flow projections for the reporting units. In order to
project future cash flows, management made a number of assumptions concerning
such things as future sales volume levels, future price levels, and rates of
increase in operating expenses. Since the estimated fair values of the
reporting units exceeded the carrying value of their recorded net assets, no
impairment was identified or recorded. However, if SafeNet used different
assumptions and estimates in the calculation of the fair value of the reporting
units, an impairment of goodwill may have been identified. Revenue Recognition SafeNet derives revenue from software and technology licenses, product
sales, maintenance and other services. Software and technology licenses
contain multiple elements, including the product license, maintenance and/or
other services. The recognition of revenue under these arrangements requires
management to make judgments about the likelihood of granting future
concessions and the ultimate collectibility of fees. Revenues that are earned under long-term contracts to develop high
assurance encryption technology are recognized using contract accounting.
Under contract accounting, revenue from these arrangements is recognized using
the percentage-of-completion method. Progress to completion is measured using
contract milestones. Accounting for these contracts requires the estimation of
the cost, scope and duration of each milestone and each contract. If the
Company does not accurately estimate the resources required or the scope of
work to be performed, or does not manage its projects properly within the
planned periods of time or satisfy its obligations under the contracts, then
future margins may be
significantly and negatively affected or losses on existing contracts may
need to be recognized. Any such resulting reductions in margins or contract
losses could be material to the Companys results of operations. 43




---



##### 



ITEM 7A  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market Risk Market risk is the risk of loss to future earnings, to fair values or to
future cash flows that may result from changes in the price of financial
instruments. SafeNet is exposed to financial market risks, primarily related
to changes in foreign currency exchange rates. SafeNet currently does not have
any derivative financial instruments to protect against adverse currency
movements. SafeNet manages its exposure to market risks related to operations
through regular operating and financing activities. All of the potential
impacts noted below are based on a sensitivity analysis performed as of
December 31, 2003. Actual results may differ materially. Foreign Currency Risk We are exposed to the fluctuations in foreign currency exchange rates,
principally related to the Euro and the British Pound. Such fluctuations
impact the recorded values of our investments in foreign subsidiaries in our
consolidated balance sheet, and our currency translation adjustment, a
component of other comprehensive income. For the year ended December 31, 2003,
a 10% change in average exchange rates for the Euro and British Pound would
have changed our reported currency translation adjustment of $2.5 million by
approximately $0.3 million. The Companys exposure to foreign currency
transaction risk is not significant, and therefore a 10% fluctuation in
exchange rates would have a negligible impact on earnings. Interest Rate Risk We are exposed to investment risk to the extent we purchase short-term
interest bearing investment securities, which are considered cash equivalents
and short-term investments. For the year ended December 31, 2003, we had net
interest income of approximately $0.8 million. A 10% change in the average
interest rate for the year ended December 31, 2003 would have had a negligible
effect on earnings. At December 31, 2003 and 2002, SafeNet did not have any interest bearing
obligations. In addition, SafeNet does not hold any derivative instruments and
does not have any commodity market risk. 44




---



##### 



SAFENET, INC. AND SUBSIDIARIES
 ITEM 8  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS PAGEReport of Independent
            Auditors
        
        
        46Consolidated Balance
            Sheets as of December 31, 2003 and 2002
        
        
        47Consolidated Statements
            of Operations for the years ended December 31, 2003, 2002 and
            2001
        
        
        48Consolidated Statements
            of Comprehensive Income (Loss) for the years ended December 31,
            2003, 2002 and 2001
        
        
        49Consolidated Statements
            of Stockholders Equity for the years ended December 31,
            2003, 2002 and 2001
        
        
        50Consolidated Statements
            of Cash Flows for the years ended December 31, 2003, 2002, and
            2001
        
        
        51Notes to Consolidated
            Financial Statements
        
        
        52
 45




---



##### 



REPORT OF INDEPENDENT AUDITORS The Board of Directors SafeNet, Inc. We have audited the accompanying consolidated balance sheets of SafeNet,
Inc. and subsidiaries as of December 31, 2003 and 2002, and the related
consolidated statements of operations, comprehensive income (loss),
stockholders equity, and cash flows for each of the three years in the period
ended December 31, 2003. Our audits also included the financial statement
schedule listed in the Index at Item 15(a). These financial statements and
schedule are the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial statements and
schedule based on our audits. We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of SafeNet, Inc.
and subsidiaries at December 31, 2003 and 2002, and the consolidated results of
their operations and their cash flows for the each of the three years in the
period ended December 31, 2003, in conformity with accounting principles
generally accepted in the United States. Also, in our opinion, the related
financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material
respects, the information set forth therein. As noted in Note 2 to the financial statements, in 2002 the Company
changed its method of accounting for goodwill. /s/ Ernst & Young LLP Baltimore, Maryland
February 23, 2004 46




---



##### 



SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts) December 31,2003
    
    2002AssetsCurrent assets:Cash and cash equivalents
    
    $
    21,651
    
    
    $
    3,399Restricted cash
    
    
    2,800
    
    
    
    Short-term investments
    
    
    92,280
    
    
    
    28,763Accounts receivable, net of allowance for doubtful accounts
of $940 in 2003 and $224 in 2002
    
    
    13,191
    
    
    
    4,534Inventories, net of reserve of $1,275 in 2003 and $958 in 2002
    
    
    3,123
    
    
    
    1,008Prepaid expenses and other current assets
    
    
    1,414
    
    
    
    1,002Current assets of discontinued operations
    
    
    
    
    
    
    93Total current assets
    
    
    134,459
    
    
    
    38,799Property and equipment, net
    
    
    3,809
    
    
    
    1,246Computer software development costs, net of accumulated
amortization of $1,696 in 2003 and $1,513 in 2002
    
    
    1,982
    
    
    
    479Goodwill
    
    
    42,407
    
    
    
    12,826Other intangible assets, net of accumulated amortization of
$8,483 in 2003
and $1,640 in 2002
    
    
    23,599
    
    
    
    595Other assets
    
    
    1,900
    
    
    
    1,374Total assets
    
    $
    208,156
    
    
    $
    55,319Liabilities
and Stockholders EquityCurrent liabilities:Accounts payable
    
    $
    3,799
    
    
    $
    1,456Accrued salaries and commissions
    
    
    3,770
    
    
    
    2,162Due to former owners of acquired company
    
    
    2,800
    
    
    
    Income taxes payable
    
    
    2,294
    
    
    
    Other accrued expenses
    
    
    2,768
    
    
    
    1,424Advance payments and deferred revenue
    
    
    4,791
    
    
    
    1,393Deferred income taxes
    
    
    2,607
    
    
    
    Current liabilities of discontinued operations
    
    
    
    
    
    
    377Total current liabilities
    
    
    22,829
    
    
    
    6,812Unfavorable lease liability
    
    
    4,149
    
    
    
    Deferred income taxes
    
    
    2,181
    
    
    
    129Total liabilities
    
    
    29,159
    
    
    
    6,941Commitments and contingencies
    
    
    
    
    
    
    Stockholders equity:Preferred stock, $.01 par value per share,
authorized 500 shares, no shares issued and outstanding
    
    
    
    
    
    
    Common stock, $.01 par value per share, authorized 50,000 shares,
issued and outstanding shares of 13,286 in 2003 and 7,894 in 2002
    
    
    133
    
    
    
    79Additional paid-in capital
    
    
    199,783
    
    
    
    65,665Accumulated other comprehensive income
    
    
    5,394
    
    
    
    2,859Accumulated deficit
    
    
    (26,313
    )
    
    
    (20,225
    )Total stockholders equity
    
    
    178,997
    
    
    
    48,378Total liabilities and stockholders equity
    
    $
    208,156
    
    
    $
    55,319
 See accompanying notes to consolidated financial statements. 47




---



##### 



SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts) Year ended December 31,2003
    
    2002
    
    2001Revenues:Licenses and royalties
    
    $
    16,464
    
    
    $
    7,398
    
    
    $
    4,031Products
    
    
    38,797
    
    
    
    21,588
    
    
    
    9,732Service and maintenance
    
    
    10,933
    
    
    
    3,249
    
    
    
    2,699Total revenues
    
    
    66,194
    
    
    
    32,235
    
    
    
    16,462Cost of revenues:Licenses and royalties
    
    
    812
    
    
    
    811
    
    
    
    644Products
    
    
    12,106
    
    
    
    7,699
    
    
    
    3,423Service and maintenance
    
    
    1,267
    
    
    
    453
    
    
    
    458Amortization of acquired intangible assets
    
    
    2,652
    
    
    
    
    
    
    
    Total cost of revenues
    
    
    16,837
    
    
    
    8,963
    
    
    
    4,525Gross profit
    
    
    49,357
    
    
    
    23,272
    
    
    
    11,937Operating expenses:Research and development expenses
    
    
    14,664
    
    
    
    8,504
    
    
    
    6,118Sales and marketing expenses
    
    
    14,929
    
    
    
    7,341
    
    
    
    5,061General and administrative expenses
    
    
    6,716
    
    
    
    3,852
    
    
    
    2,203Write-off of acquired in-process research and development
costs
    
    
    9,681
    
    
    
    3,375
    
    
    
    Costs of integration of acquired companies
    
    
    3,934
    
    
    
    256
    
    
    
    Amortization of acquired intangible assets
    
    
    4,710
    
    
    
    1,488
    
    
    
    Total operating expenses
    
    
    54,634
    
    
    
    24,816
    
    
    
    13,382Operating loss
    
    
    (5,277
    )
    
    
    (1,544
    )
    
    
    (1,445
    )Interest and other income, net
    
    
    807
    
    
    
    669
    
    
    
    1,336Loss from continuing operations before income taxes
    
    
    (4,470
    )
    
    
    (875
    )
    
    
    (109
    )Income tax expense (benefit)
    
    
    1,618
    
    
    
    (90
    )
    
    
    Loss from continuing operations
    
    
    (6,088
    )
    
    
    (785
    )
    
    
    (109
    )Loss from operations of discontinued GDS business (including
loss on disposal of $3,506 in 2002)
    
    
    
    
    
    
    (3,954
    )
    
    
    (3,453
    )Net loss
    
    $
    (6,088
    )
    
    $
    (4,739
    )
    
    $
    (3,562
    )Basic and diluted loss per common share:Loss from continuing operations
    
    $
    (0.54
    )
    
    $
    (0.10
    )
    
    $
    (0.01
    )Loss from discontinued GDS business
    
    
    
    
    
    
    (0.51
    )
    
    
    (0.49
    )Net loss per share
    
    $
    (0.54
    )
    
    $
    (0.61
    )
    
