##### 









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, 2004                                                 
|          
|OR        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934

Commission File Number 0-20634


SafeNet, Inc.


(Exact name of registrant as specified in its charter)


|                                                                                    |  |                                  
|----------------------------------------------------------------------------------- |  | ---------------------------------
|Delaware                                                                            |  | 52-1287752                       
|(State or other jurisdiction of
    incorporation or organization)                  |  | (IRS Employer Identification No.)
|                                                                                   
|4690 Millennium Drive
    Belcamp, Maryland(Address of principal executive offices) |  | 21017(Zip Code)                  

Registrants telephone number, including area code:


(410) 931-7500


Securities registered under Section 12 (b) of the
Exchange Act:


NONE


Securities registered under Section 12 (g) of the
Exchange Act:


|                             |  |                                          
|---------------------------- |  | -----------------------------------------
|Title of Each Class          |  | Name of Each Exchange on Which Registered
|                             |  |                                          
|Common Stock, $.01 par value |  | NASDAQ National Market                   

þ o


o


þ o






DOCUMENTS INCORPORATED BY REFERENCE












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INFORMATION REGARDING FORWARD-LOOKING STATEMENTS




1



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PART I.




|        |         
|------- | --------
|ITEM 1. | BUSINESS

Overview













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



2



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Industry Background








3



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











4



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The SafeNet Solution




5



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Broad Product Line. We offer our WAN and VPN solutions as
    a system that integrates our hardware and software products, or
    separately as discrete hardware and software products. This
    enables us to address the needs of large enterprise customers
    who require complex and integrated systems, as well as customers
    who may require individual hardware or software components. Our
    products and services enable our customers to expand their
    existing WANs efficiently and to integrate these networks with
    lower cost Internet technologies.                                                                                                                                                                                    
|
| |  | High Level of Security. Our products and services have
    been designed to meet the high level security needs of our
    government, financial institution and other commercial
    customers. We have sold our products and services to other key
    government agencies, including the Department of Defense, which
    has used them for battlefield command-and-control applications.
    In addition, we are developing chips to address classified
    government security needs and the security requirements of
    critical infrastructure, such as banks and utilities, as
    required by the Department of Homeland Security. Our products
    are designed to meet the standards set forth in the
    U.S. governments Crypto Modernization Program.

6



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##### 





| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | High Performance Systems. Our appliances are designed to
    maximize the performance of our solutions across WANs and the
    Internet. Using our VPN products, our customers are able to
    transmit secured data at up to 1 Gbps of bi-directional
    throughput. Our products can support up to 10,000 IPSec
    tunnels and a maximum of 100,000 simultaneous secure
    transactions with minimal degradation in network performance.
|
| |   | We added an appliance that offer encryption over SONET. With
    high-speed throughput and extremely low latency these products
    are ideal for high-speed data and time-sensitive voice and video
    applications. It employs the federally endorsed AES algorithm
    with the flexibility to be deployed in OC3/STM1 (155Mbps),
    OC12/STM4 (622Mbps), OC48/STM16 (2.4Gbps), and OC192/STM64
    (10Gbps) SONET networks.            
|
| |  | Ease of Deployment and Management. Our products require
    minimal configuration and can be deployed quickly and
    cost-effectively by end-user customers. Our WAN and VPN security
    products are centrally managed with our security management
    software, which enables policy management and cost-effective,
    secure, scalable monitoring of network devices and applications,
    network traffic, and security events.      
|
| |  | Standards-Based and Network Compatible. We offer products
    that are based on industry and government standards, including
    certain required standards, and accepted network communication
    protocols. These standards and protocols allow our products to
    interoperate with a large number of products from other vendors.                                                                                                      







| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Ease of Development. We offer a complete development
    environment in which OEMs can build a wide variety of encryption
    products. This allows OEMs to accelerate time to market, reduce
    development costs and provide system-level implementation of
    encryption technology.                                                                                                                                                                                                                                                 
|
| |  | Flexible Packaging. Our core technology is available for
    license to OEMs in various forms, such as embedded intellectual
    property blocks, silicon chips, or accelerator cards. In
    particular, embedded intellectual property allows selected
    elements of our VPN technology to be adapted in single or
    multiple implementations. This feature allows OEMs to
    incorporate selective blocks in their silicon chips or
    processors, resulting in cost effective, high throughput, low
    power consuming designs.
|
| |  | Price to Performance. Our products are designed for rapid
    and cost-effective implementation and to match the stringent
    cost requirements of our customers with their performance needs.
    As such, our development staff follows a design approach to
    reduce overall product costs.                                                                                                                                                                                                                                         

Strategy






| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Extend our Technology and Introduce New Products. We
    intend to leverage our technology and product strength and
    expertise to further expand our core product functionality,
    continue to develop complementary products, and expand our
    target market. We will continue to invest in research and
    development and expect to announce new product and technology
    offerings during 2005. 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
    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                                                                                                                                                          

7



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | address a wide range of customer needs. We intend to generate
    incremental sales from our existing customer base through the
    introduction of new and enhanced products and services. We
    believe that the acquisitions of Rainbow Technologies and
    Datakey will continue to provide us with an opportunity to sell
    new products and services into the larger combined customer base.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| |  | Target the Government and Financial Institution Markets.
    We have established and created a Government Solutions Sales
    Unit to focus not just on government agencies and departments,
    but also on systems integrators to produce more multi-year large
    dollar contracting opportunities. We intend to expand our
    position in these markets and leverage this position to target
    new high growth market opportunities as they arise. For example,
    our subsidiary Mykotronx, Inc. delivered nearly 100 of its
    KIV-7HSB high assurance encryption products to a major Homeland
    Security systems integrator.                                                                                                                                                                                                                                                                                                                                                                                                                             
|
| |  | Further penetrate the Digital Rights Management market.
    We have established a Rights Management Business Unit as part of
    our Embedded Security Division to develop new initiatives for
    its Sentinel brand of software protection and license management
    products.. Through this new business we have begun to offer the
    next generation in digital rights management software with
    Sentinel UltraPro.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  | Expand Strategic OEM Relationships and Other Distribution
    Channels.We intend to continue to focus on our OEM
    relationships and to expand distribution channels to develop new
    markets. We believe that these relationships allow us to provide
    our security solutions to the largest number of end-user
    customers. We sell a variety of security products to OEMs,
    including silicon chips, accelerator cards, licensed
    intellectual property, servers, and software products. For
    example, we teamed our Luna Series of products with Adobes
    document services to help customers deploy more secure documents
    on the Adobe Intelligent Document Platform. We offer
    comprehensive training and marketing programs to support our
    OEMs and channel partners. We intend to further develop our
    relationships with system integrators for the government sector
    and value added resellers for international markets. For
    example, Ingram Micro joined SafeNets Security Partner
    Alliance Program in 2004.
|
| |  | Target the Wireless Market. We continue to target the
    wireless communications market, expanding our reach from
    semiconductor companies to handset and cell phone manufacturers.
    We are currently in the process of developing additional
    security technology that will address the growing need for
    secure wireless communication.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| |  | Pursue Strategic Acquisitions on a Selective Basis. We
    explore acquisitions from time to time to acquire businesses,
    products or technologies that we believe will enhance and expand
    our current product offerings and our customer base.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

Products, Services and Technology






| |                     
| | --------------------
| | Enterprise Solutions

SafeEnterprise tm Security System.


8



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##### 



Appliances.




| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | HighAssurance Gateways: Our HighAssurance Gateway line
    provides a portfolio of IPSec VPN gateways covering small,
    medium and large network requirements. The gateways are
    differentiated by the performance needs of the network and where
    they are placed in the network. Our gateways integrate advanced
    features, such as load balancing and fail-over, secure
    multi-casting, firewalls and routing, and are all IPSec
    standards-compliant.
    HighAssurancetmGateways
    include the HighAssurance 500 Gateway, the HighAssurance 1000
    Gateway, HighAssurance 2000 Gateway, and the HighAssurance 4000
    Gateway.
|
| |  | SafeEnterprise iGate SSL Appliance: SafeEnterprise iGate
    SSL Appliance gives users the ability to access their core
    applications through any high-speed Internet connection without
    a VPN client. Applications that were not available before
    through a browser because of security concerns can now be pushed
    out to remote users easily.                                                                                                                                                                                                                                                                                           
|
| |  | ATM Encryptor: The
    SafeEnterprisetm
    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:
    SafeEnterprisetm
    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:
    SafeEnterprisetm
    Link Encryptor secures sensitive data transmitted over
    high-speed, point-to- point, or dial-up communication links at
    speeds up to 52 Mbps. The Link Encryptor is designed for
    organizations that rely heavily on close-looped secure networks
    for the transport of highly sensitive data.                                                                                                                                                                                                                                                                                                      
|
| |  | SONET Encryptor: The SafeEnterprise SONET Encryptor has
    been designed to integrate transparently and simply into one
    SONET/SDH network architecture. High-speed throughput and
    extremely low latency make it ideal for high-speed data and
    time-sensitive voice and video applications. It supports both
    path and line SONET/SDH encryption at various rates and
    distances.                                                                                                                                                                                                                                                      



| |                                   
| | ----------------------------------
| | Digital Identity and PKI Solutions



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | iKey:  Personal Two-Factor USB Authentication
    Token is a USB-based two-factor authentication token that
    provides a very cost-effective and easy-to-use control for
    multiple applications and network services, as in VPNs, and
    controls Intranet, Extranet, and Internet access. The iKey can
    also be used in Public Key Infrastructure (PKI).                                                                                                                                  
|
| |  | SafeNet Smart Cards: SafeNet designs all of its smart
    cards and tokens with security, interoperability, convenience
    and performance in mind. Our smart cards and tokens are
    validated for federal information processing standards
    (FIPS) 140-2 Level 2, an important
    U.S. government certification that demonstrates the
    card/tokens cryptographic strength and security.                                                                                                  
|
| |  | SafeNet Axis: is a complete software and smart card
    solution that delivers simplified and secure Single Sign-On
    (SSO) for a full range of enterprise applications and network
    resources.                                                                                                                                                                                                                                                                                                 
|
| |  | SafeNet CMS (Card Management System): is a Web-based
    smart card/token and digital credential management solution for
    enterprises that is used to issue, manage, and support SafeNet
    cryptographic smart cards and SafeNet
    iKeytm
    USB tokens for identity-based applications throughout the
    organization. SafeNet CMS gives enterprise customers a powerful,
    interoperable, and secure system that reduces the cost of
    deploying and supporting smart cards and iKeys.

9



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                 
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The SafeNet Luna® family of products comprises a
    complete range of hardware security solutions for digital
    identity applications. Luna products feature true hardware key
    management to maintain the integrity of encryption keys.
    Sensitive keys are created, stored, and used exclusively within
    the secure confines of the Luna hardware security module (HSM)
    to prevent compromise.



| |   |                                                                                                 
| | - | ------------------------------------------------------------------------------------------------
| |  | Luna SA 
     Flexible, scalable, high-performance network-attached hardware
    security module
|
| |  | Luna SP 
     Java application security appliance                                               
|
| |  | Luna
    CA3L
    
     A PKI Root Key hardware security module                                 

Software. tm




| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Security Management Center: Our Security Management
    Center product provides security management for our VPN and WAN
    appliances and software clients, including authentication,
    definition and enforcement of security policy, configuration,
    monitoring and audit capabilities. The Security Management
    Center allows customers to manage all aspects of their VPN and
    WAN networks and allows for easy migration from WAN to VPN
    technology. The Security Management Center is a Java-based
    management platform.                                                                                                                                                                                                                                                                                      
|
| |  | Luna PKI Toolkit: The Luna PKI Toolkit features robust
    APIs, proven hardware, and expert support to speed development
    of custom PKI-enabled applications without requiring specialized
    security knowledge or lengthy development cycles.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| |  | SoftRemote: SoftRemote allows for remote access to
    corporate networks. This product provides VPN access
    capabilities for desktops and portable computers for all
    versions of Microsoft® Windows®, including Windows
    XP®. The client software provides secure client-to-client
    or client-to-gateway communications over the Internet, dial-up
    connections and wireless local area networks. Key features
    include personal firewall capabilities and support for strong
    two-factor authentication through industry-standard smart cards.
    SoftRemote additionally includes policy protection and support
    for browser certificates. We also sell versions of our
    SoftRemote VPN client software to OEMs who are able to co-brand
    the client and offer it as part of their overall solution.
|
| |  | HighAssurancetmRemote: The
    HighAssurancetmRemote
    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
    HighAssurancetm
    Remote for government-wide use.
    HighAssurancetm
    Remote is FIPS certified.                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| |  | SoftRemoteLT: SoftRemoteLT is a streamlined version of
    SoftRemote that offers all the features of SoftRemote except for
    personal firewall capabilities.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|
| |  | SoftRemotePDA: SoftRemotePDA is based on SoftRemote and
    designed specifically to extend VPN access to mobile devices,
    such as personal digital assistants, or PDAs. SoftRemotePDA is
    designed to combat the vulnerabilities in wireless
    communications by applying the IPSec technologies utilized by
    SoftRemote to handheld portable devices. It allows PDA users to
    securely communicate over wireless links to retrieve email,
    access corporate information from a network or browse the
    Internet. SoftRemotePDA is available for both Palm OS®
    and Pocket PC® handheld devices.                                                                                                                                                                                                                

Services. tm




| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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

10



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| |  |                                                                                                                                                          
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | and other maintenance functions. SafeNet Trusted Services
    specialists work closely with the customer to define and
    implement its security policy.



| |                    
| | -------------------
| | Borderless Security










| |                   
| | ------------------
| | Mykotronx Products



Space Communications Security:


11



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| |   |                                                                                               
| | - | ----------------------------------------------------------------------------------------------
| |  | For commercial applications, the MYK-42 Centurion VLSI, and
    MYK-41 DES VLSI microcircuits.
|
| |  | In the Caribou category, the U-TXZ microcircuit.                                              
|
| |  | In the Pegasus category, the KGV-227 VLSI microcircuit.                                       
|
| |  | In the KI-23 category, the MYK-1 microcircuit.                                                
|
| |  | In the KG-28/46 category, the MYK-11 VLSI microcircuit.                                       
|
| |  | And in the KG-44 and KG-29/57 categories, the KG-44 LSI
    microcircuit.                     

Cryptographic Cards: tm tm


tm tm tm


Network Security:






| |                    
| | -------------------
| | Embedded Solutions.