    $
    (0.50
    )
 See accompanying notes to consolidated financial statements. 48




---



##### 



SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(In thousands) Year ended December 31,2003
    
    2002
    
    2001Net loss
    
    $
    (6,088
    )
    
    $
    (4,739
    )
    
    $
    (3,562
    )Other comprehensive income (loss):Foreign currency translation adjustment
    
    
    2,535
    
    
    
    2,904
    
    
    
    (165
    )Reclassification adjustment  realization of
foreign currency translation adjustment
upon disposal of GDS business
    
    
    
    
    
    
    1,526
    
    
    
    Other
    
    
    
    
    
    
    (45
    )
    
    
    (84
    )Total other comprehensive income (loss)
    
    
    2,535
    
    
    
    4,385
    
    
    
    (249
    )Comprehensive loss
    
    $
    (3,553
    )
    
    $
    (354
    )
    
    $
    (3,811
    )
 See accompanying notes to consolidated
financial statements. 49




---



##### 



SAFENET, INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY
(In thousands) AccumulatedCommon stock
    
    Additional
    
    other
    
    
    
    
    
    Totalpaid-in
    
    comprehensive
    
    Accumulated
    
    stockholders'Shares
    
    Amount
    
    capital
    
    income (loss)
    
    deficit
    
    equityBalance at January 1, 2001
    
    
    6,941
    
    
    $
    69
    
    
    $
    50,855
    
    
    $
    (1,277
    )
    
    $
    (11,924
    )
    
    $
    37,723Stock options exercised
    
    
    167
    
    
    
    2
    
    
    
    1,547
    
    
    
    
    
    
    
    
    
    
    
    1,549Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,562
    )
    
    
    (3,562
    )Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (249
    )
    
    
    
    
    
    
    (249
    )Other
    
    
    
    
    
    
    
    
    
    
    (2
    )
    
    
    
    
    
    
    
    
    
    
    (2
    )Balance at December 31, 2001
    
    
    7,108
    
    
    
    71
    
    
    
    52,400
    
    
    
    (1,526
    )
    
    
    (15,486
    )
    
    
    35,459Issuance of common stock in
connection with the
acquisition of Securealink
    
    
    575
    
    
    
    6
    
    
    
    10,630
    
    
    
    
    
    
    
    
    
    
    
    10,636Issuance of common stock under
Employee Stock Purchase Plan
    
    
    6
    
    
    
    
    
    
    
    217
    
    
    
    
    
    
    
    
    
    
    
    217Issuance of common stock for
stock option exercises
    
    
    205
    
    
    
    2
    
    
    
    1,968
    
    
    
    
    
    
    
    
    
    
    
    1,970Income tax benefit related to
stock option exercises
    
    
    
    
    
    
    
    
    
    
    450
    
    
    
    
    
    
    
    
    
    
    
    450Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,739
    )
    
    
    (4,739
    )Other comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,385
    
    
    
    
    
    
    
    4,385Balance at December 31, 2002
    
    
    7,894
    
    
    
    79
    
    
    
    65,665
    
    
    
    2,859
    
    
    
    (20,225
    )
    
    
    48,378Issuance of common stock in
connection with secondary offering
    
    
    2,698
    
    
    
    27
    
    
    
    83,893
    
    
    
    
    
    
    
    
    
    
    
    83,920Issuance of common stock in
connection with the acquisition
of Cylink Corporation
    
    
    1,680
    
    
    
    17
    
    
    
    31,067
    
    
    
    
    
    
    
    
    
    
    
    31,084Assumption of stock options in
connection with the acquisition
of Cylink Corporation
    
    
    
    
    
    
    
    
    
    
    1,399
    
    
    
    
    
    
    
    
    
    
    
    1,399Assumption of stock warrants in
connection with the acquisition
of Cylink Corporation
    
    
    
    
    
    
    
    
    
    
    292
    
    
    
    
    
    
    
    
    
    
    
    292Issuance of common stock in
connection with the asset
acquisition of Raqia Networks
    
    
    354
    
    
    
    4
    
    
    
    6,094
    
    
    
    
    
    
    
    
    
    
    
    6,098Income tax benefit related to
stock option exercises
    
    
    
    
    
    
    
    
    
    
    2,362
    
    
    
    
    
    
    
    
    
    
    
    2,362Issuance of common stock under
Employee Stock Purchase Plan
    
    
    7
    
    
    
    
    
    
    
    162
    
    
    
    
    
    
    
    
    
    
    
    162Issuance of common stock for
stock option exercises
    
    
    653
    
    
    
    6
    
    
    
    8,849
    
    
    
    
    
    
    
    
    
    
    
    8,855Net 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
    )
    
    $
    178,997
 See accompanying notes to consolidated financial
statements. 50




---



##### 



SAFENET, INC
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands) Year ended December 31,2003
    
    2002
    
    2001Cash flows from operating activities:Net loss
    
    $
    (6,088
    )
    
    $
    (4,739
    )
    
    $
    (3,562
    )Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:Write-off of acquired in-process research and
development costs
    
    
    9,681
    
    
    
    3,375
    
    
    
    Loss on disposal of discontinued GDS business
    
    
    
    
    
    
    2,687
    
    
    
    Depreciation and amortization of property and equipment
    
    
    1,318
    
    
    
    975
    
    
    
    662Amortization of computer software development costs
    
    
    183
    
    
    
    574
    
    
    
    954Amortization of other intangible assets
    
    
    7,362
    
    
    
    1,488
    
    
    
    85Income tax benefit related to stock option exercises
    
    
    2,362
    
    
    
    450
    
    
    
    Other non-cash charges
    
    
    
    
    
    
    501
    
    
    
    Deferred income taxes
    
    
    (2,445
    )
    
    
    
    
    
    
    Amortization of unfavorable lease liability
    
    
    (632
    )
    
    
    
    
    
    
    Changes in operating assets and liabilities:Accounts receivable, net
    
    
    (1,772
    )
    
    
    (551
    )
    
    
    167Inventories, net
    
    
    (230
    )
    
    
    270
    
    
    
    1,369Prepaid expenses and other current assets
    
    
    259
    
    
    
    383
    
    
    
    (621
    )Accounts payable
    
    
    1,890
    
    
    
    (257
    )
    
    
    (778
    )Accrued salaries and commissions
    
    
    (3,979
    )
    
    
    977
    
    
    
    (937
    )Accrued income taxes
    
    
    2,294
    
    
    
    
    
    
    
    Other accrued expenses
    
    
    (3,521
    )
    
    
    329
    
    
    
    (8
    )Advanced payments and deferred revenue
    
    
    489
    
    
    
    (529
    )
    
    
    959Net cash provided by (used in) operating activities
    
    
    7,171
    
    
    
    5,933
    
    
    
    (1,710
    )Cash flows from investing activities:Maturities
of held to maturity securities
    
    
    28,763
    
    
    
    25,378
    
    
    
    8,433Sales of
available for sale securities
    
    
    52,927
    
    
    
    
    
    
    
    Purchases of
available for sale securities
    
    
        (145,207
    )
    
    
    (38,277
    )
    
    
    (17,966
    )Purchases of equipment and leasehold improvements
    
    
    (2,628
    )
    
    
    (507
    )
    
    
    (399
    )Expenditures for computer software development
    
    
    (1,686
    )
    
    
    (326
    )
    
    
    (167
    )Cash paid for Securealink, net of cash acquired
    
    
    
    
    
    
    (3,769
    )
    
    
    Cash paid for SSH, including restricted cash
    
    
    (13,796
    )
    
    
    
    
    
    
    Cash received upon acquisition of Cylink, net of cash
paid
    
    
    703
    
    
    
    
    
    
    
    Cash paid for Raqia, net of cash acquired
    
    
    (1,390
    )
    
    
    
    
    
    
    Deferred acquisition costs
    
    
    
    
    
    
    (625
    )
    
    
    Other assets
    
    
    (46
    )
    
    
    (565
    )
    
    
    Net cash used in investing activities
    
    
    (82,360
    )
    
    
    (18,691
    )
    
    
    (10,099
    )Cash flows from financing activities:Proceeds from stock options exercised and issuance
of stock under Employee Stock Purchase Plan, net
    
    
    9,017
    
    
    
    2,187
    
    
    
    1,549Proceeds from secondary stock offering, net
    
    
    83,920
    
    
    
    
    
    
    
    Repayment of Securealink line of credit
    
    
    
    
    
    
    (1,484
    )
    
    
    Net cash provided by financing activities
    
    
    92,937
    
    
    
    703
    
    
    
    1,549Effect of exchange rate changes on cash
    
    
    504
    
    
    
    460
    
    
    
    (115
    )Net increase (decrease) in cash and cash equivalents
    
    
    18,252
    
    
    
    (11,595
    )
    
    
    (10,375
    )Cash and cash equivalents at beginning of year
    
    
    3,399
    
    
    
    14,994
    
    
    
    25,369Cash and cash equivalents at end of year
    
    $
    21,651
    
    
    $
    3,399
    
    
    $
    14,994
 See accompanying notes to consolidated financial
statements. 51




---



##### 



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 (Amounts in Thousands) (1) BUSINESS SafeNet, Inc. (SafeNet or the Company) delivers a widely deployed
Virtual Private Network, or VPN, technology for secure business communications
over the Internet, offering both Original Equipment Manufacturer (OEM)
technology and end-user products for VPN and e-commerce applications. The
Company provides its network security solutions worldwide for financial,
enterprise, telecommunications and government use. The Companys technology is
sold and licensed in various formats, including software, hardware, silicon
chips, and intellectual property. In January 2002, the Company acquired Pijnenburg Securealink, Inc.
(Securealink), a European manufacturer of security chips for e-commerce
transactions. In February 2003, the Company acquired Cylink, Inc. (Cylink). Cylink
develops, markets, and supports a comprehensive portfolio of hardware and
software security products for mission-critical private networks and business
communications over the Internet. In February 2003, the Company acquired the assets of Raqia Networks, Inc.
(Raqia), a development stage company that was developing content inspection
technology. In November 2003, the Company acquired the OEM Products Group of SSH
Communication Security Corp. (SSH), a European developer of VPN client
software and security and networking toolkits. As discussed in Note 3, in February 2002, the Company made a decision to
discontinue the operations of its Swiss subsidiary, GretaCoder Data Systems
(GDS). The financial position and results of operations of GDS have been
disclosed as discontinued operations in the accompanying consolidated financial
statements. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of the Company
and its subsidiaries, all of which are wholly owned. Significant intercompany
accounts and transactions have been eliminated in consolidation. Use of Estimates The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect amounts reported in
the consolidated financial statements and the accompanying notes. Actual
results could differ from those estimates. Cash Equivalents The Company considers all highly liquid investments with maturities of
three months or less when purchased to be cash equivalents. The Company had
approximately $20,312 and $3,399 of cash equivalents at December 31, 2003 and
2002, respectively, consisting primarily of overnight repurchase agreements,
short-term money market funds and commercial paper. 52