Software Solutions.




| |   |                                     
| | - | ------------------------------------
| |  | CGX Library                         
|
| |  | CGX Mobile Library                  
|
| |  | QuickSec IPS                        
|
| |  | QuickSec Toolkit for Access Networks

12



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| |   |                         
| | - | ------------------------
| |  | QuickSec Toolkit for SAN
|
| |  | Secure Shell Toolkit    

Hardware Solutions.




| |   |                                                                                                                                                                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | SafeXceltm:
    SafeXceltm
    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 SSL, encryption. Our
    SafeXceltm
    product line includes the following series:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                 
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | SafeXceltmMomentum Series. The
    SafeXceltm
    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.



| |   |              
| | - | -------------
| |  | SafeXcel-1140
|
| |  | SafeXcel-1141
|
| |  | SafeXcel-1741
|
| |  | SafeXcel-1840
|
| |  | SafeXcel-1841
|
| |  | SafeXcel-1842



| |   |                                                                                                                                                                                                                                                                                  
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | SafeXceltmVelocity Series. The
    SafeXceltm
    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.         



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | SafeXceltmTransaction Series. The
    SafeXceltm
    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-810).                                                                                                                                                                                                                                                                                                                     
|
| |  | SafeXceltmContent Inspection Series. This line of silicon chip is
    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-4850).



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | SafeXceltmCards.
    SafeXceltm
    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.

SafeZone IP 2.0.


SafeXcel tm IP.


13



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| |   |                                                           
| | - | ----------------------------------------------------------
| |  | 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).         



| |                             
| | ----------------------------
| | Rights Management Solutions.



| |                                 
| | --------------------------------
| | Sentinel Rights Management Suite





| |   |                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Sentinel SuperPro 
     Sentinels line of intellectual property protection
    hardware keys;                                                                                                                   
|
| |  | Sentinel UltraPro 
     Sentinels latest full-featured line of hardware keys that
    speed integration, manage licenses and offer the highest level
    security against piracy and license non-compliance; and
|
| |  | Sentinel LM 
     Sentinels robust electronic license management software
    supporting flexible licensing models, dynamic product packaging
    and electronic license distribution.                          



| |           
| | ----------
| | Technology

tm


Customers and Customer Support








| |   |                                                                                                                                                                                                                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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.                                                                                                                                                                                                                                                               

14



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| |   |                                                                                                                       
| | - | ----------------------------------------------------------------------------------------------------------------------
| |  | Cisco Systems, Microsoft, WatchGuard, NetScreen, TALLY Systems,
    Advanced Micro Devices, Texas Instruments and ARM.





Sales and Marketing








| |   |                                                                                                                                                                                                                             
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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.                                                                                                                            



Product Development








| |   |                                                                                                                                                                           
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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

15



---



##### 





| |   |                                                                                                                                                                                                                                                                                                   
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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.



Backlog




Contract Manufacturing




Competition








16



---



##### 







| |   |                                                                                               
| | - | ----------------------------------------------------------------------------------------------
| |  | General Dynamics, L3 Communications, NetScreen, Thales, Cisco
    Systems and Nortel Networks.





| |   |                                               
| | - | ----------------------------------------------
| |  | Aladdin, Discretix, HiFn, Cavium and Certicom.

Patents and Intellectual Property










Employees




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.



17



---



##### 





| |                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------
| | The loss of significant customers could have a material
    adverse effect on our business and results of operations.





| |                                                                                     
| | ------------------------------------------------------------------------------------
| | We may not be able to successfully integrate companies we
    acquire in the future.







| |   |                                                                                                                                                                                              
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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.                                                                                                                                 





| |                                                                                                           
| | ----------------------------------------------------------------------------------------------------------
| | Our quarterly operating results may fluctuate and our
    future revenues and profitability are uncertain.





| |   |                                                                                                          
| | - | ---------------------------------------------------------------------------------------------------------
| |  | introduction and market acceptance of new products and product
    enhancements by us or our competitors;
|
| |  | budgeting cycles of customers, including the
    U.S. government;                                        
|
| |  | timing and execution of individual contracts;                                                            
|
| |  | changes in the percentage of revenues attributable to OEM
    license fees and royalties;                
|
| |  | length of time required by OEMs to embed our products into their
    products that generate royalties;   
|
| |  | competitive conditions in the highly competitive and
    increasingly consolidated security industry;    

18



---



##### 





| |   |                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------
| |  | changes in general economic conditions; and                                                                       
|
| |  | shortfall of revenues in relation to expectations that formed
    the basis for the calculation of fixed expenses.





| |                                                                                                                                                                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If our subsidiary, Mykotronx, Inc., were to lose its
    eligibility as a small business under the rules of the Small
    Business Administration, it would incur additional costs and
    charges relating to disclosure, accounting and reporting to the
    U.S. government.





| |                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------
| | Our industry is highly competitive and becoming
    increasingly consolidated, which may result in our losing
    customers and declining revenue.







| |   |                                 
| | - | --------------------------------
| |  | standards compliance;           
|
| |  | product quality and reliability;
|
| |  | technical features;             
|
| |  | network compatibility;          
|
| |  | product ease of use;            
|
| |  | client service and support;     
|
| |  | distribution; and               
|
| |  | price.                          



| |                                                                
| | ---------------------------------------------------------------
| | We may not be able to protect our proprietary
    technologies.



19



---



##### 









| |                                                                                                                                                                                                                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.





| |                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------
| | We may not be able to maintain effective product
    distribution channels, which could result in decreased
    revenue.





| |                                                                                            
| | -------------------------------------------------------------------------------------------
| | Delays in product development could adversely affect
    market acceptance of our products.



20



---



##### 







| |                                                                                                                                                                                            
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may be subject to product liability or other claims
    that could adversely affect our reputation with existing and
    potential customers and expose us to significant
    liability.









| |                                                                                                                                              
| | ---------------------------------------------------------------------------------------------------------------------------------------------
| | We rely on key technical and management employees and if
    such employees become unavailable, our business could be
    adversely affected.







| |                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------
| | Our recent growth has required us to improve our internal
    systems and may require substantial management efforts.



21



---



##### 







| |                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.







| |                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------
| | Prolonged economic weakness in the Internet
    infrastructure, network security and related markets may
    decrease our revenues and margins.





| |                                                                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If our products and services do not interoperate with our
    end-users networks, installations could be delayed or
    cancelled, which could significantly reduce our revenues.



22



---



##### 







| |                                                                                                            
| | -----------------------------------------------------------------------------------------------------------
| | A decrease of average selling prices for our products and
    services could adversely affect our business.





| |                                                                         
| | ------------------------------------------------------------------------
| | We face risks associated with our international business
    activities.







| |                                                                                                                                      
| | -------------------------------------------------------------------------------------------------------------------------------------
| | A breach of network security could harm public perception
    of our products and services, which could cause us to lose
    revenue.





| |                                                                                                                                                                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Because a significant portion of our total assets is
    represented by goodwill that is subject to mandatory annual
    impairment evaluations, we could be required to write off some
    or all of this goodwill, which may adversely affect our
    financial condition and results of operations.



23



---



##### 



Goodwill and Other Intangible Assets,


RISKS RELATED TO OUR COMMON STOCK




| |                                   
| | ----------------------------------
| | Our stock price has been volatile.





| |                                                                                                                   
| | ------------------------------------------------------------------------------------------------------------------
| | Anti-takeover provisions in our charter documents and
    Delaware law could prevent or delay a change in control.





| |                                                                                             
| | --------------------------------------------------------------------------------------------
| | We have not paid dividends and do not intend to pay
    dividends in the foreseeable future.





|        |           
|------- | ----------
|ITEM 2. | PROPERTIES









24



---



##### 















|        |                  
|------- | -----------------
|ITEM 3. | LEGAL PROCEEDINGS





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



PART II




|        |                                             
|------- | --------------------------------------------
|ITEM 5. | MARKET FOR COMMON EQUITY AND RELATED MATTERS



|               |  |      |       |  |     |   |       | 
|-------------- |  | ---- | ----- |  | --- | - | ----- | 
|               |  | High |       |  | Low |  
|               |  |      |       |  |     |  
|2004           |  |      |       |  |     |   |       | 
|Fourth Quarter |  | $    | 37.68 |  |     | $ | 26.46 | 
|Third Quarter  |  |      | 30.23 |  |     |   | 22.19 | 
|Second Quarter |  |      | 38.90 |  |     |   | 20.61 | 
|First Quarter  |  |      | 41.80 |  |     |   | 30.66 | 
|2003           |  |      |       |  |     |   |       | 
|Fourth Quarter |  |      | 42.95 |  |     |   | 30.07 | 
|Third Quarter  |  |      | 39.85 |  |     |   | 28.46 | 
|Second Quarter |  |      | 30.94 |  |     |   | 19.70 | 
|First Quarter  |  |      | 32.21 |  |     |   | 16.47 | 



25



---



##### 







|        |                        
|------- | -----------------------
|ITEM 6. | SELECTED FINANCIAL DATA



|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |        |        |   |   |        |        | 
|------------------------------------------------------------ | -------------------- | --------------------------------------------- | ------- | ------- | ------- | - | ------ | ------- | - | - | ------ | ------ | - | ---- | ------ | ------ | - | - | ------ | ------ | 
|                                                             |                      | December 31,                                  |        
|                                                             |                      |                                               |        
|                                                             |                      | 2004(1)                                       |         |         | 2003(1) |   |        | 2002(1) |   |   | 2001   |        |   | 2000 |       
|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |       
|                                                             |                      | (Dollars in thousands, except per share data) |        
|Revenues                                                     |                      | $                                             | 201,600 |         |         | $ | 66,194 |         |   | $ | 32,235 |        |   | $    | 16,462 |        |   | $ | 25,278 |       
|Cost of revenues                                             |                      |                                               | 99,275  |         |         |   | 16,837 |         |   |   | 8,963  |        |   |      | 4,525  |        |   |   | 5,834  |       
|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |       
|Gross profit                                                 |                      |                                               | 102,325 |         |         |   | 49,357 |         |   |   | 23,272 |        |   |      | 11,937 |        |   |   | 19,444 |       
|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |       
|Research and development expenses                            |                      |                                               | 24,249  |         |         |   | 14,664 |         |   |   | 8,504  |        |   |      | 6,118  |        |   |   | 6,342  |       
|Sales and marketing expenses                                 |                      |                                               | 28,626  |         |         |   | 14,929 |         |   |   | 7,341  |        |   |      | 5,061  |        |   |   | 4,756  |       
|General and administrative expenses                          |                      |                                               | 16,564  |         |         |   | 6,716  |         |   |   | 3,852  |        |   |      | 2,203  |        |   |   | 2,681  |       
|Write-off of in-process research and development             |                      |                                               |        |         |         |   | 9,681  |         |   |   | 3,375  |        |   |      |       |        |   |   |       |       
|Costs of integration of acquired companies                   |                      |                                               | 15,908  |         |         |   | 3,934  |         |   |   | 256    |        |   |      |       |        |   |   |       |       
|Amortization of intangibles                                  |                      |                                               | 8,676   |         |         |   | 4,710  |         |   |   | 1,488  |        |   |      |       |        |   |   |       |       
|Amortization of unearned compensation                        |                      |                                               | 5,925   |         |         |   |       |         |   |   |       |        |   |      |       |        |   |   |       |       
|Restructuring charge                                         |                      |                                               | 1,300   |         |         |   |       |         |   |   |       |        |   |      |       |        |   |   |       |       
|Recovery of Cyberguard advance                               |                      |                                               |        |         |         |   |       |         |   |   |       |        |   |      |       |        |   |   | (275   | )     
|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |       
|Total operating expenses                                     |                      |                                               | 101,248 |         |         |   | 54,634 |         |   |   | 24,816 |        |   |      | 13,382 |        |   |   | 13,504 |       
|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |       
|Operating income (loss)                                      |                      |                                               | 1,077   |         |         |   | (5,277 | )       |   |   | (1,544 | )      |   |      | (1,445 | )      |   |   | 5,940  |       
|Investment income and other expenses, net                    |                      |                                               | 2,687   |         |         |   | 807    |         |   |   | 669    |        |   |      | 1,336  |        |   |   | 1,320  |       
|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |       
|Income (loss) from continuing operations before income taxes |                      |                                               | 3,764   |         |         |   | (4,470 | )       |   |   | (875   | )      |   |      | (109   | )      |   |   | 7,260  |       
|Income tax expense (benefit)                                 |                      |                                               | 1,581   |         |         |   | 1,618  |         |   |   | (90    | )      |   |      |       |        |   |   |       |       
|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |       
|Income (loss) from continuing operations                     |                      | $                                             | 2,183   |         |         | $ | (6,088 | )       |   | $ | (785   | )      |   | $    | (109   | )      |   | $ | 7,260  |       
|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |       
|Income (loss) from continuing operations per common share:   |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |        |        |   |   |        |       
|                                                             | Basic                |                                               | $       | 0.10    |         |   | $      | (0.54   | ) |   | $      | (0.10  | ) |      | $      | (0.01  | ) |   | $      | 1.08   | 
|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |       
|                                                             | Diluted              |                                               | $       | 0.10    |         |   | $      | (0.54   | ) |   | $      | (0.10  | ) |      | $      | (0.01  | ) |   | $      | 1.01   | 
|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |       
|Shares used in computation:                                  |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |        |        |   |   |        |       
|                                                             | Basic                |                                               |         | 21,816  |         |   |        | 11,350  |   |   |        | 7,730  |   |      |        | 7,057  |   |   |        | 6,751  | 
|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |       
|                                                             | Diluted              |                                               |         | 22,637  |         |   |        | 11,350  |   |   |        | 7,730  |   |      |        | 7,057  |   |   |        | 7,195  | 
|                                                             |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |       
|Balance Sheet Data:                                          |                      |                                               |         |         |         |   |        |         |   |   |        |        |   |      |        |        |   |   |        |       
|                                                             | Working capital      |                                               | $       | 202,659 |         |   | $      | 111,630 |   |   | $      | 31,987 |   |      | $      | 32,385 |   |   | $      | 33,695 | 
|                                                             | Intangible assets    |                                               |         | 446,852 |         |   |        | 67,988  |   |   |        | 13,900 |   |      |        | 727    |   |   |        | 1,516  | 
|                                                             | Total assets         |                                               |         | 723,978 |         |   |        | 208,156 |   |   |        | 55,319 |   |      |        | 39,877 |   |   |        | 43,106 | 
|                                                             | Stockholders equity |                                               |         | 612,586 |         |   |        | 178,997 |   |   |        | 48,378 |   |      |        | 35,459 |   |   |        | 37,723 | 






|    |                                                                                                                                                            
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | During 2004, 2003 and 2002, the Company completed significant
    acquisitions as discussed further in Note 4 to the
    consolidated financial statements.