---



##### 



Restricted Cash Restricted cash consists of cash in placed in escrow and designated for
future disbursement to the former owners of acquired companies. As of December
31, 2003, the Company had $2,800 in restricted cash related to the SSH
acquisition (see Note 4). Short-Term Investments Management determines the appropriate classification of debt securities at
the time of purchase and reevaluates such designation as of each balance sheet
date. Debt securities are classified as held-to-maturity when the Company has
the positive intent and ability to hold the securities to maturity.
Held-to-maturity securities are stated at amortized cost, adjusted for
amortization of premiums and accretion of discounts to maturity computed under
the effective interest method. Such amortization is included in interest
income. Interest on securities classified as held-to-maturity is included in
interest income. Marketable equity securities and debt securities not classified as
held-to-maturity are classified as available-for-sale. Available-for-sale
securities are carried at fair value, with the unrealized gains and losses, net
of tax, reporting in other comprehensive income. The amortized cost of debt
securities in this category is adjusted for amortization of premiums and
accretion of discounts to maturity computed under the effective interest
method. Such amortization is included in interest income. Realized gains and
losses and declines in value judged to be other-than-temporary on
available-for-sale securities are included in interest income. The cost of
securities sold is based on the specific identification method. Interest and
dividends on securities classified as available-for-sale are included in
interest income. At December 31,
    2003 and 2002, the Company has held-to-maturity securities totaling $0 and
    $28,763, respectively, and available-for-sale securities totaling $92,280
    and $0, respectively, consisting primarily of corporate debt instruments for
    which amortized cost approximated fair value. As of December 31, 2003, aggregate
    maturities of the Companys available-for-sale securities are as follows:
    $22,105 within one year, 1,500 within two to five years, $3,000 within five
    to ten years and $65,675 thereafter. All investments are classified as current
    as the Company views its available-for-sale securities as available for use
    in its current operations. Accounts Receivable and Allowance for Doubtful Accounts The Company reports accounts receivable at net realizable value. The
Company maintains an allowance for doubtful accounts for estimated losses
resulting from the inability of its customers to make required payments. The
Company calculates the allowance based on a specific analysis of past due
balances and also considers historical trends of write-offs. Past due status
is based on how recently payments have been received by customers. Actual
collection experience has not differed significantly from the Companys
estimates, due primarily to credit and collections practices and the financial
strength of its customers. Inventories Inventories are stated at the lower of cost or market. Cost is determined
by the first-in, first-out method. Property and Equipment Property and equipment is stated at cost and depreciation is computed
using the straight-line method over estimated useful lives ranging primarily
from three to seven years. Amortization of leasehold improvements is computed
using the straight-line method over the lesser of the useful life of the asset
or the remaining term of the lease. Computer Software Development Costs Costs for the development of new software products and substantial
enhancements to existing software products are expensed as research and
development costs as incurred until technological feasibility has been
established, at which time any additional development costs are capitalized
until the 53




---



##### 



product is available for general release to customers. The Company
defines the establishment of technological feasibility as the completion of a
working model of the software product that has been tested to be consistent
with the product design specifications and that is free of any uncertainties
related to known high-risk development issues. Amortization of software development costs, which is included in cost of
revenues, begins upon general release of the software. These costs are
amortized on a product by-product basis using the greater of: (i) the amount
computed using the ratio that current gross revenues for each product bear to
the total of current and anticipated future revenue for that product, or (ii)
the amount computed using the straight-line method over the estimated economic
useful life of three to five years. Such costs are amortized beginning on
product release dates. The Company assesses the recoverability of computer
software development costs by comparing the unamortized balance to the net
realizable value of the asset and writes-off the amount by which the
unamortized capitalized costs exceed the estimated net realizable value.
During the year ended December 31, 2001, the Company wrote-off $218 of
capitalized software development costs for which the unamortized balance
exceeded the estimated net realizable value. This write-off has been included
as a charge to 2001 research and development expenses. Goodwill and Other Intangible Assets Goodwill
    is initially measured as the excess of the cost of an acquired company over
    the sum of the amounts assigned to tangible and identifiable intangible assets
    acquired less liabilities assumed. The Company does not amortize goodwill,
    but rather reviews the carrying value of the asset for impairment at least
    annually in accordance with the provisions of FASB Statement No. 142,
    Goodwill and Intangible Assets, the provisions of which the Company
    adopted effective January 1, 2002. During the year ended December 31,
    2001, the Company recorded $85 of amortization of goodwill, all of which was
    included in loss from operations of discontinued GDS business in the accompanying
    statement of operations. The goodwill impairment test under Statement 142 involves a two-step
approach. Under the first step, the Company determines the fair value of each
reporting unit to which goodwill has been assigned. The reporting units of the
Company for purposes of the impairment test are the Companys two operating
segments, the Embedded Security Division and the Enterprise Security Division,
as these are the components of the business for which discrete financial
information is available and segment management regularly reviews the operating
results of those components. The Company then compares the fair value of each
reporting unit to its carrying value, including goodwill. The Company
estimates the fair value of each reporting unit by estimating the present value
of the reporting units future cash flows. If the fair value exceeds the
carrying value, no impairment loss is recognized. If the carrying value
exceeds the fair value, the goodwill of the reporting unit is considered
potentially impaired and the second step is completed in order to measure the
impairment loss. Under the second step, the Company calculates the implied
fair value of goodwill by deducting the fair value of all tangible and
intangible net assets, including any unrecognized intangible assets, of the
reporting unit from the fair value of the reporting unit as determined in the
first step. The Company then compares the implied fair value of goodwill to
the carrying value of goodwill. If the implied fair value of goodwill is less
than the carrying value of goodwill, the Company recognizes an impairment loss
equal to the difference. Intangible assets with finite lives are amortized over their estimated
useful lives ranging from one to five years, with a weighted average useful
live of 35 months (see Note 8). Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of Long-lived assets, including amortized intangible assets, are reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be fully recoverable. If an impairment
indicator is present, the Company evaluates whether impairment exists on the
basis of undiscounted expected future cash flows from the assets over the
remaining amortization period. If impairment exists, the asset is reduced by
the estimated difference between its fair value and its carrying value. Fair
value is usually determined using discounted cash flows. Assets to be disposed
of are reported at the lower of carrying value or fair value less costs to
sell. 54




---



##### 



Product Warranties The Company offers a one-year warranty for substantially all of its
products. The specific terms and conditions of those warranties vary depending
upon the product sold and country in which SafeNet does business. The Company
estimates the costs that may be incurred under its basic limited warranty and
records a liability in the amount of such costs at the time product revenue is
recognized. Factors that affect the Companys warranty liability include the
number of installed units, historical and anticipated rates of warranty claims
and cost per claim. The Company periodically assesses the adequacy of its
recorded warranty liabilities and adjusts the amounts as necessary. The
balance of the Companys warranty accrual totaled $259 and $50 at December 31,
2003 and 2002, respectively. Unfavorable Lease Liability Unfavorable lease liability represents a liability assumed in the
acquisition of Cylink (see Note 4) for an operating lease with terms
unfavorable to market prices. The liability was measured as the present value
of the excess of contractual lease obligations over market prices, discounted
using the Companys credit adjusted interest rate. The liability is being
amortized as a reduction of rent expense using the interest method over the
remaining term of the lease. For the year ended December 31, 2003,
amortization of the unfavorable lease liability totaled $632 and is included in
general and administrative expenses. The current portion of the unfavorable
lease liability as of December 31, 2003 of $735 is included in other accrued
expenses in the accompanying consolidated balance sheet. Revenue Recognition The Company derives revenue from software and technology licenses, product
sales, maintenance (post-contract customer support), and services. Software
and technology licenses typically contain multiple elements, including the
product license, maintenance, and/or other services. The Company allocates the
total arrangement fee among each deliverable based on the fair value of each of
the deliverables determined based on vendor-specific objective evidence. License and Royalties License revenue is comprised of perpetual and time-based license fees,
which are derived from arrangements with end-users, original equipment
manufacturers and resellers. For each license arrangement, the Company defers
revenue recognition until: (a) persuasive evidence of an arrangement exists;
(b) delivery of the software or technology has occurred and there are no
remaining obligations or substantive customer acceptance provisions; (c) the
fee is fixed or determinable; and (d) collection of the fee is probable. For
both perpetual and time-based licenses, once all of these conditions are
satisfied, the Company recognizes license revenue based on the residual method
after all elements other than maintenance have been delivered as prescribed by
SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect
to Certain Transactions. Royalties are recognized as they are earned. Revenues that are earned under long-term contracts to develop high
assurance encryption technology are recognized using contract accounting.
Under contract accounting, revenue from these arrangements is recognized using
the percentage-of-completion method. Progress to completion is measured using
contract milestones. Management considers contract milestones to be the best
available measure of progress on these contracts since each milestone contains
customer-specified acceptance criteria. Any estimated losses are provided for
in their entirety in the period they are first determined. Actual remaining
costs under fixed price contracts could vary significantly from the Companys
estimates, and such differences could be material to the financial statements. Products The Company also sells hardware and related encryption products. For each
product sale, the Company defers revenue recognition until: (a) persuasive
evidence of an arrangement exists; (b) delivery has occurred and there are no
remaining obligations or substantive customer acceptance provisions; (c) the
selling price to the customer is fixed or determinable; and (d) collectibility
of the selling price is reasonably assured. 55




---



##### 



Maintenance and Other Services Maintenance revenue is derived from support arrangements. Maintenance
arrangements provide technical customer support and the right to unspecified
upgrades on an if-and-when-available basis. In accordance with SOP 97-2,
Software Revenue Recognition, vendor specific objective evidence of fair value
of maintenance is determined based on the price charged for the maintenance
element when sold separately. The maintenance term is typically one year in
duration and maintenance revenue is recognized ratably over the maintenance
term. Unrecognized maintenance fees are included in deferred revenue. Other service revenue is comprised of revenue from consulting fees and
training. Service revenue is recognized when the services are provided to the
customer. The Companys policy is to recognize software license revenue when
these associated services are not essential to the functionality of the
product. To date, these services have not been essential to the functionality
of the products. Vendor specific objective evidence of fair value of these
services is determined by reference to the price that a customer will be
required to pay when the services are sold separately, which is based on the
price history that the Company has developed for separate sales of these
services. Shipping and Handling Costs All shipping and handling costs incurred in connection with the sale of
products to customers is included in cost of product revenues. Foreign Currency Translation The financial statements of foreign subsidiaries for which the local
currency is the functional currency have been translated into U.S. dollars in
accordance with FASB Statement No. 52, Foreign Currency Translation. All
balance sheet accounts have been translated using the exchange rates in effect
at the balance sheet date. The Company, in accordance with
APB 23, Accounting for Income Taxes  Special Areas, has
not provided for deferred income taxes on unremitted earnings
including translation adjustments on these earnings. Income statement amounts have been translated using
the average exchange rates during the year. The gains and losses resulting
from the changes in exchange rates from year to year have been reported in
other comprehensive income. Transactions of foreign subsidiaries which are
denominated in currencies other than the functional currency have been
remeasured into the functional currency with any resulting gain or loss
reported as a component of income. The effect on the consolidated statements
of operations of all transaction gains and losses is insignificant for all
years presented. Income Taxes The Company uses the liability method in accounting for income taxes.
Under this method, deferred income tax assets and liabilities are determined
based on difference between financial reporting and tax bases of assets and
liabilities and are measured using the enacted tax rates and laws that will be
in effect when the differences are expected to reverse. Employee Stock-Based Compensation At December 31, 2003, the Company had five stock-based employee
compensation plans, which are described more fully in Note 12. The Company
accounts for those plans using the intrinsic value method prescribed by APB
Opinion No. 25, Accounting for Stock Issued to Employees, and related
interpretations. No stock-based employee compensation cost is reflected in the
statements of operations, as all options granted under those plans had an
exercise price equal to the market value of the underlying common stock on the
date of grant. The following table illustrates the effect on net loss and loss per share
if the Company had applied the fair value recognition provisions of FASB
Statement No. 123, Accounting for Stock-Based Compensation, to stock-based
employee compensation. 56




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##### 



Year Ended December 31,2003
    
    2002
    
    2001Net loss, as reported
    
    $
    (6,088
    )
    
    $
    (4,739
    )
    
    $
    (3,562
    )Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of taxes
    
    
    (4,178
    )
    
    
    (3,762
    )
    
    
    (5,436
    )Pro forma net loss
    
    $
    (10,266
    )
    
    $
    (8,501
    )
    
    $
    (8,998
    )Loss per share:Basic and dilutedas reported
    
    $
    (0.54
    )
    
    $
    (0.61
    )
    
    $
    (0.50
    )Basic and dilutedpro forma
    
    $
    (0.90
    )
    
    $
    (1.10
    )
    
    $
    (1.26
    )
 The fair value of the stock-based awards was estimated at the date of
grant using the Black-Scholes option-pricing model. The Black-Scholes
option-pricing model and other models were developed for use in estimating the
fair value of traded options, which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions, including the expected stock price volatility. Because
the Companys stock options have characteristics significantly different from
those of traded options and because changes in the subjective input assumptions
can materially affect the fair value estimate, in managements opinion, the
existing models do not necessarily provide a reliable single measure of the
fair value of its stock-based awards. The following assumptions were made in
computing the fair value of stock-based awards for the years ended December 31: 2003
    
    2002
    
    2001Risk-free interest rate
    
    
    3.11
    %
    
    
    3.88
    %
    
    
    4.42
    %Dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Option life
    
    3-5 years
    
    3-5 years
    
    3-5 yearsStock price volatility
    
    
    106
    %
    
    
    119
    %
    
    
    139
    %Weighted average fair value of granted options
    
    $
    16.74
    
    
    $
    8.85
    
    
    $
    11.50
 For purposes of the pro forma disclosures above, the estimated fair values
of options granted are amortized to expense over the options vesting periods. Comprehensive Income (Loss) Comprehensive income (loss) includes all changes in equity that result
from recognized transactions and other economic events of a period other than
transactions with owners in their capacity as owners. Certain non-owner
changes in equity, consisting primarily of foreign currency translation
adjustments, are included in other comprehensive income (loss). The Company
reports comprehensive income (loss) in the statement of comprehensive income
(loss) and discloses the accumulated total of other comprehensive income (loss)
in the stockholders equity section of the consolidated balance sheet. As of
December 31, 2003 and 2002, accumulated other comprehensive income (loss)
consisted solely of foreign currency translation adjustments. Fair Value of Financial Instruments The carrying amount of financial instruments, including cash and cash
equivalents, available for sale securities and held-to-maturity securities
approximates fair value based on the short-term nature of these instruments. 57




---



##### 



Reclassifications Where appropriate, certain amounts in prior year consolidated financial
statements have been reclassified to conform to the 2003 presentation. Recent Accounting Pronouncements Effective January 2003, the Company adopted FASB Statement No. 146,
Accounting for Costs Associated With Exit or Disposal Activities(Statement
146), which addresses financial accounting and reporting for costs related to
exit or disposal activities and nullifies EITF Issue No. 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit
an Activity (including Certain Costs Incurred in a Restructuring). The impact
of adoption did not have an impact on the consolidated financial statements. In January 2003, the FASB issued Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities, an interpretation of
ARB 51 and
amended it in December 2003. The primary objectives of this interpretation are
to provide guidance on the identification of entities for which control is
achieved through means other than through voting rights (variable interest
entities) and how to determine when and which business enterprise (the
primary beneficiary) should consolidate the variable interest entity. This
new model for consolidation applies to an entity in which either (i) the equity
investors (if any) do not have a controlling financial interest; or (ii) the
equity investment at risk is insufficient to finance that entitys activities
without receiving additional subordinated financial support from other parties.
In addition, FIN 46 requires that the primary beneficiary, as well as all
other enterprises with a significant variable interest in a variable interest
entity, make additional disclosures. The Company prior to the adoption of FIN
46 consolidated all enterprises in which it maintained a controlling financial
interest. Upon the adoption of FIN 46, the Company did not identify any
investments in variable interest entities not currently consolidated and in
which the Company is considered the primary beneficiary. (3) DISCONTINUED OPERATIONS As discussed further in Note 4, on January 2, 2002, SafeNet acquired 100
percent of the outstanding common shares of Pijnenburg Securealink, Inc.
(Securealink). SafeNets acquisition of Securealink resulted in changes to
SafeNets business initiatives. One of the areas impacted was the Companys
Swiss subsidiary, GDS. Based on the amount of GDS operating and cash losses
during 2000 and 2001, as well as a significant downturn in future business
prospects due to the loss of two substantial contracts in February 2002,
SafeNet management made the decision to discontinue operations at GDS. Certain
employees from GDSs sales and marketing team were transferred to SafeNet to
create a new European sales office focused on selling SafeNets Enterprise
Security products in Europe. All of the operations at GDS, including research
and development, manufacturing and administration were closed and 26 employees
were terminated during the first and second quarters of 2002. As a result of the discontinued operations, the Company recorded a charge
of $3,506 in the first quarter of 2002 related to the write-off of the
abandoned assets and the accrual of the estimated costs of the 58




---



##### 



closing and severance and related costs. The disposition of GDS
operations represents the disposal of a business segment under FASB Statement
No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.
Accordingly, the results of this operation have been classified as discontinued
during all periods presented. For business segment reporting purposes, GDSs
business results were previously classified as the segment European
Operations. Summarized operating results from the discontinued operation included in
the consolidated statements of operations, excluding the loss on
disposal, are as follows for the years ended
December 31: 2002
    
    2001Revenues
    
    $
    198
    
    
    $
    1,655Loss from operations
    
    
    (448
    )
    
    
    (3,453
    )Loss on disposal
    
    
    (3,506
    )
    
    
    Net loss
    
    $
    (3,954
    )
    
    $
    (3,453
    )
 Assets and liabilities of the discontinued operations at December 31, 2002
were as follows: Other current assets
    
    $
    93Current liabilities
    
    
    (377
    )Net liabilities of discontinued operations
    
    $
    (284
    )
 The fair values of assets to be disposed were based on estimated net
realizable value at the time of disposal. The significant components of the
loss on disposal of the GDS operations is as follows: Severance costs
    
    $
    697Lease termination costs
    
    
    573Goodwill
    
    
    316Reclassification of foreign currency translation loss
    
    
    1,526Other
    
    
    394Total
    
    $
    3,506
 There were no costs from discontinued operations for the year ended
December 31, 2003. (4) ACQUISITIONS Pijenburg Securealink, Inc. On January 2, 2002, SafeNet acquired 100% of the outstanding common shares
of Securealink in accordance with an Agreement and Plan of Reorganization dated
December 14, 2001. The purchase price the Company paid to the stockholders of
Securealink in connection with the acquisition totaled $14,778 and consisted of
an aggregate of 575 shares of SafeNet, Inc. common stock valued at $10,636,
$2,000 in cash, contingent convertible promissory notes with an aggregate
principal amount of $2,000, the resolution and payment of which were satisfied
on May 16, 2002 in the aggregate amount of $1,617, and direct costs of
acquisition of $525. The fair market value of common shares was based on the
average market price of the shares over the period from three days before to
three days after the closing date. The cash portion of the consideration was
funded with cash on hand. The amount and type of consideration was determined on the basis of arms
length negotiations between the Company and Securealink. Securealink develops
security chips and sells them in Europe and throughout the world. Securealink
is continuing to operate as a provider of security chips and is now a
subsidiary of SafeNet. As a result of the acquisition, SafeNet has broadened
its market with the addition of new technologies and a larger presence in
Europe. Additionally, Securealink brings over thirty 59




---



##### 



cryptographic experts who have complimented and strengthened development
team. The results of Securealink have been included in the Companys
consolidated results beginning on the date of acquisition. The following table summarizes the changes to assets (other than cash) and
liabilities in connection with this acquisition: Current assets, excluding cash of $374
    
    $
    1,271Property and equipment
    
    
    787Goodwill
    
    
    10,859Acquired in-process research and development costs
    
    
    3,375Intangible assets subject to amortization
    
    
    1,905Total assets acquired, excluding cash
    
    
    18,197Short-term borrowings
    
    
    1,484Deferred income taxes
    
    
    670Other current liabilities
    
    
    1,639Total liabilities assumed
    
    
    3,793Purchase price, net of cash received
    
    $
    14,404
 All of the assets and liabilities were assigned to the Embedded Security
segment. As noted above, $3,375 of the purchase price represents the estimated
fair value of acquired in-process research and development projects that had
not yet reached technological feasibility and had no alternative future use.
Accordingly, this amount was immediately expensed in the Consolidated Statement
of Operations on the acquisition date. The value assigned to purchased
in-process technology relates entirely to the development of a new application
specific integrated circuit. The estimated fair value of this project was determined by employment of a
discounted cash flow model. The discount rate used takes into account the
stage of completion and the risks surrounding the successful development and
commercialization of the purchased in-process technology project. The unaudited pro forma combined historical results for the year ended
December 31, 2001, as if Securealink had been acquired on January 1, 2001, is
as follows: Revenues
    