26



---



##### 



QUARTERLY RESULTS OF OPERATIONS




|                                         |                                          |                                    |        |        |         |   |        |              |  |   |             |        |  |   |        |        | 
|---------------------------------------- | ---------------------------------------- | ---------------------------------- | ------ | ------ | ------- | - | ------ | ------------ |  | - | ----------- | ------ |  | - | ------ | ------ | 
|                                         |                                          | 2004 Quarter Ended                 |       
|                                         |                                          |                                    |       
|                                         |                                          | March 31                           |        |        | June 30 |   |        | September 30 |  |   | December 31 |       
|                                         |                                          |                                    |        |        |         |   |        |              |  |   |             |       
|                                         |                                          | (Unaudited  Amounts in thousands, |       
|                                         |                                          | except per share data)             |       
|Revenues                                 |                                          | $                                  | 24,016 |        |         | $ | 54,345 |              |  | $ | 59,450      |        |  | $ | 63,789 |       
|Cost of revenues                         |                                          |                                    | 9,164  |        |         |   | 29,001 |              |  |   | 29,901      |        |  |   | 31,209 |       
|                                         |                                          |                                    |        |        |         |   |        |              |  |   |             |       
|Gross profit                             |                                          |                                    | 14,852 |        |         |   | 25,344 |              |  |   | 29,549      |        |  |   | 32,580 |       
|Operating (loss) income                  |                                          |                                    | (855   | )      |         |   | (485   | )            |  |   | 1,642       |        |  |   | 775    |       
|(Loss) income from continuing operations |                                          |                                    | (456   | )      |         |   | 408    |              |  |   | 996         |        |  |   | 1,235  |       
|                                         |                                          |                                    |        |        |         |   |        |              |  |   |             |       
|Net (loss) income                        |                                          | $                                  | (456   | )      |         | $ | 408    |              |  | $ | 996         |        |  | $ | 1,235  |       
|                                         |                                          |                                    |        |        |         |   |        |              |  |   |             |       
|(Loss) earnings per share, basic:        |                                          |                                    |        |        |         |   |        |              |  |   |             |        |  |   |        |       
|                                         | (Loss) income from continuing operations |                                    | $      | (0.03  | )       |   | $      | 0.02         |  |   | $           | 0.04   |  |   | $      | 0.05   | 
|                                         |                                          |                                    |        |        |         |   |        |              |  |   |             |       
|                                         | Net (loss) income per share              |                                    | $      | (0.03  | )       |   | $      | 0.02         |  |   | $           | 0.04   |  |   | $      | 0.05   | 
|                                         |                                          |                                    |        |        |         |   |        |              |  |   |             |       
|(Loss) earnings per share, diluted:      |                                          |                                    |        |        |         |   |        |              |  |   |             |        |  |   |        |       
|                                         | (Loss) income from continuing operations |                                    | $      | (0.03  | )       |   | $      | 0.02         |  |   | $           | 0.04   |  |   | $      | 0.05   | 
|                                         |                                          |                                    |        |        |         |   |        |              |  |   |             |       
|                                         | Net (loss) income                        |                                    | $      | (0.03  | )       |   | $      | 0.02         |  |   | $           | 0.04   |  |   | $      | 0.05   | 
|                                         |                                          |                                    |        |        |         |   |        |              |  |   |             |       
|Shares used in calculation:              |                                          |                                    |        |        |         |   |        |              |  |   |             |        |  |   |        |       
|                                         | Basic                                    |                                    |        | 15,183 |         |   |        | 23,801       |  |   |             | 23,976 |  |   |        | 24,252 | 
|                                         | Diluted                                  |                                    |        | 15,183 |         |   |        | 25,653       |  |   |             | 24,558 |  |   |        | 25,277 | 

|                                         |                                          |                    |        |       |         |   |        |              |   |   |             |        |  |   |        |        | 
|---------------------------------------- | ---------------------------------------- | ------------------ | ------ | ----- | ------- | - | ------ | ------------ | - | - | ----------- | ------ |  | - | ------ | ------ | 
|                                         |                                          | 2003 Quarter Ended |       
|                                         |                                          |                    |       
|                                         |                                          | March 31           |        |       | June 30 |   |        | September 30 |   |   | December 31 |       
|                                         |                                          |                    |        |       |         |   |        |              |   |   |             |       
|Revenues                                 |                                          | $                  | 13,563 |       |         | $ | 16,511 |              |   | $ | 17,385      |        |  | $ | 18,735 |       
|Cost of revenues                         |                                          |                    | 4,444  |       |         |   | 4,898  |              |   |   | 4,289       |        |  |   | 3,206  |       
|                                         |                                          |                    |        |       |         |   |        |              |   |   |             |       
|                                         | Gross Profit                             |                    |        | 9,119 |         |   |        | 11,613       |   |   |             | 13,096 |  |   |        | 15,529 | 
|Operating (loss) income                  |                                          |                    | (9,182 | )     |         |   | (2,200 | )            |   |   | 2,183       |        |  |   | 3,922  |       
|(Loss) income from continuing operations |                                          |                    | (9,734 | )     |         |   | (2,443 | )            |   |   | 1,821       |        |  |   | 4,268  |       
|                                         |                                          |                    |        |       |         |   |        |              |   |   |             |       
|Net (loss) income                        |                                          | $                  | (9,734 | )     |         | $ | (2,443 | )            |   | $ | 1,821       |        |  | $ | 4,268  |       
|                                         |                                          |                    |        |       |         |   |        |              |   |   |             |       
|(Loss) income per common share, basic:   |                                          |                    |        |       |         |   |        |              |   |   |             |        |  |   |        |       
|                                         | (Loss) income from continuing operations |                    | $      | (1.07 | )       |   | $      | (0.24        | ) |   | $           | 0.14   |  |   | $      | 0.32   | 
|                                         |                                          |                    |        |       |         |   |        |              |   |   |             |       
|                                         | Net (loss) income per share              |                    | $      | (1.07 | )       |   | $      | (0.24        | ) |   | $           | 0.14   |  |   | $      | 0.32   | 
|                                         |                                          |                    |        |       |         |   |        |              |   |   |             |       
|(Loss) income per common share, diluted: |                                          |                    |        |       |         |   |        |              |   |   |             |        |  |   |        |       
|                                         | (Loss) income from continuing operations |                    | $      | (1.07 | )       |   | $      | (0.24        | ) |   | $           | 0.13   |  |   | $      | 0.31   | 
|                                         |                                          |                    |        |       |         |   |        |              |   |   |             |       
|                                         | Net (loss) income per share              |                    | $      | (1.07 | )       |   | $      | (0.24        | ) |   | $           | 0.13   |  |   | $      | 0.31   | 
|                                         |                                          |                    |        |       |         |   |        |              |   |   |             |       
|Shares used in computation:              |                                          |                    |        |       |         |   |        |              |   |   |             |        |  |   |        |       
|                                         | Basic                                    |                    |        | 9,083 |         |   |        | 10,232       |   |   |             | 12,769 |  |   |        | 13,281 | 
|                                         | Diluted                                  |                    |        | 9,083 |         |   |        | 10,232       |   |   |             | 13,546 |  |   |        | 13,987 | 



27



---



##### 







|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|ITEM 7. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
    CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements




Overview














28



---



##### 













RESULTS OF OPERATIONS OF SAFENET




|                                                             |  |      |      |  |      |  |     |      |  |  |     |   
|------------------------------------------------------------ |  | ---- | ---- |  | ---- |  | --- | ---- |  |  | --- | --
|                                                             |  | 2004 |      |  | 2003 |  |     | 2002 | 
|                                                             |  |      |      |  |      |  |     |      | 
|Revenues                                                     |  |      | 100% |  |      |  | 100 | %    |  |  | 100 | % 
|Cost of revenues                                             |  |      | 49%  |  |      |  | 25  | %    |  |  | 28  | % 
|                                                             |  |      |      |  |      |  |     |      | 
|Gross profit                                                 |  |      | 51%  |  |      |  | 75  | %    |  |  | 72  | % 
|Research and development expenses                            |  |      | 12%  |  |      |  | 22  | %    |  |  | 26  | % 
|Sales and marketing expenses                                 |  |      | 14%  |  |      |  | 23  | %    |  |  | 23  | % 
|General and administrative expenses                          |  |      | 8%   |  |      |  | 10  | %    |  |  | 13  | % 
|Costs of integration of acquired companies                   |  |      | 8%   |  |      |  | 6   | %    |  |  | 0   | % 
|Write-off of in-process research and development             |  |      | 0%   |  |      |  | 15  | %    |  |  | 10  | % 
|Restructuring charge                                         |  |      | 1%   |  |      |  | 0   | %    |  |  | 0   | % 
|Amortization of intangibles                                  |  |      | 4%   |  |      |  | 7   | %    |  |  | 5   | % 
|Amortization of deferred compensation                        |  |      | 3%   |  |      |  | 0   | %    |  |  | 0   | % 
|                                                             |  |      |      |  |      |  |     |      | 
|Total operating expenses                                     |  |      | 50%  |  |      |  | 83  | %    |  |  | 77  | % 
|Operating income (loss)                                      |  |      | 1%   |  |      |  | (8  | )%   |  |  | (5  | )%
|Investment income and other expenses, net                    |  |      | 1%   |  |      |  | 1   | %    |  |  | 2   | % 
|                                                             |  |      |      |  |      |  |     |      | 
|Income (loss) from continuing operations before income taxes |  |      | 2%   |  |      |  | (7  | )%   |  |  | (3  | )%
|Income tax expense                                           |  |      | 1%   |  |      |  | 2   | %    |  |  | 0   | % 
|                                                             |  |      |      |  |      |  |     |      | 
|Income (loss) from continuing operations                     |  |      | 1%   |  |      |  | (9  | )%   |  |  | (3  | )%
|                                                             |  |      |      |  |      |  |     |      | 



29



---



##### 







| |                                                                          
| | -------------------------------------------------------------------------
| | Year ended December 31, 2004 Compared to Year ended
    December 31, 2003



| |                           
| | --------------------------
| | Revenues and Gross Margins

|                             |       |                        |         |         |      |          |        |        |   |   |         |         |    |  |     |     |  
|---------------------------- | ----- | ---------------------- | ------- | ------- | ---- | -------- | ------ | ------ | - | - | ------- | ------- | -- |  | --- | --- | -
|                             |       |                        |         |         |      | Variance |       
|                             |       |                        |         |         |      |          |       
|                             |       | 2004                   |         |         | 2003 |          |        | $      |   |   | %       |        
|                             |       |                        |         |         |      |          |        |        |   |   |         |        
|                             |       | (Dollars in thousands) |         |         |      |          |       
|Revenues by type             |       |                        |         |         |      |          |        |        |   |   |         |         |    |  |     |    
|License and royalties        |       | $                      | 9,677   |         |      | $        | 16,464 |        |   | $ | (6,787  | )       |    |  | (41 | )% 
|Products                     |       |                        | 172,145 |         |      |          | 38,797 |        |   |   | 133,348 |         |    |  | 344 | %  
|Service and maintenance      |       |                        | 19,778  |         |      |          | 10,933 |        |   |   | 8,845   |         |    |  | 81  | %  
|                             |       |                        |         |         |      |          |        |        |   |   |         |        
|                             | Total |                        | $       | 201,600 |      |          | $      | 66,194 |   |   | $       | 135,406 |    |  |     | 205 | %
|                             |       |                        |         |         |      |          |        |        |   |   |         |        
|Revenues by segment          |       |                        |         |         |      |          |        |        |   |   |         |         |    |  |     |    
|Embedded Security Division   |       | $                      | 56,009  |         |      | $        | 19,269 |        |   | $ | 36,740  |         |    |  | 191 | %  
|Enterprise Security Division |       |                        | 145,591 |         |      |          | 46,925 |        |   |   | 98,666  |         |    |  | 210 | %  
|                             |       |                        |         |         |      |          |        |        |   |   |         |        
|                             | Total |                        | $       | 201,600 |      |          | $      | 66,194 |   |   | $       | 135,406 |    |  |     | 205 | %
|                             |       |                        |         |         |      |          |        |        |   |   |         |        
|Revenue mix by type          |       |                        |         |         |      |          |        |        |   |   |         |         |    |  |     |    
|License and royalties        |       |                        | 5       | %       |      |          | 25     | %      |   |   |         |         |    |  |     |    
|Products                     |       |                        | 85      | %       |      |          | 59     | %      |   |   |         |         |    |  |     |    
|Service and maintenance      |       |                        | 10      | %       |      |          | 16     | %      |   |   |         |         |    |  |     |    
|                             |       |                        |         |         |      |          |        |        |   |   |         |        
|                             | Total |                        |         | 100     | %    |          |        | 100    | % |   |         |         |    |  |     |     |  
|                             |       |                        |         |         |      |          |        |        |   |   |         |        
|Revenue mix by segment       |       |                        |         |         |      |          |        |        |   |   |         |         |    |  |     |    
|Embedded Security Division   |       |                        | 28      | %       |      |          | 29     | %      |   |   |         |         |    |  |     |    
|Enterprise Security Division |       |                        | 72      | %       |      |          | 71     | %      |   |   |         |         |    |  |     |    
|                             |       |                        |         |         |      |          |        |        |   |   |         |        
|                             | Total |                        |         | 100     | %    |          |        | 100    | % |   |         |         |    |  |     |     |  
|                             |       |                        |         |         |      |          |        |        |   |   |         |        
|Gross margins by type        |       |                        |         |         |      |          |        |        |   |   |         |         |    |  |     |    
|License and royalties        |       |                        | 97      | %       |      |          | 95     | %      |   |   | 2       | %       |    |  |     |    
|Products(1)                  |       |                        | 44      | %       |      |          | 62     | %      |   |   | (18     | )%      |    |  |     |    
|Service and maintenance      |       |                        | 91      | %       |      |          | 88     | %      |   |   | 3       | %       |    |  |     |    
|                             |       |                        |         |         |      |          |        |        |   |   |         |        
|                             | Total |                        |         | 51      | %    |          |        | 75     | % |   |         | (24     | )% |  |     |     |  
|                             |       |                        |         |         |      |          |        |        |   |   |         |        
|Gross margins by segment     |       |                        |         |         |      |          |        |        |   |   |         |         |    |  |     |    
|Embedded Security Division   |       |                        | 64      | %       |      |          | 75     | %      |   |   | (11     | )%      |    |  |     |    
|Enterprise Security Division |       |                        | 46      | %       |      |          | 75     | %      |   |   | (29     | )%      |    |  |     |    
|                             |       |                        |         |         |      |          |        |        |   |   |         |        
|                             | Total |                        |         | 51      | %    |          |        | 75     | % |   |         | (24     | )% |  |     |     |  
|                             |       |                        |         |         |      |          |        |        |   |   |         |        






|    |                                                                                                                                                                                 
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes amortization of acquired intangibles ($11,104 and
    $2,652 for 2004 and 2003, respectively) and amortization of
    unearned compensation ($516 in 2004, $0 in 2003).