    $
    23,345Loss from continuing operations
    
    $
    (4,373
    )Net loss
    
    $
    (7,825
    )Loss per common share  basic and diluted:Loss from continuing operations
    
    $
    (0.57
    )Net loss
    
    $
    (1.03
    )
 The pro forma results include the estimated amortization of intangibles
and interest expense on the promissory notes used to finance part of the
purchase. As described in Note 2, the Company does not record amortization
expense related to the goodwill. The pro forma results are not necessarily
indicative of the results that would have occurred if the acquisition had
actually been completed on January 1, 2001, nor are they necessarily indicative
of future consolidated results. Cylink Corporation On February 5, 2003, SafeNet acquired 100% of the outstanding common
shares of Cylink Corporation (Cylink) in accordance with an Agreement and
Plan of Reorganization dated as of October 30, 2002. The results of operations
of Cylink have been included in the Companys consolidated results of
operations beginning on February 6, 2003. Cylink, develops, manufactures,
markets and supports a comprehensive portfolio of hardware and software
security products for mission-critical private networks and business
communications over the Internet. Cylinks solutions enable its customers to
merge their operations and transactions onto existing networks, maximize
network use, reduce the costs of operations 60




---



##### 



and expand their businesses. As a result of the acquisition, the Company
believes that it will be able to grow its base of government and commercial
customers, enhance its product line, expand its international sales and provide
broader technology and expertise to its customers. It also expects to reduce
costs through economies of scale. The aggregate purchase price was $34,994 consisting primarily of 1,680
shares of common stock valued at $31,084, 194 options and warrants assumed with
an aggregate value of $1,691, and estimated direct costs of the acquisition of
$2,219. The value of the common shares issued was determined based on the
average market price of the Companys common shares over the period including
three days before and after the terms of the acquisition were agreed to and
announced. The following table summarizes the estimated fair values of the assets
acquired and liabilities assumed at the date of acquisition. Cash and cash equivalents
    
    $
    2,922Accounts receivable
    
    
    4,928Inventories
    
    
    1,376Insurance proceeds receivable
    
    
    6,407Other current assets
    
    
    545Property and equipment
    
    
    786Goodwill
    
    
    24,880Acquired in-process research and development
    
    
    3,351Intangible assets subject to amortization (2.7 year weighted average useful life)
    
    
    17,529Other assets
    
    
    554Total assets acquired
    
    
    63,278Accounts payable
    
    
    1,073Accrued salaries and commissions
    
    
    2,526Accrued legal settlement
    
    
    6,200Other accrued expenses
    
    
    4,671Advance payments and deferred revenue
    
    
    2,266Deferred income taxes (including current portion of $2,579)
    
    
    6,661Unfavorable lease liability
    
    
    4,887Total liabilities assumed
    
    
    28,284Net assets acquired
    
    $
    34,994
 All of the assets and liabilities were assigned to the Enterprise Security
Segment. As noted above, $3,351 of the purchase price represents the estimated
fair value of acquired in-process research and development projects that had
not yet reached technological feasibility and had no alternative future use.
Accordingly, this amount was immediately expensed in the Consolidated Statement
of Operations on the acquisition date in accordance with FASB Interpretation
No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted
for by the Purchase Method. The value assigned to purchased in-process
technology relates to two projects: NetHawk 6.0 and Privacy Manager 1.0. The estimated fair value of these projects was determined using the income
approach, which involves two general steps. The first step is to establish a
forecast of the estimated future net cash flows expected to accrue to SafeNet
resulting from ownership of the group of assets. The second step involves
discounting these estimated future net cash flows to their present value. In
order to estimate future net cash flows, SafeNet employed a multi-period excess
earnings method, under which it prepared a forecast of cash inflows, cash
outflows, and pro-forma charges for economic returns of and on tangible assets
employed and other enabling intangible assets, including patents and core
technologies. Cash outflows include direct and indirect expenses for costs to
complete, cost of sales based on historical gross margin rates for similar
products, sales, marketing, general and administrative, and income taxes. The
net cash inflows over an estimated economic life of three years for NetHawk 6.0
and four years for Privacy Manager 1.0, both 61




---



##### 



beginning later in 2003, were then discounted to net present value using a
risk adjusted discount rate of 22%. The discount rate used in this calculation
takes into account the stage of completion and the risks surrounding the
successful development and commercialization of each the purchased in-process
technology project that was valued. In connection with the acquisition, the Company recorded a liability to
reflect the terms of certain operating office leases that are unfavorable
relative to current market prices as determined by an independent real estate
valuation specialist. The liability was calculated based on the difference
between the contractual lease payments and the current market prices over the
remaining lease terms and discounted using a risk-free interest rate adjusted
for SafeNets credit standing. The $24,880 of goodwill was assigned to the Enterprise Security segment.
Of that total amount, none is expected to be deductible for tax purposes. The
primary factors contributing to a purchase price for Cylink that resulted in
the recognition of goodwill included the belief that the combined strengths of
the two companies enable them to compete more effectively than SafeNet could
alone, the belief that the merger allows the combined company to grow its base
of government and commercial customers, enhance its product line, expand its
international sales and provide broader technology and expertise to its
customers, and the impact of anticipated operating efficiencies. The unaudited pro forma combined historical results for the years ended
December 31, 2003 and 2002 as if Cylink had been acquired on January 1, 2002,
are as follows: 2003
    
    2002(In thousands, except per share data)Revenues
    
    $
        68,398
    
    
    $
    59,759Loss from continuing operations
    
    $
        (10,675
    )
    
    $
    (26,193
    )Net loss
    
    $
        (10,675
    )
    
    $
    (30,147
    )Income (loss) per common share  basic and diluted:Loss from continuing operations
    
    $
        (0.92
    )
    
    $
    (2.79
    )Income (loss) from discontinued operations (GDS)
    
    
    
    
    
    
    (0.42
    )Net loss
    
    $
        (0.92
    )
    
    $
    (3.21
    )
 The pro forma results include the estimated amortization of intangibles.
As described in Note 2, the Company does not record amortization expense
related to goodwill. The pro forma results are not necessarily indicative of
the results that would have occurred if the acquisition had actually been
completed on January 1, 2002, nor are they necessarily indicative of future
consolidated results. Raqia Networks, Inc. On February 27, 2003, the Company acquired substantially all the assets of
Raqia Networks, Inc., a development stage company, consisting primarily of
technology-related intangible assets. Total consideration paid by the Company
was 354 shares of SafeNet common stock with an estimated value of $6,098 and
$890 in cash. The Company had previously invested $1,000 in Raqia Networks. The allocation of the cost to acquire the assets of Raqia is as follows: Working capital (deficit)
    
    $
    (285
    )Property and equipment
    
    
    776Acquired in-process research and development assets
    
    
    6,330Acquired patents
    
    
    1,167Net assets acquired
    
    $
    7,988
 62




---



##### 



Since Raqia was a development stage enterprise, the acquisition of its
assets was not accounted for as a purchase business combination in accordance
with accounting principles generally accepted in the United States.
Accordingly, goodwill has not been recorded in the transaction. Instead, the
difference between the total cost and the fair value of the assets acquired and
liabilities assumed has been allocated based on the fair values of the acquired
net assets. All of the assets and liabilities were assigned to the Embedded Security
Segment. As noted above, $6,330 of the purchase price represents the estimated
fair value of acquired in-process research and development projects that had
not yet reached technological feasibility and had no alternative future use.
Accordingly, this amount was immediately expensed in the Consolidated Statement
of Operations on the acquisition date. The value assigned to purchased
in-process technology relates to one project for ReGXP, which is a content
inspection technology. The estimated fair value of this project was determined using the income
approach. In order to estimate future net cash flows, SafeNet employed a
multi-period excess earnings method, under which it prepared a forecast of cash
inflows, cash outflows, and pro-forma charges for economic returns of and on
tangible assets employed and other enabling intangible assets, including
patents and core technologies. Cash outflows include direct and indirect
expenses for costs to complete, cost of sales based on historical gross margin
rates for similar products, sales, marketing, general and administrative, and
income taxes. The net cash inflows over an estimated economic life of ten
years beginning later in 2003 were then discounted to net present value using a
risk adjusted discount rate of 40%. The discount rate used in this calculation
takes into account the stage of completion and the risks surrounding the
successful development and commercialization of the purchased in-process
technology project that was valued. SSH Communications Security Corp. On November 18, 2003, SafeNet purchased the assets of the OEM Products
Group of SSH Communications Security Corp. (SSH) in accordance with the Asset
Purchase Agreement dated as of October 2003. In connection with the
acquisition, SafeNet obtained substantially all of the assets and properties
used in connection with the toolkit, IPVia VPN and VPN client businesses of
SSH. SSH is a leading supplier of managed security middleware. The total
consideration paid by SafeNet was $13,796 in cash, including $2,800 being held
in escrow, and estimated direct costs of the acquisition of $221. The results
of operations of SSH have been included in the Companys consolidated results
of operations beginning on November 19, 2003. The Company is in the process of finalizing the valuation of certain
acquired tangible assets and liabilities; thus the allocation of the purchase
price is subject to refinement, which should be completed by the end of the
first quarter of fiscal year 2004. The following table summarizes the
estimated fair value of the assets acquired and liabilities assumed at the date
of acquisition. Accounts receivable
    
    $
    1,225Property and equipment
    
    
    55Goodwill
    
    
    2,744Intangible assets subject to amortization (4 year weighted average useful life)
    
    
    8,370Intangible assets not subject to amortization
    
    
    2,700Other assets
    
    
    130Total assets acquired
    
    
    15,224Accrued compensation and benefits
    
    
    19Advance payments and deferred revenue
    
    
    1,409Total liabilities assumed
    
    
    1,428Net assets acquired
    
    $
    13,796
 63




---



##### 



All of the assets and liabilities were assigned to the Embedded Security
Segment. The $2,744 of goodwill that was assigned to the Embedded Security
segment is expected to be deductible for tax purposes. The primary factors
contributing to a purchase price for the OEM business of SSH that resulted in
the recognition of goodwill included the belief that the acquisition will
enhance the Companys product line, expand its international sales and provide
broader technology and expertise to its customers. The acquisition of SSH would not have materially affected the reported
results of operations in 2003 and 2002 had the acquisition occurred on January
1, 2002. Rainbow Technologies, Inc. On October 22, 2003, the Company entered into an agreement to acquire Rainbow
Technologies, Inc., a provider of information security solutions for
mission-critical data and applications used in business, organization and
government computing environments, in a stock-for-stock transaction.
Consummation of the transaction is subject to customary closing conditions,
including the approval of Rainbows stockholders and our stockholders. Under
the terms of the agreement, each outstanding share of Rainbow common stock will
be exchanged for 0.374 of a share of the Companys common stock. All
outstanding options to acquire Rainbow common stock will be assumed by the
Company and converted into options to purchase shares of the Companys common
stock using the same exchange ratio. If the merger is consummated, the Company
will issue in the transaction approximately 11,000 shares of common stock which
would represent approximately 43% of the outstanding stock of the combined
company on a fully diluted basis. The Company expects the merger, if
consummated, to close during the first quarter of 2004. (5) INVENTORIES Inventories consisted of the following at December 31: 2003
    