30



---



##### 















| |                   
| | ------------------
| | Operating Expenses

|                                                                |       |                        |        |         |      |          |        |        |  |   |        |        |  |  |      |    |  
|--------------------------------------------------------------- | ----- | ---------------------- | ------ | ------- | ---- | -------- | ------ | ------ |  | - | ------ | ------ |  |  | ---- | -- | -
|                                                                |       |                        |        |         |      | Variance |       
|                                                                |       |                        |        |         |      |          |       
|                                                                |       | 2004                   |        |         | 2003 |          |        | $      |  |   | %      |       
|                                                                |       |                        |        |         |      |          |        |        |  |   |        |       
|                                                                |       | (Dollars in thousands) |        |         |      |          |       
|Operating expenses                                              |       |                        |        |         |      |          |        |        |  |   |        |        |  |  |      |   
|Research and development                                        |       | $                      | 24,249 |         |      | $        | 14,664 |        |  | $ | 9,585  |        |  |  | 65   | % 
|Sales and marketing                                             |       |                        | 28,626 |         |      |          | 14,929 |        |  |   | 13,697 |        |  |  | 92   | % 
|General and administrative                                      |       |                        | 16,564 |         |      |          | 6,716  |        |  |   | 9,848  |        |  |  | 147  | % 
|Write-off of acquired in-process research and development costs |       |                        |       |         |      |          | 9,681  |        |  |   | (9,681 | )      |  |  | (100 | )%
|Cost of integration of acquired companies                       |       |                        | 15,908 |         |      |          | 3,934  |        |  |   | 11,974 |        |  |  | 304  | % 
|Restructuring charge                                            |       |                        | 1,300  |         |      |          |       |        |  |   | 1,300  |        |  |  |      |   
|Amortization of intangible assets                               |       |                        | 8,676  |         |      |          | 4,710  |        |  |   | 3,966  |        |  |  | 84   | % 
|Amortization of unearned compensation                           |       |                        | 5,925  |         |      |          |       |        |  |   | 5,925  |        |  |  |      |   
|                                                                |       |                        |        |         |      |          |        |        |  |   |        |       
|                                                                | Total |                        | $      | 101,248 |      |          | $      | 54,634 |  |   | $      | 46,614 |  |  |      | 85 | %
|                                                                |       |                        |        |         |      |          |        |        |  |   |        |       



31



---



##### 





















| |                               
| | ------------------------------
| | Interest and Other Income, Net

|                               |  |             |       |  |      |          |     |   |  |   |       |  |  |  |      | 
|------------------------------ |  | ----------- | ----- |  | ---- | -------- | --- | - |  | - | ----- |  |  |  | ---- | 
|                               |  |             |       |  |      | Variance |    
|                               |  |             |       |  |      |          |    
|                               |  | 2004        |       |  | 2003 |          |     | $ |  |   | %     | 
|                               |  |             |       |  |      |          |     |   |  |   |       | 
|                               |  | (Dollars in |       |  |      |          |    
|                               |  | thousands)  |       |  |      |          |    
|Interest and other income, net |  | $           | 2,687 |  |      | $        | 807 |   |  | $ | 1,880 |  |  |  | 233% | 



32



---



##### 





| |                   
| | ------------------
| | Income Tax Expense

|                   |  |             |       |  |      |          |       |   |  |   |     |   |  |  |    |   
|------------------ |  | ----------- | ----- |  | ---- | -------- | ----- | - |  | - | --- | - |  |  | -- | --
|                   |  |             |       |  |      | Variance |      
|                   |  |             |       |  |      |          |      
|                   |  | 2004        |       |  | 2003 |          |       | $ |  |   | %   |  
|                   |  |             |       |  |      |          |       |   |  |   |     |  
|                   |  | (Dollars in |       |  |      |          |      
|                   |  | thousands)  |       |  |      |          |      
|Income tax expense |  | $           | 1,581 |  |      | $        | 1,618 |   |  | $ | (37 | ) |  |  | (2 | )%





| |                                                                          
| | -------------------------------------------------------------------------
| | Year ended December 31, 2003 Compared to Year ended
    December 31, 2002



| |                           
| | --------------------------
| | Revenues and Gross Margins

|                             |       |             |        |        |      |          |        |        |   |   |        |        |   |  |     |     |  
|---------------------------- | ----- | ----------- | ------ | ------ | ---- | -------- | ------ | ------ | - | - | ------ | ------ | - |  | --- | --- | -
|                             |       |             |        |        |      | Variance |       
|                             |       |             |        |        |      |          |       
|                             |       | 2003        |        |        | 2002 |          |        | $      |   |   | %      |       
|                             |       |             |        |        |      |          |        |        |   |   |        |       
|                             |       | (Dollars in |        |        |      |          |       
|                             |       | thousands)  |        |        |      |          |       
|Revenues by type             |       |             |        |        |      |          |        |        |   |   |        |        |   |  |     |    
|License 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 segment          |       |             |        |        |      |          |        |        |   |   |        |        |   |  |     |    
|Embedded 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 type          |       |             |        |        |      |          |        |        |   |   |        |        |   |  |     |    
|License and royalties        |       |             | 25     | %      |      |          | 23     | %      |   |   |        |        |   |  |     |    
|Products                     |       |             | 59     | %      |      |          | 67     | %      |   |   |        |        |   |  |     |    
|Service and maintenance      |       |             | 16     | %      |      |          | 10     | %      |   |   |        |        |   |  |     |    
|                             |       |             |        |        |      |          |        |        |   |   |        |       
|                             | Total |             |        | 100    | %    |          |        | 100    | % |   |        |        |   |  |     |     |  
|                             |       |             |        |        |      |          |        |        |   |   |        |       
|Revenue mix by segment       |       |             |        |        |      |          |        |        |   |   |        |        |   |  |     |    
|Embedded Security Division   |       |             | 29     | %      |      |          | 57     | %      |   |   |        |        |   |  |     |    
|Enterprise Security Division |       |             | 71     | %      |      |          | 43     | %      |   |   |        |        |   |  |     |    
|                             |       |             |        |        |      |          |        |        |   |   |        |       
|Total                        |       |             | 100    | %      |      |          | 100    | %      |   |   |        |        |   |  |     |    
|                             |       |             |        |        |      |          |        |        |   |   |        |       
|Gross margins by type        |       |             |        |        |      |          |        |        |   |   |        |        |   |  |     |    
|License and royalties        |       |             | 95     | %      |      |          | 89     | %      |   |   | 6      | %      |   |  |     |    
|Products(1)                  |       |             | 62     | %      |      |          | 64     | %      |   |   | (2     | )%     |   |  |     |    
|Service and maintenance      |       |             | 88     | %      |      |          | 86     | %      |   |   | 2      | %      |   |  |     |    
|                             |       |             |        |        |      |          |        |        |   |   |        |       
|                             | Total |             |        | 75     | %    |          |        | 72     | % |   |        | 3      | % |  |     |     |  
|                             |       |             |        |        |      |          |        |        |   |   |        |       
|Gross margins by segment     |       |             |        |        |      |          |        |        |   |   |        |        |   |  |     |    
|Embedded Security Division   |       |             | 75     | %      |      |          | 72     | %      |   |   | 3      | %      |   |  |     |    
|Enterprise Security Division |       |             | 75     | %      |      |          | 74     | %      |   |   | 1      | %      |   |  |     |    
|                             |       |             |        |        |      |          |        |        |   |   |        |       
|                             | Total |             |        | 75     | %    |          |        | 72     | % |   |        | 3      | % |  |     |     |  
|                             |       |             |        |        |      |          |        |        |   |   |        |       






|    |                                                     
|--- | ----------------------------------------------------
|(1) | Includes amortization of acquired intangible assets.

33



---



##### 















| |                   
| | ------------------
| | Operating Expenses

|                                                                |       |                        |        |        |      |          |       |        |  |   |       |        |  |  |       |     |  
|--------------------------------------------------------------- | ----- | ---------------------- | ------ | ------ | ---- | -------- | ----- | ------ |  | - | ----- | ------ |  |  | ----- | --- | -
|                                                                |       |                        |        |        |      | Variance |      
|                                                                |       |                        |        |        |      |          |      
|                                                                |       | 2003                   |        |        | 2002 |          |       | $      |  |   | %     |       
|                                                                |       |                        |        |        |      |          |       |        |  |   |       |       
|                                                                |       | (Dollars in thousands) |        |        |      |          |      
|Operating expenses                                              |       |                        |        |        |      |          |       |        |  |   |       |        |  |  |       |    
|Research 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 |        |  |  | 1,437 | %  
|                                                                |       |                        |        |        |      |          |       |        |  |   |       |       
|                                                                | Total |                        | $      | 54,634 |      |          | $     | 24,816 |  |   | $     | 29,818 |  |  |       | 120 | %
|                                                                |       |                        |        |        |      |          |       |        |  |   |       |       



34



---



##### 















35



---



##### 





| |                               
| | ------------------------------
| | Interest and Other Income, Net

|                               |  |             |     |  |      |          |     |   |  |   |     |  |  |  |     | 
|------------------------------ |  | ----------- | --- |  | ---- | -------- | --- | - |  | - | --- |  |  |  | --- | 
|                               |  |             |     |  |      | Variance |    
|                               |  |             |     |  |      |          |    
|                               |  | 2003        |     |  | 2002 |          |     | $ |  |   | %   | 
|                               |  |             |     |  |      |          |     |   |  |   |     | 
|                               |  | (Dollars in |     |  |      |          |    
|                               |  | thousands)  |     |  |      |          |    
|Interest and other income, net |  | $           | 807 |  |      | $        | 669 |   |  | $ | 138 |  |  |  | 21% | 





| |                             
| | ----------------------------
| | Income Tax Expense (Benefit)

|                             |  |             |       |  |      |          |     |   |  |   |       |  |  |  |          | 
|---------------------------- |  | ----------- | ----- |  | ---- | -------- | --- | - |  | - | ----- |  |  |  | -------- | 
|                             |  |             |       |  |      | Variance |    
|                             |  |             |       |  |      |          |    
|                             |  | 2003        |       |  | 2002 |          |     | $ |  |   | %     | 
|                             |  |             |       |  |      |          |     |   |  |   |       | 
|                             |  | (Dollars in |       |  |      |          |    
|                             |  | thousands)  |       |  |      |          |    
|Income tax expense (benefit) |  | $           | 1,618 |  |      | $        | (90 | ) |  | $ | 1,708 |  |  |  | (1,898)% | 





| |                                        
| | ---------------------------------------
| | Loss from Discontinued Operations (GDS)

|                                  |  |             |   |      |  |          |        |   |  |   |       |  |  |  |        | 
|--------------------------------- |  | ----------- | - | ---- |  | -------- | ------ | - |  | - | ----- |  |  |  | ------ | 
|                                  |  |             |   |      |  | Variance |       
|                                  |  |             |   |      |  |          |       
|                                  |  | 2003        |   | 2002 |  |          | $      |   |  | % |      
|                                  |  |             |   |      |  |          |        |   |  |   |      
|                                  |  | (Dollars in |   |      |  |          |       
|                                  |  | thousands)  |   |      |  |          |       
|Loss from discontinued operations |  | $           |  |      |  | $        | (3,954 | ) |  | $ | 3,954 |  |  |  | (100)% | 



Liquidity and Capital Resources






36



---



##### 









|                    |  |       |        |           |          |   |        |       |  |       |        |   |           |         |        |   |  |   |       | 
|------------------- |  | ----- | ------ | --------- | -------- | - | ------ | ----- |  | ----- | ------ | - | --------- | ------- | ------ | - |  | - | ----- | 
|                    |  |       |        | Less than |          |   | 1 - 3  |       |  | 3 - 5 |        |   | More than |        
|                    |  | Total |        |           | One Year |   |        | Years |  |       | Years  |   |           | 5 Years |       
|                    |  |       |        |           |          |   |        |       |  |       |        |   |           |         |       
|Operating leases(1) |  | $     | 39,584 |           |          | $ | 8,694  |       |  | $     | 12,504 |   |           | $       | 10,288 |   |  | $ | 8,098 | 
|Subleases           |  |       | (4,192 | )         |          |   | (1,698 | )     |  |       | (2,173 | ) |           |         | (321   | ) |  |   |      | 
|                    |  |       |        |           |          |   |        |       |  |       |        |   |           |         |       
|Total               |  | $     | 35,392 |           |          | $ | 6,996  |       |  | $     | 10,331 |   |           | $       | 9,967  |   |  | $ | 8,098 | 
|                    |  |       |        |           |          |   |        |       |  |       |        |   |           |         |       






|    |                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------
|(1) | The operating leases are for the multiple facilities that we
    lease for our operations, sales and headquarters

Inflation and Seasonality




Critical Accounting Policies








| |                                
| | -------------------------------
| | Allowance for Doubtful Accounts





| |          
| | ---------
| | Inventory



37



---



##### 





| |                           
| | --------------------------
| | Software Development Costs







| |                   
| | ------------------
| | Product Warranties





| |                                     
| | ------------------------------------
| | Goodwill and Other Intangible Assets



Applicability
of FASB Statement No. 2 to Business Combinations Accounted
for by the Purchase Method.


Goodwill and Other Intangible
Assets.


38



---



##### 







| |                    
| | -------------------
| | Revenue Recognition







|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
    RISK

Market Risk




Foreign Currency Risk




Interest Rate Risk






39



---



##### 



SAFENET, INC.


AND SUBSIDIARIES




|        |                                            
|------- | -------------------------------------------
|Item 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO FINANCIAL STATEMENTS


|                                                                                                                    |  |      |    | 
|------------------------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|                                                                                                                    |  | Page |   
|                                                                                                                    |  |      |   
|Report of Independent Registered Public
    Accounting Firm                                                         |  |      | 41 | 
|Consolidated Balance Sheets as of
    December 31, 2004 and 2003                                                    |  |      | 42 | 
|Consolidated Statements of Operations for
    the years ended December 31, 2004, 2003 and 2002                      |  |      | 43 | 
|Consolidated Statements of Comprehensive
    Income (Loss) for the years ended December 31, 2004, 2003
    and 2002 |  |      | 44 | 
|Consolidated Statements of
    Stockholders Equity for the years ended December 31,
    2004, 2003 and 2002        |  |      | 45 | 
|Consolidated Statements of Cash Flows for
    the years ended December 31, 2004, 2003, and 2002                     |  |      | 46 | 
|Notes to Consolidated Financial
    Statements                                                                      |  |      | 47 | 

40



---



##### 






REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM












| |                      
| | ---------------------
| | /s/ Ernst & Young LLP





41



---



##### 



SAFENET, INC.