    2002Raw materials
    
    $
    2,158
    
    
    $
    252Finished goods
    
    
    2,240
    
    
    
    1,7144,398
    
    
    
    1,966Reserve for excess and obsolete inventory
    
    
    (1,275
    )
    
    
    (958
    )$
    3,123
    
    
    $
    1,008
 (6) PROPERTY AND EQUIPMENT Property and equipment consisted of the following at December 31: 2003
    
    2002Furniture and equipment
    
    $
    7,442
    
    
    $
    4,350Computer software
    
    
    2,501
    
    
    
    912Leasehold improvements
    
    
    741
    
    
    
    71810,684
    
    
    
    5,980Accumulated depreciation and amortization
    
    
    (6,875
    )
    
    
    (4,734
    )$
    3,809
    
    
    $
    1,246
 64




---



##### 



(7) GOODWILL The changes in the carrying amount of goodwill for the years ended
December 31, 2003 and 2002 are as follows: Embedded
    
    EnterpriseSecurity
    
    SecuritySegment
    
    Segment
    
    TotalBalance as of January 1, 2002
    
    $
    
    
    
    $
    
    
    
    $
    Goodwill recorded during the year:Acquisition of Securealink
    
    
    10,859
    
    
    
    
    
    
    
    10,859Foreign currency translation adjustment
    
    
    1,967
    
    
    
    
    
    
    
    1,967Balance as of December 31, 2002
    
    
    12,826
    
    
    
    
    
    
    
    12,826Goodwill recorded during the year:Acquisition of Cylink
    
    
    
    
    
    
    24,880
    
    
    
    24,880Acquisition of SSH
    
    
    2,744
    
    
    
    
    
    
    
    2,744Foreign currency translation adjustment
    
    
    2,535
    
    
    
    
    
    
    
    2,535Other
    
    
    (19
    )
    
    
    (559
    )
    
    
    (578
    )Balance as of December 31, 2003
    
    $
    18,086
    
    
    $
    24,321
    
    
    $
    42,407
 (8) ACQUIRED INTANGIBLE ASSETS Acquired intangible assets consisted of the following at December 31,
2003, of which $10,900 related to the Enterprise Security Division, and 12,699
related to the Embedded Security Division: Weighted
        
        
        
        
        
        
        
        
        
        NetAverage Useful
        
        Gross Carrying
        
        Accumulated
        
        CarryingLife in Years
        
        Amount
        
        Amortization
        
        AmountIntangible assets
            subject to amortization:Customer contracts
            / relationships
        
        
        3.4
        
        
        $
        10,947
        
        
        $
        (2,151
        )
        
        $
        8,796Developed technology
        
        
        3.5
        
        
        
        9,426
        
        
        
        (2,469
        )
        
        
        6,957Patents and related
        
        
        3.2
        
        
        
        5,588
        
        
        
        (1,588
        )
        
        
        4,000Non-compete agreements
        
        
        2.0
        
        
        
        2,066
        
        
        
        (947
        )
        
        
        1,119Purchase orders and
            contract backlog
        
        
        1.0
        
        
        
        1,328
        
        
        
        (1,328
        )
        
        
        Total
        
        
        2.9
        
        
        
        29,355
        
        
        
        (8,483
        )
        
        
        20,872Intangible assets
            subject to amortization:Domain names
        
        
        N/A
        
        
        
        2,727
        
        
        
        
        
        
        
        2,727Total acquired intangible
            assets
        
        
        
        
        
        $
        32,082
        
        
        $
        (8,483
        )
        
        $
        23,599
 Acquired intangible assets consisted of the following as of December 31,
2002, all related to the Embedded Security segment: 65




---



##### 



Weighted
    
    
    
    
    
    
    
    
    
    NetAverage Useful
    
    Gross Carrying
    
    Accumulated
    
    CarryingLife in Years
    
    Amount
    
    Amortization
    
    AmountIntangible assets subject to amortization:Developed technology
    
    
    1.0
    
    
    
    1,336
    
    
    
    (1,336
    )
    
    
    Patents and related
    
    
    5.0
    
    
    
    738
    
    
    
    (143
    )
    
    
    595Purchase orders and contract backlog
    
    
    1.0
    
    
    
    161
    
    
    
    (161
    )
    
    
    Total
    
    
    2.3
    
    
    
    2,235
    
    
    
    (1,640
    )
    
    
    595
 Amortization expense related to acquired intangible assets for the years
ended December 31, 2003 and 2002 was $7,499 and $1,488, respectively. The
estimated amortization expense for the years ending December 31 is as follows: 2004
    
    $
    8,5562005
    
    
    7,6092006
    
    
    2,7722007
    
    
    1,935
 (9) INCOME TAXES The Company recorded no provision for income taxes on earnings from
continuing operations for the year ended December 31, 2001. Significant
components of the Companys income tax expense (benefit) from continuing
operations for the years ended December 31, are as follows: 2003
    
    2002Current:Federal
    
    $
    3,662
    
    
    $
    State
    
    
    523
    
    
    
    179Foreign
    
    
    161
    
    
    
    Total current
    
    
    4,346
    
    
    
    179Deferred (benefit):Federal
    
    
    (2,672
    )
    
    
    271State
    
    
    
    
    
    
    Foreign
    
    
    (56
    )
    
    
    (540
    )Total deferred
    
    
    (2,728
    )
    
    
    (269
    )Total tax expense (benefit)
    
    $
    1,618
    
    
    $
    (90
    )
 For the years ended December 31, 2003, 2002 and 2001, the Companys
foreign loss from continuing operations before income taxes was ($3,105),
($7,149) and $0, respectively. Deferred tax assets and liabilities arising from continuing operations are
comprised of the following at December 31: 66




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##### 



2003
    
    2002Deferred tax assets:Inventories
    
    $
    2,111
    
    
    $
    272Net operating loss carryforwards
    
    
    26,676
    
    
    
    7,191Tax credits
    
    
    7,310
    
    
    
    Property and equipment
    
    
    1,765
    
    
    
    Compensation and accrued reserves
    
    
    785
    
    
    
    200Other
    
    
    923
    
    
    
    478Total deferred tax assets
    
    
    39,570
    
    
    
    8,141Deferred tax liabilities:Intangible assets
    
    
    (4,788
    )
    
    
    (129
    )Total deferred tax liabilities
    
    
    (4,788
    )
    
    
    (129
    )Net deferred tax asset
    
    
    34,782
    
    
    
    8,012Less: valuation allowance
    
    
    (39,570
    )
    
    
    (8,141
    )Total
    
    $
    (4,788
    )
    
    $
    (129
    )
 The reconciliation of the reported income tax expense (benefit) to the
amount that would result by applying the U.S. federal statutory tax rate of 34%
to loss from continuing operations before income taxes is as follows: 2003
    
    2002
    
    2001Tax benefit at U.S. statutory rate
    
    $
    (1,520
    )
    
    $
    (298
    )
    
    $
    (37
    )Effect of permanent differences:Non-deductible in-process research and
and development
    
    
    3,292
    
    
    
    1,182
    
    
    
    Tax benefit of foreign subsidiary
    
    
    (954
    )
    
    
    
    
    
    
    State income taxes, net of federal benefit
    
    
    346
    
    
    
    179
    
    
    
    (5
    )Change in valuation allowance, excluding charge
related to stock option exercises
    
    
    592
    
    
    
    (1,031
    )
    
    
    18Other, net
    
    
    (138
    )
    
    
    (122
    )
    
    
    24Total
    
    $
    1,618
    
    
    $
    (90
    )
    
    $
    
 In assessing the realization of deferred tax assets, management considers
whether it is more likely than not that all or some portion of the deferred tax
assets will not be realized. The ultimate realization of the deferred tax
assets is dependent upon the generation of future taxable income during the
periods in which temporary differences are deductible and net operating losses
are utilized. Based on consideration of these factors, the Company has
established a valuation allowance of $39,570 and $8,141 at December 31, 2003
and 2002, respectively. At December 31, 2003, the Company had net operating loss carryforwards
related to its Netherlands subsidiary of approximately $4,852, which do not
expire and are available to offset future taxable income of that subsidiary.
The acquisitions of Cylink and Raqia increased the Companys net operating loss
carryforwards for U.S. income tax purposes. At December 31, 2003, the Company
had net operating loss carryforwards for U.S. income tax purposes of
approximately $64,677, which expire from 2011 to 2023 and are available to
offset future U.S. taxable income subject to limitations with regards to
Section 382 of the Internal Revenue Code. The exercise of non-qualified stock
options and disqualified disposition of incentive stock options (stock option
deductions) have generated all of the remaining U.S. 67




---



##### 



net operating loss carryforwards. When these net operating loss
carryforwards are utilized, the resulting reduction in the valuation allowance
will be recorded as a direct increase to additional paid-in capital. During
the year ended December 31, 2003, an increase to
stockholders equity of $2,362
was recorded related to the tax benefit of stock option deductions. (10) LEASES The Company leases office facilities and equipment under non-cancelable
operating leases expiring at various dates through 2013. The leases require
the Company to pay a proportionate share of real estate taxes, insurance and
maintenance. The Company recognizes rent expense on a straight-line basis.
The future minimum payments under the leases for the years ending December 31,
are as follows: 2004
    