AND SUBSIDIARIES





CONSOLIDATED BALANCE SHEETS


|                                                                                                              |                                                                                                                                              |                                            |         |         |         |  |        |         |         | 
|------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------- | ------- | ------- |  | ------ | ------- | ------- | 
|                                                                                                              |                                                                                                                                              | December 31,                               |        
|                                                                                                              |                                                                                                                                              |                                            |        
|                                                                                                              |                                                                                                                                              | 2004                                       |         |         | 2003    | 
|                                                                                                              |                                                                                                                                              |                                            |         |         |         | 
|                                                                                                              |                                                                                                                                              | (In thousands,                             |        
|                                                                                                              |                                                                                                                                              | except per share amounts)                  |        
|ASSETS                                                                                                       
|Current assets:                                                                                               |                                                                                                                                              |                                            |         |         |         |  |        |        
|                                                                                                              | Cash and cash equivalents                                                                                                                    |                                            | $       | 74,751  |         |  | $      | 21,651  |        
|                                                                                                              | Restricted cash                                                                                                                              |                                            |         | 150     |         |  |        | 2,800   |        
|                                                                                                              | Short-term investments                                                                                                                       |                                            |         | 93,310  |         |  |        | 92,280  |        
|                                                                                                              | Accounts receivable, net of allowance for doubtful accounts of
    $2,264 in 2004 and $940 in 2003                                           |                                            |         | 56,224  |         |  |        | 13,191  |        
|                                                                                                              | Inventories, net of reserve of $726 in 2004 and $1,275 in 2003                                                                               |                                            |         | 18,168  |         |  |        | 3,123   |        
|                                                                                                              | Unbilled costs and fees                                                                                                                      |                                            |         | 1,259   |         |  |        |        |        
|                                                                                                              | Deferred income taxes                                                                                                                        |                                            |         | 9,694   |         |  |        |        |        
|                                                                                                              | Prepaid expenses and other current assets                                                                                                    |                                            |         | 3,252   |         |  |        | 1,414   |        
|                                                                                                              |                                                                                                                                              |                                            |         |         |         | 
|                                                                                                              |                                                                                                                                              | Total current assets                       |         |         | 256,808 |  |        |         | 134,459 | 
|Property and equipment, net                                                                                   |                                                                                                                                              |                                            | 18,313  |         |         |  | 3,809  |        
|Computer software development costs, net of accumulated
    amortization of $2,619 in 2004 and $1,696 in 2003 |                                                                                                                                              |                                            | 2,349   |         |         |  | 1,982  |        
|Goodwill                                                                                                      |                                                                                                                                              |                                            | 305,311 |         |         |  | 42,407 |        
|Other intangible assets, net of accumulated amortization of
    $28,223 in 2004 and $8,483 in 2003            |                                                                                                                                              |                                            | 139,192 |         |         |  | 23,599 |        
|Other assets                                                                                                  |                                                                                                                                              |                                            | 2,005   |         |         |  | 1,900  |        
|                                                                                                              |                                                                                                                                              |                                            |         |         |         | 
|                                                                                                              |                                                                                                                                              | Total assets                               |         | $       | 723,978 |  |        | $       | 208,156 | 
|                                                                                                              |                                                                                                                                              |                                            |         |         |         | 
|                                                                                                             
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                         
|                                                                                                             
|Current liabilities:                                                                                          |                                                                                                                                              |                                            |         |         |         |  |        |        
|                                                                                                              | Accounts payable                                                                                                                             |                                            | $       | 11,615  |         |  | $      | 3,799   |        
|                                                                                                              | Accrued compensation and related costs                                                                                                       |                                            |         | 13,046  |         |  |        | 3,770   |        
|                                                                                                              | Advance payments and deferred revenue                                                                                                        |                                            |         | 11,319  |         |  |        | 4,791   |        
|                                                                                                              | Accrued warranty costs                                                                                                                       |                                            |         | 3,192   |         |  |        | 259     |        
|                                                                                                              | Unfavorable lease liability                                                                                                                  |                                            |         | 1,099   |         |  |        | 735     |        
|                                                                                                              | Other accrued expenses                                                                                                                       |                                            |         | 7,060   |         |  |        | 1,774   |        
|                                                                                                              | Due to former owners of acquired company                                                                                                     |                                            |         |        |         |  |        | 2,800   |        
|                                                                                                              | Accrued income taxes                                                                                                                         |                                            |         | 6,818   |         |  |        | 2,294   |        
|                                                                                                              | Deferred income taxes                                                                                                                        |                                            |         |        |         |  |        | 2,607   |        
|                                                                                                              |                                                                                                                                              |                                            |         |         |         | 
|                                                                                                              |                                                                                                                                              | Total current liabilities                  |         |         | 54,149  |  |        |         | 22,829  | 
|Unfavorable lease liability, less current portion                                                             |                                                                                                                                              |                                            | 3,840   |         |         |  | 4,149  |        
|Deferred income taxes                                                                                         |                                                                                                                                              |                                            | 50,922  |         |         |  | 2,181  |        
|Other liabilities                                                                                             |                                                                                                                                              |                                            | 2,481   |         |         |  |       |        
|                                                                                                              |                                                                                                                                              |                                            |         |         |         | 
|                                                                                                              |                                                                                                                                              | Total liabilities                          |         |         | 111,392 |  |        |         | 29,159  | 
|Commitments and contingencies                                                                                 |                                                                                                                                              |                                            |        |         |         |  |       |        
|Stockholders equity:                                                                                         |                                                                                                                                              |                                            |         |         |         |  |        |        
|                                                                                                              | Preferred stock, $.01 par value per share, authorized
    500 shares, no shares issued and outstanding                                       |                                            |         |        |         |  |        |        |        
|                                                                                                              | Common stock, $.01 par value per share, authorized
    50,000 shares, issued and outstanding shares of 24,401 in
    2004 and 13,286 in 2003 |                                            |         | 244     |         |  |        | 133     |        
|                                                                                                              | Additional paid-in capital                                                                                                                   |                                            |         | 633,882 |         |  |        | 199,783 |        
|                                                                                                              | Unearned compensation                                                                                                                        |                                            |         | (6,719  | )       |  |        |        |        
|                                                                                                              | Accumulated other comprehensive income                                                                                                       |                                            |         | 9,309   |         |  |        | 5,394   |        
|                                                                                                              | Accumulated deficit                                                                                                                          |                                            |         | (24,130 | )       |  |        | (26,313 | )      
|                                                                                                              |                                                                                                                                              |                                            |         |         |         | 
|                                                                                                              |                                                                                                                                              | Total stockholders equity                 |         |         | 612,586 |  |        |         | 178,997 | 
|                                                                                                              |                                                                                                                                              |                                            |         |         |         | 
|                                                                                                              |                                                                                                                                              | Total liabilities and stockholders equity |         | $       | 723,978 |  |        | $       | 208,156 | 
|                                                                                                              |                                                                                                                                              |                                            |         |         |         | 



42



---



##### 



SAFENET, INC.


AND SUBSIDIARIES





CONSOLIDATED STATEMENTS OF OPERATIONS


|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |        |   |        |        |        | 
|---------------------------------------------------------------------------------------------------- | --------------------------------------------------------------- | ------------------------- | ------- | ------- | ------- | - | ------ | ------ | ------ | - | ------ | ------ | ------ | 
|                                                                                                     |                                                                 | Year Ended December 31,   |        
|                                                                                                     |                                                                 |                           |        
|                                                                                                     |                                                                 | 2004                      |         |         | 2003    |   |        | 2002   |       
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|                                                                                                     |                                                                 | (In thousands,            |        
|                                                                                                     |                                                                 | except per share amounts) |        
|Revenues:                                                                                            |                                                                 |                           |         |         |         |   |        |        |        |   |        |       
|                                                                                                     | Licenses and royalties                                          |                           | $       | 9,677   |         |   | $      | 16,464 |        |   | $      | 7,398  |       
|                                                                                                     | Products                                                        |                           |         | 172,145 |         |   |        | 38,797 |        |   |        | 21,588 |       
|                                                                                                     | Service and maintenance                                         |                           |         | 19,778  |         |   |        | 10,933 |        |   |        | 3,249  |       
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|Total revenues                                                                                       |                                                                 |                           | 201,600 |         |         |   | 66,194 |        |        |   | 32,235 |       
|Cost of revenues:                                                                                    |                                                                 |                           |         |         |         |   |        |        |        |   |        |       
|                                                                                                     | Licenses and royalties                                          |                           |         | 325     |         |   |        | 812    |        |   |        | 811    |       
|                                                                                                     | Products                                                        |                           |         | 85,457  |         |   |        | 12,106 |        |   |        | 7,699  |       
|                                                                                                     | Service and maintenance                                         |                           |         | 1,873   |         |   |        | 1,267  |        |   |        | 453    |       
|                                                                                                     | Amortization of acquired intangible assets                      |                           |         | 11,104  |         |   |        | 2,652  |        |   |        |       |       
|                                                                                                     | Amortization of unearned compensation*                          |                           |         | 516     |         |   |        |       |        |   |        |       |       
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|Total cost of revenues                                                                               |                                                                 |                           | 99,275  |         |         |   | 16,837 |        |        |   | 8,963  |       
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|                                                                                                     |                                                                 | Gross profit              |         |         | 102,325 |   |        |        | 49,357 |   |        |        | 23,272 | 
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|Operating expenses:                                                                                  |                                                                 |                           |         |         |         |   |        |        |        |   |        |       
|                                                                                                     | Research and development expenses                               |                           |         | 24,249  |         |   |        | 14,664 |        |   |        | 8,504  |       
|                                                                                                     | Sales and marketing expenses                                    |                           |         | 28,626  |         |   |        | 14,929 |        |   |        | 7,341  |       
|                                                                                                     | General and administrative expenses                             |                           |         | 16,564  |         |   |        | 6,716  |        |   |        | 3,852  |       
|                                                                                                     | Write-off of acquired in-process research and development costs |                           |         |        |         |   |        | 9,681  |        |   |        | 3,375  |       
|                                                                                                     | Restructuring charges                                           |                           |         | 1,300   |         |   |        |       |        |   |        |       |       
|                                                                                                     | Costs of integration of acquired companies                      |                           |         | 15,908  |         |   |        | 3,934  |        |   |        | 256    |       
|                                                                                                     | Amortization of unearned compensation*                          |                           |         | 5,925   |         |   |        |       |        |   |        |       |       
|                                                                                                     | Amortization of acquired intangible assets                      |                           |         | 8,676   |         |   |        | 4,710  |        |   |        | 1,488  |       
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|Total operating expenses                                                                             |                                                                 |                           | 101,248 |         |         |   | 54,634 |        |        |   | 24,816 |       
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|Operating income (loss)                                                                              |                                                                 |                           | 1,077   |         |         |   | (5,277 | )      |        |   | (1,544 | )     
|Interest and other income, net                                                                       |                                                                 |                           | 2,687   |         |         |   | 807    |        |        |   | 669    |       
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|Income (loss) from continuing operations before income taxes                                         |                                                                 |                           | 3,764   |         |         |   | (4,470 | )      |        |   | (875   | )     
|Income tax expense (benefit)                                                                         |                                                                 |                           | 1,581   |         |         |   | 1,618  |        |        |   | (90    | )     
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|                                                                                                     | Income (loss) from continuing operations                        |                           |         | 2,183   |         |   |        | (6,088 | )      |   |        | (785   | )     
|Loss from operations of discontinued GDS business (including
    loss on disposal of $3,506 in 2002) |                                                                 |                           |        |         |         |   |       |        |        |   | (3,954 | )     
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|Net income (loss)                                                                                    |                                                                 | $                         | 2,183   |         |         | $ | (6,088 | )      |        | $ | (4,739 | )     
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|Basic income (loss) per common share:                                                                |                                                                 |                           |         |         |         |   |        |        |        |   |        |       
|                                                                                                     | Income (loss) from continuing operations                        |                           | $       | 0.10    |         |   | $      | (0.54  | )      |   | $      | (0.10  | )     
|                                                                                                     | Loss from discontinued GDS business                             |                           |         |        |         |   |        |       |        |   |        | (0.51  | )     
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|                                                                                                     | Net income (loss) per share                                     |                           | $       | 0.10    |         |   | $      | (0.54  | )      |   | $      | (0.61  | )     
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|Diluted income (loss) per common share:                                                              |                                                                 |                           |         |         |         |   |        |        |        |   |        |       
|                                                                                                     | Income (loss) from continuing operations                        |                           | $       | 0.10    |         |   | $      | (0.54  | )      |   | $      | (0.10  | )     
|                                                                                                     | Loss from discontinued GDS business                             |                           |         |        |         |   |        |       |        |   |        | (0.51  | )     
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|                                                                                                     | Net income (loss) per share                                     |                           | $       | 0.10    |         |   | $      | (0.54  | )      |   | $      | (0.61  | )     
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|*Composition of amortization of unearned compensation:                                               |                                                                 |                           |         |         |         |   |        |        |        |   |        |       
|                                                                                                     | Cost of revenues                                                |                           | $       | 516     |         |   | $      |       |        |   | $      |       |       
|                                                                                                     | Research and development                                        |                           |         | 1,225   |         |   |        |       |        |   |        |       |       
|                                                                                                     | Sales and marketing                                             |                           |         | 1,102   |         |   |        |       |        |   |        |       |       
|                                                                                                     | General and administrative                                      |                           |         | 1,303   |         |   |        |       |        |   |        |       |       
|                                                                                                     | Integration                                                     |                           |         | 2,295   |         |   |        |       |        |   |        |       |       
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       
|                                                                                                     |                                                                 | Total                     |         | $       | 6,441   |   |        | $      |       |   |        | $      |       | 
|                                                                                                     |                                                                 |                           |         |         |         |   |        |        |       



43



---



##### 



SAFENET, INC.


AND SUBSIDIARIES





CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)


|                                        |                                                                                                                        |                         |       |       |      |   |        |       |  |   |        |       |  
|--------------------------------------- | ---------------------------------------------------------------------------------------------------------------------- | ----------------------- | ----- | ----- | ---- | - | ------ | ----- |  | - | ------ | ----- | -
|                                        |                                                                                                                        | Year Ended December 31, |      
|                                        |                                                                                                                        |                         |      
|                                        |                                                                                                                        | 2004                    |       |       | 2003 |   |        | 2002  | 
|                                        |                                                                                                                        |                         |       |       |      |   |        |       | 
|                                        |                                                                                                                        | (In thousands)          |      
|Net income (loss)                       |                                                                                                                        | $                       | 2,183 |       |      | $ | (6,088 | )     |  | $ | (4,739 | )    
|                                        |                                                                                                                        |                         |       |       |      |   |        |       | 
|Other comprehensive income (loss):      |                                                                                                                        |                         |       |       |      |   |        |       |  |   |        |      
|                                        | Foreign currency translation adjustment                                                                                |                         |       | 4,196 |      |   |        | 2,535 |  |   |        | 2,904 |  
|                                        | Unrealized loss on available-for-sale securities                                                                       |                         |       | (281  | )    |   |        |      |  |   |        |      |  
|                                        | Reclassification adjustment  realization of foreign
    currency translation adjustment upon disposal of GDS business |                         |       |      |      |   |        |      |  |   |        | 1,526 |  
|                                        | Other                                                                                                                  |                         |       |      |      |   |        |      |  |   |        | (45   | )
|                                        |                                                                                                                        |                         |       |       |      |   |        |       | 
|Total other comprehensive income (loss) |                                                                                                                        |                         | 3,915 |       |      |   | 2,535  |       |  |   | 4,385  |      
|                                        |                                                                                                                        |                         |       |       |      |   |        |       | 
|Comprehensive income (loss)             |                                                                                                                        | $                       | 6,098 |       |      | $ | (3,553 | )     |  | $ | (354   | )    
|                                        |                                                                                                                        |                         |       |       |      |   |        |       | 



44



---



##### 



SAFENET, INC.


AND SUBSIDIARIES





CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY


|                                                                                                                                 |                                      |                |        |        |            |   |     |             |  |       |               |         |  |               |        |         |               |   |        |        |  |   |         |   |  |   |         |         | 
|-------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------ | -------------- | ------ | ------ | ---------- | - | --- | ----------- |  | ----- | ------------- | ------- |  | ------------- | ------ | ------- | ------------- | - | ------ | ------ |  | - | ------- | - |  | - | ------- | ------- | 
|                                                                                                                                 |                                      |                |        |        |            |   |     | Accumulated |  |       |               |         | 
|                                                                                                                                 |                                      | Common Stock   |        |        | Additional |   |     |             |  | Other |               |         |  |               | Total  |        
|                                                                                                                                 |                                      |                |        |        | Paid-In    |   |     | Unearned    |  |       | Comprehensive |         |  | Accumulated   |        |         | Stockholders |  
|                                                                                                                                 |                                      | Shares         |        |        | Amount     |   |     | Capital     |  |       | Compensation  |         |  | Income (Loss) |        |         | Deficit       |   |        | Equity | 
|                                                                                                                                 |                                      |                |        |        |            |   |     |             |  |       |               |         |  |               |        |         |               |   |        |        | 
|                                                                                                                                 |                                      | (In thousands) |       
|Balance at January 1, 2002                                                                                                       |                                      |                | 7,108  |        |            | $ | 71  |             |  | $     | 52,400        |         |  | $             |       |         |               | $ | (1,526 | )      |  | $ | (15,486 | ) |  | $ | 35,459  |        
|Issuance of common stock in connection with:                                                                                     |                                      |                |        |        |            |   |     |             |  |       |               |         |  |               |        |         |               |   |        |        |  |   |         |   |  |   |         |        
|                                                                                                                                 | Securealink acquisition              |                |        | 575    |            |   |     | 6           |  |       |               | 10,630  |  |               |        |        |               |   |        |       |  |   |         |  |  |   | $       | 10,636  | 
|                                                                                                                                 | Employee Stock Purchase Plan         |                |        | 6      |            |   |     |            |  |       |               | 217     |  |               |        |        |               |   |        |       |  |   |         |  |  |   |         | 217     | 
|                                                                                                                                 | Stock option exercises               |                |        | 205    |            |   |     | 2           |  |       |               | 1,968   |  |               |        |        |               |   |        |       |  |   |         |  |  |   |         | 1,970   | 
|Income tax benefit related to stock option exercises                                                                             |                                      |                |       |        |            |   |    |             |  |       | 450           |         |  |               |       |         |               |   |       |        |  |   |        |   |  |   | 450     |        
|Net loss                                                                                                                         |                                      |                |       |        |            |   |    |             |  |       |              |         |  |               |       |         |               |   |       |        |  |   | (4,739  | ) |  |   | (4,739  | )      
|Other comprehensive income                                                                                                       |                                      |                |       |        |            |   |    |             |  |       |              |         |  |               |       |         |               |   | 4,385  |        |  |   |        |   |  |   | 4,385   |        
|                                                                                                                                 |                                      |                |        |        |            |   |     |             |  |       |               |         |  |               |        |         |               |   |        |        | 
|Balance at December 31, 2002                                                                                                     |                                      |                | 7,894  |        |            |   | 79  |             |  |       | 65,665        |         |  |               |       |         |               |   | 2,859  |        |  |   | (20,225 | ) |  |   | 48,378  |        
|Issuance of common stock in connection with:                                                                                     |                                      |                |        |        |            |   |     |             |  |       |               |         |  |               |        |         |               |   |        |        |  |   |         |   |  |   |         |        
|                                                                                                                                 | Secondary offering                   |                |        | 2,698  |            |   |     | 27          |  |       |               | 83,893  |  |               |        |        |               |   |        |       |  |   |         |  |  |   |         | 83,920  | 
|                                                                                                                                 | Cylink Corporation acquisition       |                |        | 1,680  |            |   |     | 17          |  |       |               | 31,067  |  |               |        |        |               |   |        |       |  |   |         |  |  |   |         | 31,084  | 
|                                                                                                                                 | Asset acquisition of Raquia Networks |                |        | 354    |            |   |     | 4           |  |       |               | 6,094   |  |               |        |        |               |   |        |       |  |   |         |  |  |   |         | 6,098   | 
|                                                                                                                                 | Employee Stock Purchase Plan         |                |        | 7      |            |   |     |            |  |       |               | 162     |  |               |        |        |               |   |        |       |  |   |         |  |  |   |         | 162     | 
|                                                                                                                                 | Stock option exercises               |                |        | 653    |            |   |     | 6           |  |       |               | 8,849   |  |               |        |        |               |   |        |       |  |   |         |  |  |   |         | 8,855   | 
|Assumption of stock options in connection with Cylink
    Corporation acquisition                                                |                                      |                |       |        |            |   |    |             |  |       | 1,399         |         |  |               |       |         |               |   |       |        |  |   |        |   |  |   | 1,399   |        
|Assumption of stock warrants in connection with Cylink
    Corporation acquisition                                               |                                      |                |       |        |            |   |    |             |  |       | 292           |         |  |               |       |         |               |   |       |        |  |   |        |   |  |   | 292     |        
|Income tax benefit related to stock option exercises                                                                             |                                      |                |       |        |            |   |    |             |  |       | 2,362         |         |  |               |       |         |               |   |       |        |  |   |        |   |  |   | 2,362   |        
|Net loss                                                                                                                         |                                      |                |       |        |            |   |    |             |  |       |              |         |  |               |       |         |               |   |       |        |  |   | (6,088  | ) |  |   | (6,088  | )      
|Other comprehensive income                                                                                                       |                                      |                |       |        |            |   |    |             |  |       |              |         |  |               |       |         |               |   | 2,535  |        |  |   |        |   |  |   | 2,535   |        
|                                                                                                                                 |                                      |                |        |        |            |   |     |             |  |       |               |         |  |               |        |         |               |   |        |        | 
|Balance at December 31, 2003                                                                                                     |                                      |                | 13,286 |        |            |   | 133 |             |  |       | 199,783       |         |  |               |       |         |               |   | 5,394  |        |  |   | (26,313 | ) |  |   | 178,997 |        
|Costs in connection with registration of common stock related to
    the acquisitions of Raqia Networks and Rainbow Technologies |                                      |                |       |        |            |   |    |             |  |       | (1,034        | )       |  |               |       |         |               |   |       |        |  |   |        |   |  |   | (1,034  | )      
|Issuance of common stock in connection with:                                                                                     |                                      |                |        |        |            |   |     |             |  |       |               |         |  |               |        |         |               |   |        |        |  |   |         |   |  |   |         |        
|                                                                                                                                 | Rainbow Technologies acquisition     |                |        | 10,306 |            |   |     | 103         |  |       |               | 375,025 |  |               |        |        |               |   |        |       |  |   |         |  |  |   |         | 375,128 | 
|                                                                                                                                 | Employee Stock Purchase Plan         |                |        | 23     |            |   |     |            |  |       |               | 553     |  |               |        |        |               |   |        |       |  |   |         |  |  |   |         | 553     | 
|                                                                                                                                 | Stock option exercises               |                |        | 766    |            |   |     | 8           |  |       |               | 11,558  |  |               |        |        |               |   |        |       |  |   |         |  |  |   |         | 11,566  | 
|                                                                                                                                 | Stock warrant exercises              |                |        | 20     |            |   |     |            |  |       |               |        |  |               |        |        |               |   |        |       |  |   |         |  |  |   |         |        | 
|Assumption of stock options in connection with:                                                                                  |                                      |                |        |        |            |   |     |             |  |       |               |         |  |               |        |         |               |   |        |        |  |   |         |   |  |   |         |        
|                                                                                                                                 | Rainbow Technologies acquisition     |                |        |       |            |   |     |            |  |       |               | 44,600  |  |               |        | (13,160 | )             |   |        |       |  |   |         |  |  |   |         | 31,440  | 
|                                                                                                                                 | Datakey acquisition                  |                |        |       |            |   |     |            |  |       |               | 449     |  |               |        |        |               |   |        |       |  |   |         |  |  |   |         | 449     | 
|Income tax benefit related to stock option exercises                                                                             |                                      |                |       |        |            |   |    |             |  |       | 2,948         |         |  |               |       |         |               |   |       |        |  |   |        |   |  |   | 2,948   |        
|Amortization of unearned compensation                                                                                            |                                      |                |       |        |            |   |    |             |  |       |              |         |  |               | 6,441  |         |               |   |       |        |  |   |        |   |  |   | 6,441   |        
|Net income                                                                                                                       |                                      |                |       |        |            |   |    |             |  |       |              |         |  |               |       |         |               |   |       |        |  |   | 2,183   |   |  |   | 2,183   |        
|Other comprehensive income                                                                                                       |                                      |                |       |        |            |   |    |             |  |       |              |         |  |               |       |         |               |   | 3,915  |        |  |   |        |   |  |   | 3,915   |        
|                                                                                                                                 |                                      |                |        |        |            |   |     |             |  |       |               |         |  |               |        |         |               |   |        |        | 
|Balance at December 31, 2004                                                                                                     |                                      |                | 24,401 |        |            | $ | 244 |             |  | $     | 633,882       |         |  | $             | (6,719 | )       |               | $ | 9,309  |        |  | $ | (24,130 | ) |  | $ | 612,586 |        
|                                                                                                                                 |                                      |                |        |        |            |   |     |             |  |       |               |         |  |               |        |         |               |   |        |        | 