    $
    2,6182005
    
    
    2,4262006
    
    
    2,5322007
    
    
    2,5002008
    
    
    2,3682009 and thereafter
    
    
    4,602
 Rent expense under all operating leases related to continuing operations for
the years ended December 31, 2003, 2002, and 2001 was $1,236, $517 and $360,
respectively. (11) RETIREMENT PLAN The Company sponsors a defined contribution retirement plan for employees
who have completed three months of service. The Plan permits pre-tax
contributions by participants pursuant to Section 401(k) of the Internal
Revenue Code (the Code) of 3% to 15% of base compensation up to the maximum
allowable contributions as determined by the Code. The Company matches up to
50% of the first 4% of employee compensation that is contributed to the plan.
The Companys matching contributions vest with the participant over a 5-year
period on a pro rata basis. The Company may also make additional discretionary
contributions. The Company incurred expenses for its matching contributions
for the years ended December 31, 2003, 2002 and 2001 totaling $360, $77 and
$137, respectively. (12) STOCK
COMPENSATION PLANS AND WARRANTS Stock Option Plans The Company sponsors five stock option plans that provide for the granting
of stock options to officers, directors, consultants and employees of the
Company. Options have been granted with exercise prices that are equal to the
fair market value of the common stock on the date of grant and, subject to
termination of employment, expire seven years from the date of grant. Either
incentive stock options or non-qualified stock options may be granted under the
plans. The vesting and exercise periods are determined by the Board of
Directors and the lives may not exceed ten years. Options issued to date
generally vest in equal amounts over a vesting period of either three or four
years. Option activity during 2001, 2002 and 2003 was as follows: 68




---



##### 



WeightedAverageNumber
    
    Range of
    
    Exerciseof Shares
    
    Exercise Prices
    
    PriceOutstanding as of January 1, 2001
    
    
    1,342
    
    
    $
    3.09 to $43.50
    
    
    $
    17.01Granted
    
    
    825
    
    
    $
    5.85 to $43.63
    
    
    $
    11.79Exercised
    
    
    (167
    )
    
    $
    3.09 to $24.87
    
    
    $
    9.41Cancelled
    
    
    (117
    )
    
    $
    3.25 to $43.50
    
    
    $
    25.78Outstanding as of December 31, 2001
    
    
    1,883
    
    
    $
    4.37 to $43.63
    
    
    $
    14.85Granted
    
    
    404
    
    
    $
    11.10 to $16.51
    
    
    $
    13.09Exercised
    
    
    (205
    )
    
    $
    5.13 to $24.13
    
    
    $
    9.50Cancelled
    
    
    (158
    )
    
    $
    8.53 to $33.63
    
    
    $
    15.15Outstanding as of December 31, 2002
    
    
    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
    
    
    (177
    )
    
    $
    0.20 to $33.63
    
    
    $
    17.78Outstanding as of December 31, 2003
    
    
    2,189
    
    
    $
    4.37 to $43.63
    
    
    $
    17.03Exercisable as of December 31, 2003
    
    
    1,214
    
    
    $
    4.37 to $43.63
    
    
    $
    16.06
 The following table summarizes information about stock options outstanding
at December 31, 2003: Options Outstanding
    
    Options ExercisableWeighted
    
    Weighted
    
    
    
    
    
    WeightedAverage
    
    Average
    
    
    
    
    
    AverageRange of
    
    Number
    
    Remaining
    
    Exercise
    
    Number
    
    ExerciseExercise Prices
    
    of Shares
    
    Contractual Life
    
    Price
    
    of Shares
    
    Price$4.37 to $8.70
    
    
    340
    
    
    
    4.2
    
    
    $
    6.60
    
    
    
    216
    
    
    $
    6.50$9.18 to $17.56
    
    
    1,148
    
    
    
    5.7
    
    
    $
    14.35
    
    
    
    635
    
    
    $
    13.81$18.13 to $29.00
    
    
    471
    
    
    
    5.9
    
    
    $
    23.21
    
    
    
    308
    
    
    $
    23.80$30.67 to $43.63
    
    
    230
    
    
    
    6.8
    
    
    $
    33.19
    
    
    
    55
    
    
    $
    36.492,189
    
    
    
    5.6
    
    
    $
    17.03
    
    
    
    1,214
    
    
    $
    16.06
 At December 31, 2003, the Company had reserved 2,688 shares of common
stock for exercise of outstanding stock options, outstanding warrants and additional stock options
authorized for granting under existing stock option plans. In connection with the acquisition of Cylink, the Company issued 25
warrants, which have an exercise price of $7.68 and expire
October 30, 2012. Employee Stock Purchase Plan In 2002, the Company adopted the SafeNet, Inc. Employee Stock Purchase
Plan. The plan allows eligible employees to purchase shares of common stock at
85% of the lower of the closing price of the 69




---



##### 



Companys common stock on the first trading day or the last trading day of
each semi-annual offering period. Employees may authorize the Company to
withhold up to 10% of their compensation during any offering period, subject to
certain limitations. During 2003 and 2002, 7 and 6 shares, respectively, were
issued under the plan at a price of $22.11 and $15.06 per share, respectively. (13) SEGMENTS OF THE COMPANY AND RELATED INFORMATION The Company has two reportable segments related to continuing operations.
The Embedded Security Division designs and sells a broad range of security
products, including silicon chips, accelerator cards, licensed intellectual
property and software products, to original equipment manufacturers (OEMs)
that embed them into their own network and wireless products. The Enterprise
Security Division sells high-performance security solutions, including software
and appliances, to address the needs of the U.S. government, financial
institution and other security-sensitive commercial companies. The reportable
segments are strategic business units that offer different products. The
segments are managed separately because each segment requires different
technology and marketing strategies. The Embedded Security Division and
Enterprise Security Division include some international sales mainly to South
America, Europe and Asia. The following table sets forth information about the Companys reportable
segments for the years ended December 31: 2003
    
    2002
    
    2001Revenue from external customers:Embedded security
    
    $
    19,269
    
    
    $
    18,292
    
    
    $
    5,477Enterprise security
    
    
    46,925
    
    
    
    13,943
    
    
    
    10,985Consolidated revenues
    
    $
    66,194
    
    
    $
    32,235
    
    
    $
    16,462Significant non-cash items other than depreciation
and amortization expense (write-off of acquired
research and development costs):Embedded security
    
    $
    6,330
    
    
    $
    3,375
    
    
    $
    Enterprise security
    
    
    3,351
    
    
    
    
    
    
    
    Consolidated significant non-cash items
other than depreciation and amortization expense
    
    $
    9,681
    
    
    $
    3,375
    
    
    $
    Operating (loss) income:Embedded security
    
    $
    (6,711
    )
    
    $
    (4,227
    )
    
    $
    (1,697
    )Enterprise security
    
    
    1,434
    
    
    
    2,683
    
    
    
    252Consolidated operating loss
    
    $
    (5,277
    )
    
    $
    (1,544
    )
    
    $
    (1,445
    )Depreciation and amortization:Embedded security
    
    $
    1,382
    
    
    $
    2,180
    
    
    $
    1,303Enterprise security
    
    
    7,481
    
    
    
    857
    
    
    
    398Consolidated depreciation and amortization
    
    $
    8,863
    
    
    $
    3,037
    
    
    $
    1,701(Loss) income from continuing operations
before income taxes:Embedded security
    
    $
    (6,632
    )
    
    $
    (3,794
    )
    
    $
    (1,253
    )Enterprise security
    
    
    2,162
    
    
    
    2,919
    
    
    
    1,144Consolidated loss from continuing
operations before income taxes
    
    $
    (4,470
    )
    
    $
    (875
    )
    
    $
    (109
    )
 70




---



##### 



2003
    
    2002
    
    2001Geographic InformationRevenues:United States
    
    $
    58,321
    
    
    $
    28,945
    
    
    $
    15,134All other countries
    
    
    7,873
    
    
    
    3,290
    
    
    
    1,328Total
    
    $
    66,194
    
    
    $
    32,235
    
    
    $
    16,462Long-lived assets:United States
    
    $
    5,478
    
    
    $
    1,140
    
    
    $
    1,696All other countries
    
    
    313
    
    
    
    585
    
    
    
    Total
    
    $
    5,791
    
    
    $
    1,725
    
    
    $
    1,696
 Revenues are attributed to countries based on the location of the
customer. The Company does not allocate assets to its reportable segments, as
assets generally are not specifically attributable to any particular segment.
Accordingly, asset information by reportable segment is not presented. Where
the underlying assets can be specifically attributed to a segment, the related
depreciation and amortization have been classified accordingly. The remaining
depreciation is allocated based on a percentage of revenue. (14) SIGNIFICANT CUSTOMERS AND CONCENTRATIONS OF CREDIT RISK Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist primarily of accounts receivable. The
Company performs ongoing credit evaluations of its customers and generally does
not require collateral. Sales terms with customers, including distributors, do
not provide for right of return privileges for credit, refund or other
products. The Companys payment terms are generally 30 days from delivery of
products, but could fluctuate depending on the terms of each specific contract.
The Companys customers, who include both commercial companies and
governmental agencies, are in various industries, including banking, security,
communications and distributors of electronic products. In 2003, one customer of the Embedded Security Division accounted for 13%
of the Companys consolidated revenues and one Enterprise Security Division
customer accounted for 12% of the Companys consolidated revenues. In 2002,
one commercial client of the Embedded Security Division accounted for 41% of
the Companys consolidated revenues. In 2001, one commercial client of the
Enterprise Security Division accounted for 15% of the Companys consolidated
revenues. As of December 31, 2003, one government client of the Enterprise Security
Division accounted for 16% of accounts receivable. As of December 31, 2002,
one government client of the Enterprise Security Division accounted for 22% of
accounts receivable and two commercial clients of the Embedded Security
Division accounted for a combined 42% of accounts receivable. (15) LOSS PER SHARE The following table sets forth the computation of basic and diluted income
(loss) from continuing operations per common share for the years ended December
31: 71




---



##### 



2003
    
    2002
    
    2001Numerator:Loss from continuing operations
    
    $
    (6,088
    )
    
    $
    (785
    )
    
    $
    (109
    )Denominator
Denominator for basic and diluted loss per shareweighted average shares outstanding
    
    
    11,350
    
    
    
    7,730
    
    
    
    7,057Basic and diluted loss from continuing operations
per share
    
    $
    (0.54
    )
    
    $
    (0.10
    )
    
    $
    (0.01
    )
 The diluted loss from continuing operations per common share in all years
presented is equal to the basic loss per common share because if potentially
dilutive securities were included in the computations, the results would be
anti-dilutive. These securities consist of outstanding options and warrants to
purchase 2,214 shares, 1,924 shares and 1,883 shares of the Companys common
stock as of December 31, 2003, 2002 and 2001, respectively. 72




---



##### 



ITEM 9  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A  CONTROLS AND PROCEDURES a) Evaluation of disclosure controls and procedures. As required by Rule 13a-15 under the Exchange Act, as of the end of the
fiscal year covered by this annual report, we carried out an evaluation of the
effectiveness of the design and operation of our disclosure controls and
procedures. This evaluation was carried out under the supervision and with the
participation of our management, including the chief executive officer and
chief financial officer. Based upon that evaluation, our chief executive
officer and chief financial officer concluded that our disclosure controls and
procedures are effective. Disclosure controls and procedures are controls and
other procedures that are designed to ensure that information required to be
disclosed in our reports filed or submitted under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified in the
SECs rules and forms. Disclosure controls and procedures include, without
limitation, controls and procedures designed to ensure that information
required to be disclosed in our reports filed under the Exchange Act is
accumulated and communicated to management, including our chief executive
officer and chief financial officer, as appropriate, to allow timely decisions
regarding required disclosures. b) Changes in internal control over financial reporting. As required by Rule 13a-15 under the Exchange Act, we carried out an
evaluation of any changes in our internal control over financial reporting that
occurred during the fiscal year covered by this annual report. This evaluation
was carried out under the supervision and with the participation of our
management, including the chief executive officer and chief financial officer.
Based upon that evaluation, we concluded that there was no change in our
internal control over financial reporting during this period that has
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting. Internal control over financial reporting is
a process designed by, or under the supervision of, the principal executive
officer and principal financial officer, and effected by the board of
directors, management and other personnel, to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally
accepted accounting principles. Internal control over financial reporting
includes those policies and procedures that (1) pertain to the maintenance of
records that in reasonable detail accurately and fairly reflect the
transactions and dispositions of our assets; (2) provide reasonable assurance
that transactions are recorded as necessary to permit preparation of our
financial statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the company are being made
only in accordance with authorizations of our management and directors; and (3)
provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use or disposition of our assets that could have a
material effect on our financial statements. PART III ITEM 10  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item is incorporated herein by reference to
the definitive Proxy Statement of SafeNet, which will be filed with the
Securities and Exchange Commission no later than 120 days after the close of
SafeNets fiscal year ended December 31, 2003. ITEM 11  EXECUTIVE COMPENSATION The information required by this item is incorporated herein by reference to
the definitive Proxy Statement of SafeNet, which will be filed with the
Securities and Exchange Commission no later than 120 days after the close of
SafeNets fiscal year ended December 31, 2003. 73




---



##### 



ITEM 12  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated herein by reference to
the definitive Proxy Statement of SafeNet, which will be filed with the
Securities and Exchange Commission no later than 120 days after the close of
SafeNets fiscal year ended December 31, 2003. ITEM 13  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated herein by reference to
the definitive Proxy Statement of SafeNet, which will be filed with the
Securities and Exchange Commission no later than 120 days after the close of
SafeNets fiscal year ended December 31, 2003. ITEM 14  PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item is incorporated herein by reference to
the definitive Proxy Statement of SafeNet, which will be filed with the
Securities and Exchange Commission no later than 120 days after the close of
SafeNets fiscal year ended December 31, 2003. PART IV ITEM 15  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)
    
    
    1.
    
    
    The financial statements filed as part of this report are listed separately on the Index To Financial
Statements on page 45 of this Form 10-K.2.
    
    
    Financial Statement Schedules: Schedule II Valuation and Qualifying Accounts
  All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not
required under the related instructions or are inapplicable therefore have been omitted(b)
    
    Reports on Form 8-K:1) The Company filed a Current Report on Form 8-K with the Securities and Exchange Commission on November 21, 2002 under Item 2 thereto in
connection with the closing of the acquisition of certain assets of SSH Communications Security Corp.2) The Company filed a Current Report on Form 8-K with the Securities and Exchange Commission on October 24, 2003 under Item 5 in connection
with entering into a definitive agreement and plan of reorganization with Rainbow Technologies, Inc.3) The Company filed a Current Report on Form 8-K with the Securities and Exchange Commission on October 23, 2003 under Item 12 in connection
with the announcement of financial results for the quarter ended September 30, 2003.4) The Company filed a Current Report on Form 8-K with the Securities and Exchange Commission on October 21, 2003 under Item 5 in connection
with entering into a definitive agreement to acquire certain assets of SSH Communications Security Corp.(c)
    
    Exhibits required by Item 601 of Regulation S-K: 2A
    
    Agreement and Plan of Reorganization dated October 22, 2003 by and among the Registrant, Ravens
Acquisition Corp. and Rainbow Technologies, Inc.
    
    I/B/R(1)3A
    
    Restated Certificate of Incorporation of Registrant, as filed with the Secretary of State of
Delaware on May 23, 2001
    
    I/B/R(2)
 74




---



##### 



3B
    
    By-laws of Registrant
    
    I/B/R(3)4
    
    Specimen of Common Stock Certificate of Registrant
    
    I/B/R(3)10A
    
    Office lease dated June 25, 2003 by and between Waters Edge Corporate Campus LLC and SafeNet, Inc.
    
    I/B/R(4)10B
    
    Stock Option Plan of 1989
    
    I/B/R(5)10C
    
    Joint Development and Marketing Agreement between the Registrant and CyberGuard Corporation
    
    I/B/R(6)10D
    
    Agreement between SafeNet Secure Solutions, Inc. (wholly-owned subsidiary of the Registrant) and
Analog Devices, Inc.
    
    I/B/R(7)10E
    
    1999 Employee Stock Option Plan
    
    I/B/R(8)10F
    
    1999 Stock Bonus Plan
    
    I/B/R(8)10G
    
    Non-Employee Director Stock Option Plan
    
    I/B/R(8)10H
    
    2000 Employee and Directors Stock Option Plan
    
    I/B/R(8)10I
    
    2001 Omnibus Stock Plan
    
    I/B/R(9)10J
    
    Employment Agreement with Anthony Caputo
    
    I/B/R(10)10K
    
    Employment Offer Letter with Carole D. Argo
    
    I/B/R(11)10L
    
    Employment Offer Letter with Shelley A. Harrison
    
    I/B/R(11)10M
    
    Employee Stock Purchase Plan
    
    I/B/R(12)10N
    
    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(13)21
    
    Subsidiaries of Registrant23.1
    
    Consent of Ernst & Young LLP, independent auditors31.1
    
    Certification pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 200231.2
    
    Certification pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 200232.1
    
    Certification pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
 75




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##### 



32.2
    
    Certification pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
  (1)
    
    Filed as an exhibit to the Registration Statement on Form S-4 (File No. 333-110520) of the Registrant and incorporated herein by reference.(2)
    
    Filed as an exhibit to the Form 10-Q for the quarterly period ended June 30, 2002 and incorporated herein by reference.(3)
    
    Filed as an exhibit to the Registration Statement on Form S-18 (File No. 33-28673) of the Registrant and incorporated herein by reference.(4)
    
    Filed as an exhibit to Form 10-Q for the quarterly period ended June 30, 2003 and incorporated herein by reference.(5)
    
    Filed as an exhibit to the Registration Statement on Form S-1 (File No. 33-52066) of the Registrant and incorporated herein by reference.(6)
    
    Filed as an exhibit to Form 10-K for the fiscal year ended December 31, 1996 and incorporated herein by reference.(7)
    
    Filed as an exhibit to Form 10-Q for the quarterly period ended September 30, 1996 and incorporated herein by reference.(8)
    
    Filed as an exhibit to a Definitive Proxy Statement on Schedule 14A for the Annual Meeting of Shareholders held on July 28, 1999 and incorporated
herein by reference.(9)
    
    Filed as an exhibit to a Definitive Proxy Statement on Schedule 14A for the Annual Meeting of Shareholders held on June 18, 2003 and incorporated
herein by reference.(10)
    
    Filed as an exhibit to the Form 10-Q for the quarterly period ended September 30, 2002 and incorporated herein by reference.(11)
    
    Filed as an exhibit to the Registration Statement on Form S-3 (File No. 333-106084) of the Registrant and incorporated herein by reference.(12)
    
    Filed as an exhibit to the Registration Statement on Form S-8 (File No. 333-98029) of the Registrant and incorporated herein by reference.(13)
    
    Filed as an exhibit to the Form 10-Q of Cylink Corporation (File No. 0-27742) for the quarterly period ended September 29,2002 and incorporated
herein by reference. 76




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##### 



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on behalf
of the undersigned, thereunto duly authorized. SAFENET, INC.By:
    
    /s/ Anthony A. CaputoAnthony A. CaputoChairman, Chief Executive
Officer and PresidentDate: March 10, 2004
 Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated. Signature
    
    Title
    
    Date/s/ Anthony A. Caputo
Anthony A. Caputo
    
    Chairman, Chief Executive Officer
And President
    
    March 10, 2004/s/ Carole D. Argo
Carole D. Argo
    
    Senior Vice President and Chief Financial Officer
(Principal Financial and Accounting
Officer)
    
    March 10, 2004/s/ Thomas A. Brooks
Thomas A. Brooks
    
    Director
    
    March 10, 2004/s/ Shelley A. Harrison
Shelley A. Harrison
    
    Director
    
    March 10, 2004/s/ Ira A. Hunt, Jr.
Ira A. Hunt, Jr.
    
    Director
    
    March 10, 2004/s/ Bruce R. Thaw
Bruce R. Thaw
    
    Director
    
    March 10, 2004
 77




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##### 



SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS
Years Ended December 31, 2003, 2002 and 2001
(Amounts in thousands) Balance at
    
    Charged to
    
    Charges
    
    
    
    
    
    
    
    
    
    BalanceBeginning
    
    Costs and
    
    to Other
    
    Deductions
    
    
    
    
    
    at Endof Period
    
    Expenses
    
    Accounts (a)
    
    (b)
    
    Recovery
    
    of PeriodAllowance for
doubtful accounts:2003
    
    $
    224
    
    
    $
    24
    
    
    $
    775
    
    
    $
    83
    
    
    $
    
    
    
    $
    9402002
    
    
    150
    
    
    
    74
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2242001
    
    
    196
    
    
    
    32
    
    
    
    
    
    
    
    78
    
    
    
    
    
    
    
    150Reserve for
obsolete inventory:2003
    
    
    958
    
    
    
    418
    
    
    
    
    
    
    
    101
    
    
    
    
    
    
    
    1,2752002
    
    
    482
    
    
    
    476
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9582001
    
    
    207
    
    
    
    284
    
    
    
    
    
    
    
    9
    
    
    
    
    
    
    
    482Warranty reserve:2003
    
    
    50
    
    
    
    
    
    
    
    209
    
    
    
    
    
    
    
    
    
    
    
    2592002
    
    
    50
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    502001
    
    
    50
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    50Valuation allowance
for deferred tax
assets:2003
    
    
    8,141
    
    
    
    592
    
    
    
    30,837
    
    
    
    
    
    
    
    
    
    
    
    39,5702002
    
    
    9,172
    
    
    
    (1,031
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,1412001
    
    
    7,972
    
    
    
    1,200
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,172
 (a) Represents reserves acquired through purchase business combinations (b) Deductions represent
write-offs of specifically identified balances 78