45



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##### 



SAFENET, INC


AND SUBSIDIARIES





CONSOLIDATED STATEMENTS OF CASH FLOWS


|                                                     |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |        |        |         |         |       |      |         |  
|---------------------------------------------------- | ------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------- | ----------------------------------------- | --------------------------------------------------- | ------ | ------- | ------ | -------- | ------ | ------ | ------- | ------- | ----- | ---- | ------- | -
|                                                     |                                                                                                         | Year Ended December 31,                                         |                                          
|                                                     |                                                                                                         |                                                                 |                                          
|                                                     |                                                                                                         | 2004                                                            |                                           |                                                     | 2003   |         |        | 2002     |       
|                                                     |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |       
|                                                     |                                                                                                         | (In thousands)                                                  |                                          
|Cash flows from operating activities:                |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |        |        |         |        
|                                                     | Net income (loss)                                                                                       |                                                                 | $                                         | 2,183                                               |        |         | $      | (6,088   | )      |        | $       | (4,739  | )    
|                                                     | Adjustments to reconcile net income (loss) to net cash provided
    by 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         |                                           |                                                     | 2,893  |         |        |          | 1,318  |        |         |         | 975   |     
|                                                     |                                                                                                         | Amortization of computer software development costs             |                                           |                                                     | 921    |         |        |          | 183    |        |         |         | 574   |     
|                                                     |                                                                                                         | Amortization of other intangible assets                         |                                           |                                                     | 19,780 |         |        |          | 7,362  |        |         |         | 1,488 |     
|                                                     |                                                                                                         | Amortization of unearned compensation                           |                                           |                                                     | 6,441  |         |        |          |       |        |         |         |      |     
|                                                     |                                                                                                         | Income tax benefit related to stock option exercises            |                                           |                                                     | 2,948  |         |        |          | 2,362  |        |         |         | 450   |     
|                                                     |                                                                                                         | Restucturing charges                                            |                                           |                                                     | 1,300  |         |        |          |       |        |         |         |      |     
|                                                     |                                                                                                         | Other non-cash charges                                          |                                           |                                                     |       |         |        |          |       |        |         |         | 501   |     
|                                                     |                                                                                                         | Deferred income taxes                                           |                                           |                                                     | (4,168 | )       |        |          | (2,445 | )      |         |         |      |     
|                                                     |                                                                                                         | Amortization of unfavorable lease liability                     |                                           |                                                     | (1,311 | )       |        |          | (632   | )      |         |         |      |     
|                                                     |                                                                                                         | Changes in operating assets and liabilities:                    |                                           |                                                     |        |         |        |          |        |        |         |         |       |     
|                                                     |                                                                                                         |                                                                 | Accounts receivable, net                  |                                                     |        | (21,994 | )      |          |        | (1,772 | )       |         |       | (551 | )      
|                                                     |                                                                                                         |                                                                 | Inventories, net                          |                                                     |        | (4,021  | )      |          |        | (230   | )       |         |       | 270  |        
|                                                     |                                                                                                         |                                                                 | Prepaid expenses and other current assets |                                                     |        | (76     | )      |          |        | 259    |         |         |       | 383  |        
|                                                     |                                                                                                         |                                                                 | Accounts payable                          |                                                     |        | (2,221  | )      |          |        | 1,890  |         |         |       | (257 | )      
|                                                     |                                                                                                         |                                                                 | Accrued salaries and commissions          |                                                     |        | 3,061   |        |          |        | (3,979 | )       |         |       | 977  |        
|                                                     |                                                                                                         |                                                                 | Accrued income taxes                      |                                                     |        | 2,453   |        |          |        | 2,294  |         |         |       |     |        
|                                                     |                                                                                                         |                                                                 | Other accrued expenses                    |                                                     |        | (5,263  | )      |          |        | (3,521 | )       |         |       | 329  |        
|                                                     |                                                                                                         |                                                                 | Advanced payments and deferred revenue    |                                                     |        | 2,335   |        |          |        | 489    |         |         |       | (529 | )      
|                                                     |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |       
|                                                     |                                                                                                         |                                                                 |                                           | Net cash provided by operating activities           |        |         | 5,261  |          |        |        | 7,171   |         |       |      | 5,933   |  
|                                                     |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |       
|Cash flows from investing activities:                |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |        |        |         |        
|                                                     | Maturities of held to maturity securities                                                               |                                                                 |                                           |                                                    |        |         |        | 28,763   |        |        |         | 25,378  |      
|                                                     | Sales of available for sale securities                                                                  |                                                                 |                                           | 89,857                                              |        |         |        | 52,927   |        |        |         |        |      
|                                                     | Purchases of available for sale securities                                                              |                                                                 |                                           | (88,865                                             | )      |         |        | (145,207 | )      |        |         | (38,277 | )    
|                                                     | Purchases of equipment and leasehold improvements                                                       |                                                                 |                                           | (6,795                                              | )      |         |        | (2,628   | )      |        |         | (507    | )    
|                                                     | Expenditures for computer software development                                                          |                                                                 |                                           | (1,285                                              | )      |         |        | (1,686   | )      |        |         | (326    | )    
|                                                     | Cash paid for Securealink, net of cash acquired                                                         |                                                                 |                                           |                                                    |        |         |        |         |        |        |         | (3,769  | )    
|                                                     | Cash paid for SSH, including restricted cash                                                            |                                                                 |                                           | (197                                                | )      |         |        | (13,796  | )      |        |         |        |      
|                                                     | Cash received upon acquisition of Cylink, net of cash paid                                              |                                                                 |                                           | (277                                                | )      |         |        | 703      |        |        |         |        |      
|                                                     | Cash paid for Raqia, net of cash acquired                                                               |                                                                 |                                           |                                                    |        |         |        | (1,390   | )      |        |         |        |      
|                                                     | Cash received upon acquisition of Rainbow, net of cash paid                                             |                                                                 |                                           | 55,158                                              |        |         |        |         |        |        |         |        |      
|                                                     | Cash paid for Datakey, net of cash acquired                                                             |                                                                 |                                           | (10,993                                             | )      |         |        |         |        |        |         |        |      
|                                                     | Deferred acquisition costs                                                                              |                                                                 |                                           |                                                    |        |         |        |         |        |        |         | (625    | )    
|                                                     | Other assets                                                                                            |                                                                 |                                           | (1,404                                              | )      |         |        | (46      | )      |        |         | (565    | )    
|                                                     |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |       
|                                                     |                                                                                                         |                                                                 |                                           | Net cash provided by (used in) investing activities |        |         | 35,199 |          |        |        | (82,360 | )       |       |      | (18,691 | )
|                                                     |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |       
|Cash flows from financing activities:                |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |        |        |         |        
|                                                     | Proceeds from stock options exercised and issuance of stock
    under Employee Stock Purchase Plan, net |                                                                 |                                           | 12,119                                              |        |         |        | 9,017    |        |        |         | 2,187   |      
|                                                     | Proceeds from secondary stock offering, net                                                             |                                                                 |                                           |                                                    |        |         |        | 83,920   |        |        |         |        |      
|                                                     | Registration costs for issuances of common stock in connection
    with acquisitions                    |                                                                 |                                           | (1,034                                              | )      |         |        |         |        |        |         |        |      
|                                                     | Repayment of Securealink line of credit                                                                 |                                                                 |                                           |                                                    |        |         |        |         |        |        |         | (1,484  | )    
|                                                     |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |       
|                                                     |                                                                                                         |                                                                 |                                           | Net cash provided by financing activities           |        |         | 11,085 |          |        |        | 92,937  |         |       |      | 703     |  
|                                                     |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |       
|Effect of exchange rate changes on cash              |                                                                                                         |                                                                 | 1,555                                     |                                                     |        |         | 504    |          |        |        | 460     |        
|                                                     |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |       
|Net increase (decrease) in cash and cash equivalents |                                                                                                         |                                                                 | 53,100                                    |                                                     |        |         | 18,252 |          |        |        | (11,595 | )      
|Cash and cash equivalents at beginning of year       |                                                                                                         |                                                                 | 21,651                                    |                                                     |        |         | 3,399  |          |        |        | 14,994  |        
|                                                     |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |       
|Cash and cash equivalents at end of year             |                                                                                                         | $                                                               | 74,751                                    |                                                     |        | $       | 21,651 |          |        | $      | 3,399   |        
|                                                     |                                                                                                         |                                                                 |                                           |                                                     |        |         |        |          |       



46



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##### 






SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


December 31, 2004


(Amounts in Thousands)


(1) BUSINESS




















|    |                                           
|--- | ------------------------------------------
|(2) | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



| |                            
| | ---------------------------
| | Principles of Consolidation





| |                 
| | ----------------
| | Use of Estimates





| |                 
| | ----------------
| | Cash Equivalents



47



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##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)






| |                
| | ---------------
| | Restricted Cash





| |                       
| | ----------------------
| | Short-Term Investments









| |                                                            
| | -----------------------------------------------------------
| | Accounts Receivable and Allowance for Doubtful
    Accounts





| |            
| | -----------
| | Inventories





| |                       
| | ----------------------
| | Property and Equipment



48



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##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




| |                                    
| | -----------------------------------
| | Computer Software Development Costs







| |                                     
| | ------------------------------------
| | Goodwill and Other Intangible Assets

Goodwill and Other Intangible Assets,








| |                                                                            
| | ---------------------------------------------------------------------------
| | Impairment of Long-Lived Assets and Long-Lived Assets to
    Be Disposed Of



49



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##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)






| |                   
| | ------------------
| | Product Warranties





|                                |                               |   |       |       |  
|------------------------------- | ----------------------------- | - | ----- | ----- | -
|Balance as of December 31, 2003 |                               | $ | 259   |      
|                                | Balance acquired from Rainbow |   |       | 3,423 |  
|                                | Cash payments made            |   |       | (521  | )
|                                | Provisions                    |   |       | 31    |  
|                                |                               |   |      
|Balance as of December 31, 2004 |                               | $ | 3,192 |      
|                                |                               |   |      



| |                              
| | -----------------------------
| | Unfavorable Lease Liabilities





| |                    
| | -------------------
| | Revenue Recognition





| |                      
| | ---------------------
| | License and Royalties



50



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


Modification
of SOP 97-2, Software Revenue Recognition, With Respect to
Certain Transactions.






| |         
| | --------
| | Products







| |                               
| | ------------------------------
| | Maintenance and Other Services

Software Revenue
Recognition,




51



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##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)






| |                    
| | -------------------
| | Advertising Expense





| |                            
| | ---------------------------
| | Shipping and Handling Costs





| |                             
| | ----------------------------
| | Foreign Currency Translation

Foreign Currency Translation. Accounting for Income
Taxes  Special Areas,




| |             
| | ------------
| | Income Taxes





| |                                  
| | ---------------------------------
| | Employee Stock-Based Compensation

Accounting for Stock Issued to Employees,


52



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##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


Accounting for
Stock-Based Compensation,


|                                                                                                                                      |  |                         |        |   |      |   |         |      |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------ | - | ---- | - | ------- | ---- |  | - | ------ | -
|                                                                                                                                      |  | Year Ended December 31, |       
|                                                                                                                                      |  |                         |       
|                                                                                                                                      |  | 2004                    |        |   | 2003 |   |         | 2002 | 
|                                                                                                                                      |  |                         |        |   |      |   |         |      | 
|Net income (loss), as reported                                                                                                        |  | $                       | 2,183  |   |      | $ | (6,088  | )    |  | $ | (4,739 | )
|Deduct: Total stock-based employee compensation expense
    determined under fair value based method for all awards, net of
    taxes |  |                         | (8,033 | ) |      |   | (4,178  | )    |  |   | (3,762 | )
|                                                                                                                                      |  |                         |        |   |      |   |         |      | 
|Pro forma net loss                                                                                                                    |  | $                       | (5,850 | ) |      | $ | (10,266 | )    |  | $ | (8,501 | )
|                                                                                                                                      |  |                         |        |   |      |   |         |      | 
|Income (loss) per share:                                                                                                              |  |                         |        |   |      |   |         |      |  |   |        |  
|Basic  as reported                                                                                                                   |  | $                       | 0.10   |   |      | $ | (0.54   | )    |  | $ | (0.61  | )
|                                                                                                                                      |  |                         |        |   |      |   |         |      | 
|Basic  pro forma                                                                                                                     |  | $                       | (0.27  | ) |      | $ | (0.90   | )    |  | $ | (1.10  | )
|                                                                                                                                      |  |                         |        |   |      |   |         |      | 
|Diluted  as reported                                                                                                                 |  | $                       | 0.10   |   |      | $ | (0.54   | )    |  | $ | (0.61  | )
|                                                                                                                                      |  |                         |        |   |      |   |         |      | 
|Diluted  pro forma                                                                                                                   |  | $                       | (0.27  | ) |      | $ | (0.90   | )    |  | $ | (1.10  | )
|                                                                                                                                      |  |                         |        |   |      |   |         |      | 



|                                               |  |      |           |   |      |  |           |      |  |  |           |  
|---------------------------------------------- |  | ---- | --------- | - | ---- |  | --------- | ---- |  |  | --------- | -
|                                               |  | 2004 |           |   | 2003 |  |           | 2002 | 
|                                               |  |      |           |   |      |  |           |      | 
|Risk-free interest rate                        |  |      | 3.86      | % |      |  | 3.11      | %    |  |  | 3.88      | %
|Dividend yield                                 |  |      | 0         | % |      |  | 0         | %    |  |  | 0         | %
|Option life                                    |  |      | 3-5 years |   |      |  | 3-5 years |      |  |  | 3-5 years |  
|Stock price volatility                         |  |      | 91        | % |      |  | 106       | %    |  |  | 119       | %
|Weighted average fair value of granted options |  |      | $14.77    |   |      |  | $16.74    |      |  |  | $8.85     |  





| |                            
| | ---------------------------
| | Comprehensive Income (Loss)





| |                  
| | -----------------
| | Reclassifications



53



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##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




| |                                 
| | --------------------------------
| | Recent Accounting Pronouncements

Share-Based Payment Accounting for Stock-Based
Compensation Accounting for Stock Issued to Employees Statement of Cash
Flows






|    |                        
|--- | -----------------------
|(3) | DISCONTINUED OPERATIONS



Accounting for the Impairment or Disposal of Long-Lived
Assets.


54



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##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|                     |  |   |        |  
|-------------------- |  | - | ------ | -
|Revenues             |  | $ | 198    |  
|Loss from operations |  |   | (448   | )
|Loss on disposal     |  |   | (3,506 | )
|                     |  |   |       
|Net loss             |  | $ | (3,954 | )
|                     |  |   |       



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





|    |             
|--- | ------------
|(4) | ACQUISITIONS



| |                   
| | ------------------
| | Cylink Corporation





55



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|                                                                                      |                           |   |        |        | 
|------------------------------------------------------------------------------------- | ------------------------- | - | ------ | ------ | 
|Cash and cash equivalents                                                             |                           | $ | 2,922  |       
|Accounts receivable                                                                   |                           |   | 4,928  |       
|Inventories                                                                           |                           |   | 1,376  |       
|Insurance proceeds receivable                                                         |                           |   | 6,407  |       
|Other current assets                                                                  |                           |   | 545    |       
|Property and equipment                                                                |                           |   | 786    |       
|Goodwill                                                                              |                           |   | 24,880 |       
|Acquired in-process research and development                                          |                           |   | 3,351  |       
|Intangible assets subject to amortization (2.7 year
    weighted average useful life) |                           |   | 17,529 |       
|Other assets                                                                          |                           |   | 554    |       
|                                                                                      |                           |   |       
|                                                                                      | Total assets acquired     |   |        | 63,278 | 
|                                                                                      |                           |   |       
|Accounts payable                                                                      |                           |   | 1,073  |       
|Accrued salaries and commissions                                                      |                           |   | 2,526  |       
|Accrued legal settlement                                                              |                           |   | 6,200  |       
|Other accrued expenses                                                                |                           |   | 4,671  |       
|Advance payments and deferred revenue                                                 |                           |   | 2,266  |       
|Deferred income taxes (including current portion of $2,579)                           |                           |   | 6,661  |       
|Unfavorable lease liability                                                           |                           |   | 4,887  |       
|                                                                                      |                           |   |       
|                                                                                      | Total liabilities assumed |   |        | 28,284 | 
|                                                                                      |                           |   |       
|                                                                                      | Net assets acquired       |   | $      | 34,994 | 
|                                                                                      |                           |   |       

Applicability
of FASB Statement No. 2 to Business Combinations Accounted
for by the Purchase Method.




56



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)








|                                             |                                           |                       |         |       |      |   |         |       |  
|-------------------------------------------- | ----------------------------------------- | --------------------- | ------- | ----- | ---- | - | ------- | ----- | -
|                                             |                                           | 2003                  |         |       | 2002 |  
|                                             |                                           |                       |         |       |      |  
|                                             |                                           | (In thousands, except |        
|                                             |                                           | per share data)       |        
|Revenues                                     |                                           | $                     | 68,398  |       |      | $ | 59,759  |      
|Loss from continuing operations              |                                           | $                     | (10,675 | )     |      | $ | (26,193 | )    
|Net loss                                     |                                           | $                     | (10,675 | )     |      | $ | (30,147 | )    
|                                            
|(Loss) per common share  basic and diluted: |                                           |                       |         |       |      |   |         |      
|                                             | Loss from continuing operations           |                       | $       | (0.92 | )    |   | $       | (2.79 | )
|                                             | (Loss) from discontinued operations (GDS) |                       |         |      |      |   |         | (0.42 | )
|                                             |                                           |                       |         |       |      |  
|                                             | Net loss                                  |                       | $       | (0.92 | )    |   | $       | (3.21 | )
|                                             |                                           |                       |         |       |      |  





| |                     
| | --------------------
| | Raqia Networks, Inc.





|                                                    |                     |   |       |       | 
|--------------------------------------------------- | ------------------- | - | ----- | ----- | 
|Working capital (deficit)                           |                     | $ | (285  | )    
|Property and equipment                              |                     |   | 776   |      
|Acquired in-process research and development assets |                     |   | 6,330 |      
|Acquired patents                                    |                     |   | 1,167 |      
|                                                    |                     |   |      
|                                                    | Net assets acquired |   | $     | 7,988 | 
|                                                    |                     |   |      



57



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)










| |                                  
| | ---------------------------------
| | SSH Communications Security Corp.





|                                                                                    |                           |   |       |        | 
|----------------------------------------------------------------------------------- | ------------------------- | - | ----- | ------ | 
|Accounts receivable                                                                 |                           | $ | 888   |       
|Property and equipment                                                              |                           |   | 55    |       
|Goodwill                                                                            |                           |   | 3,557 |       
|Intangible assets subject to amortization (4 year weighted
    average useful life) |                           |   | 8,370 |       
|Intangible assets not subject to amortization                                       |                           |   | 2,700 |       
|Other assets                                                                        |                           |   | 8     |       
|                                                                                    |                           |   |      
|                                                                                    | Total assets acquired     |   |       | 15,578 | 
|                                                                                    |                           |   |      
|Accrued compensation and benefits                                                   |                           |   | 19    |       
|Advance payments and deferred revenue                                               |                           |   | 1,517 |       
|                                                                                    |                           |   |      
|                                                                                    | Total liabilities assumed |   |       | 1,536  | 
|                                                                                    |                           |   |      
|                                                                                    | Net assets acquired       |   | $     | 14,042 | 
|                                                                                    |                           |   |      

58



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)








| |                           
| | --------------------------
| | Rainbow Technologies, Inc.





59



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|                                                                             |                           |   |         |         | 
|---------------------------------------------------------------------------- | ------------------------- | - | ------- | ------- | 
|Cash and cash equivalents                                                    |                           | $ | 60,815  |        
|Short-term investments                                                       |                           |   | 319     |        
|Accounts receivable, net                                                     |                           |   | 16,743  |        
|Unbilled cost and fees                                                       |                           |   | 1,780   |        
|Inventories                                                                  |                           |   | 9,980   |        
|Prepaid expenses                                                             |                           |   | 2,625   |        
|Deferred income taxes                                                        |                           |   | 4,182   |        
|Property and equipment                                                       |                           |   | 9,837   |        
|Goodwill                                                                     |                           |   | 252,402 |        
|Intangible assets subject to amortization (8 year weighted
    average life) |                           |   | 117,277 |        
|Intangible assets not subject to amortization                                |                           |   | 13,520  |        
|Other assets                                                                 |                           |   | 512     |        
|                                                                             |                           |   |        
|                                                                             | Total assets acquired     |   |         | 489,992 | 
|                                                                             |                           |   |        
|Accounts payable                                                             |                           |   | 8,222   |        
|Accrued salaries and commissions                                             |                           |   | 7,833   |        
|Other accrued expenses                                                       |                           |   | 7,939   |        
|Other liabilities                                                            |                           |   | 3,187   |        
|Accrued income taxes                                                         |                           |   | 1,828   |        
|Deferred income taxes                                                        |                           |   | 42,258  |        
|Other current liabilities                                                    |                           |   | 2,641   |        
|Accrued warranty costs                                                       |                           |   | 3,423   |        
|Accrued restructuring costs                                                  |                           |   | 436     |        
|                                                                             |                           |   |        
|                                                                             | Total liabilities assumed |   |         | 77,767  | 
|                                                                             |                           |   |        
|                                                                             | Net assets acquired       |   | $       | 412,225 | 
|                                                                             |                           |   |        





60



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)






| |                    
| | -------------------
| | Datakey Corporation







61



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|                                          |                           |   |       |        | 
|----------------------------------------- | ------------------------- | - | ----- | ------ | 
|Cash and cash equivalents                 |                           | $ | 63    |       
|Accounts receivable, net                  |                           |   | 1,442 |       
|Inventories, net                          |                           |   | 673   |       
|Prepaid expenses and other current assets |                           |   | 526   |       
|Property and equipment                    |                           |   | 66    |       
|Goodwill                                  |                           |   | 7,606 |       
|Intangible assets subject to amortization |                           |   | 4,573 |       
|Other assets                              |                           |   | 6     |       
|                                          |                           |   |      
|                                          | Total assets acquired     |   |       | 14,955 | 
|                                          |                           |   |      
|Accounts payable                          |                           |   | 462   |       
|Accrued salaries and commissions          |                           |   | 457   |       
|Advance payments and deferred revenue     |                           |   | 494   |       
|Other accrued expenses                    |                           |   | 299   |       
|Deferred income taxes                     |                           |   | 1,738 |       
|                                          |                           |   |      
|                                          | Total liabilities assumed |   |       | 3,450  | 
|                                          |                           |   |      
|                                          | Net assets acquired       |   | $     | 11,505 | 
|                                          |                           |   |      







|                                           |                                         |                       |         |       |      |   |         |       |  
|------------------------------------------ | --------------------------------------- | --------------------- | ------- | ----- | ---- | - | ------- | ----- | -
|                                           |                                         | 2004                  |         |       | 2003 |  
|                                           |                                         |                       |         |       |      |  
|                                           |                                         | (In thousands, except |        
|                                           |                                         | per share data)       |        
|Revenues                                   |                                         | $                     | 235,622 |       |      | $ | 214,614 |      
|Loss from continuing operations            |                                         | $                     | (2,077  | )     |      | $ | (20,695 | )    
|Net loss                                   |                                         | $                     | (2,077  | )     |      | $ | (20,956 | )    
|                                          
|Loss per common share  basic and diluted: |                                         |                       |         |       |      |   |         |      
|                                           | Loss from continuing operations         |                       | $       | (0.09 | )    |   | $       | (0.97 | )
|                                           | Loss from discontinued operations (GDS) |                       |         |      |      |   |         | (0.01 | )
|                                           |                                         |                       |         |       |      |  
|                                           | Net loss                                |                       | $       | (0.09 | )    |   | $       | (0.98 | )
|                                           |                                         |                       |         |       |      |  

62



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##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|    |                     
|--- | --------------------
|(5) | RESTRUCTURING CHARGE

Accounting for Costs Associated with Exit or
Disposal Activities,


(6) INVENTORIES




|                                                                                                          |  |      |        |   |      |   |        |  
|--------------------------------------------------------------------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|                                                                                                          |  | 2004 |        |   | 2003 |  
|                                                                                                          |  |      |        |   |      |  
|Raw materials                                                                                             |  | $    | 4,667  |   |      | $ | 2,158  |  
|Finished goods                                                                                            |  |      | 8,462  |   |      |   | 2,240  |  
|Inventoried costs relating to long-term contracts, net of
    amounts attributable to revenues recognized |  |      | 5,765  |   |      |   |       |  
|                                                                                                          |  |      |        |   |      |  
|                                                                                                          |  |      | 18,894 |   |      |   | 4,398  |  
|Reserve for excess and obsolete inventory                                                                 |  |      | (726   | ) |      |   | (1,275 | )
|                                                                                                          |  |      |        |   |      |  
|                                                                                                          |  | $    | 18,168 |   |      | $ | 3,123  |  
|                                                                                                          |  |      |        |   |      |  

(7) PROPERTY AND EQUIPMENT




|                                          |  |      |        |   |      |   |        |  
|----------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|                                          |  | 2004 |        |   | 2003 |  
|                                          |  |      |        |   |      |  
|Furniture and equipment                   |  | $    | 13,251 |   |      | $ | 7,442  |  
|Buildings                                 |  |      | 5,572  |   |      |   |       |  
|Computer software                         |  |      | 3,276  |   |      |   | 2,501  |  
|Leasehold improvements                    |  |      | 2,602  |   |      |   | 741    |  
|                                          |  |      |        |   |      |  
|                                          |  |      | 24,701 |   |      |   | 10,684 |  
|Accumulated depreciation and amortization |  |      | (6,388 | ) |      |   | (6,875 | )
|                                          |  |      |        |   |      |  
|                                          |  | $    | 18,313 |   |      | $ | 3,809  |  
|                                          |  |      |        |   |      |  

63



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##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


(8) GOODWILL




|                                        |                        |          |         |         |            |   |         |        |  |   |         |         | 
|--------------------------------------- | ---------------------- | -------- | ------- | ------- | ---------- | - | ------- | ------ |  | - | ------- | ------- | 
|                                        |                        | Embedded |         |         | Enterprise |   |         |       
|                                        |                        | Security |         |         | Security   |   |         |       
|                                        |                        | Segment  |         |         | Segment    |   |         | Total  | 
|                                        |                        |          |         |         |            |   |         |        | 
|Balance as of January 1, 2003           |                        | $        | 12,826  |         |            | $ |        |        |  | $ | 12,826  |        
|Goodwill recorded during the year:      |                        |          |         |         |            |   |         |        |  |   |         |        
|                                        | Acquisition of Cylink  |          |         |        |            |   |         | 24,880 |  |   |         | 24,880  | 
|                                        | Acquisition of SSH     |          |         | 2,744   |            |   |         |       |  |   |         | 2,744   | 
|Foreign currency translation adjustment |                        |          | 2,535   |         |            |   |        |        |  |   | 2,535   |        
|Other                                   |                        |          | (19     | )       |            |   | (559    | )      |  |   | (578    | )      
|                                        |                        |          |         |         |            |   |         |        | 
|Balance as of December 31, 2003         |                        |          | 18,086  |         |            |   | 24,321  |        |  |   | 42,407  |        
|Goodwill recorded during the year:      |                        |          |         |         |            |   |         |        |  |   |         |        
|                                        | Acquisition of Rainbow |          |         | 158,256 |            |   |         | 94,146 |  |   |         | 252,402 | 
|                                        | Acquisition of Datakey |          |         |        |            |   |         | 7,606  |  |   |         | 7,606   | 
|Purchase price allocation adjustments   |                        |          | 705     |         |            |   | 785     |        |  |   | 1,490   |        
|Foreign currency translation adjustment |                        |          | 1,406   |         |            |   |        |        |  |   | 1,406   |        
|                                        |                        |          |         |         |            |   |         |        | 
|Balance as of December 31, 2004         |                        | $        | 178,453 |         |            | $ | 126,858 |        |  | $ | 305,311 |        
|                                        |                        |          |         |         |            |   |         |        | 

(9) ACQUIRED INTANGIBLE ASSETS




|                                               |                                      |                |  |     |                |   |         |              |     |   |          |         |   |   |         |         | 
|---------------------------------------------- | ------------------------------------ | -------------- |  | --- | -------------- | - | ------- | ------------ | --- | - | -------- | ------- | - | - | ------- | ------- | 
|                                               |                                      | Weighted       |  |     |                |   |         |              | Net |  
|                                               |                                      | Average Useful |  |     | Gross Carrying |   |         | Accumulated  |     |   | Carrying |        
|                                               |                                      | Life in Years  |  |     | Amount         |   |         | Amortization |     |   | Amount   |        
|                                               |                                      |                |  |     |                |   |         |              |     |   |          |        
|Intangible assets subject to amortization:     |                                      |                |  |     |                |   |         |              |     |   |          |         |   |   |         |        
|                                               | Customer contracts/ relationships    |                |  | 7.4 |                |   | $       | 29,140       |     |   | $        | (6,891  | ) |   | $       | 22,249  | 
|                                               | Developed technology                 |                |  | 8.3 |                |   |         | 102,520      |     |   |          | (13,432 | ) |   |         | 89,088  | 
|                                               | Patents and related                  |                |  | 7.2 |                |   |         | 15,842       |     |   |          | (4,472  | ) |   |         | 11,370  | 
|                                               | Non-compete agreements               |                |  | 2.0 |                |   |         | 2,066        |     |   |          | (1,980  | ) |   |         | 86      | 
|                                               | Tradenames                           |                |  | 0.5 |                |   |         | 100          |     |   |          | (33     | ) |   |         | 67      | 
|                                               | Purchase orders and contract backlog |                |  | 0.9 |                |   |         | 1,459        |     |   |          | (1,415  | ) |   |         | 44      | 
|                                               |                                      |                |  |     |                |   |         |              |     |   |          |        
|                                               | Total                                |                |  | 7.8 |                |   |         | 151,127      |     |   |          | (28,223 | ) |   |         | 122,904 | 
|                                               |                                      |                |  |     |                |   |         |              |     |   |          |        
|Intangible assets not subject to amortization: |                                      |                |  |     |                |   |         |              |     |   |          |         |   |   |         |        
|                                               | Trademarks                           |                |  | N/A |                |   |         | 13,520       |     |   |          |        |   |   |         | 13,520  | 
|                                               | Domain names                         |                |  | N/A |                |   |         | 2,768        |     |   |          |        |   |   |         | 2,768   | 
|                                               |                                      |                |  |     |                |   |         |              |     |   |          |        
|Total acquired intangible assets               |                                      |                |  |     |                | $ | 167,415 |              |     | $ | (28,223  | )       |   | $ | 139,192 |        
|                                               |                                      |                |  |     |                |   |         |              |     |   |          |        

64



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|                                               |                                      |                |  |     |                |   |        |              |     |   |          |        |   |   |        |        | 
|---------------------------------------------- | ------------------------------------ | -------------- |  | --- | -------------- | - | ------ | ------------ | --- | - | -------- | ------ | - | - | ------ | ------ | 
|                                               |                                      | Weighted       |  |     |                |   |        |              | Net |  
|                                               |                                      | Average Useful |  |     | Gross Carrying |   |        | Accumulated  |     |   | Carrying |       
|                                               |                                      | Life in Years  |  |     | Amount         |   |        | Amortization |     |   | Amount   |       
|                                               |                                      |                |  |     |                |   |        |              |     |   |          |       
|Intangible assets subject to amortization:     |                                      |                |  |     |                |   |        |              |     |   |          |        |   |   |        |       
|                                               | Customer contracts/ relationships    |                |  | 3.4 |                |   | $      | 10,947       |     |   | $        | (2,151 | ) |   | $      | 8,796  | 
|                                               | Developed technology                 |                |  | 3.5 |                |   |        | 9,426        |     |   |          | (2,469 | ) |   |        | 6,957  | 
|                                               | Patents and related                  |                |  | 3.2 |                |   |        | 5,588        |     |   |          | (1,588 | ) |   |        | 4,000  | 
|                                               | Non-compete agreements               |                |  | 2.0 |                |   |        | 2,066        |     |   |          | (947   | ) |   |        | 1,119  | 
|                                               | Purchase orders and contract backlog |                |  | 1.0 |                |   |        | 1,328        |     |   |          | (1,328 | ) |   |        |       | 
|                                               |                                      |                |  |     |                |   |        |              |     |   |          |       
|                                               | Total                                |                |  | 2.9 |                |   |        | 29,355       |     |   |          | (8,483 | ) |   |        | 20,872 | 
|                                               |                                      |                |  |     |                |   |        |              |     |   |          |       
|Intangible assets not subject to amortization: |                                      |                |  |     |                |   |        |              |     |   |          |        |   |   |        |       
|                                               | Domain names                         |                |  | N/A |                |   |        | 2,727        |     |   |          |       |   |   |        | 2,727  | 
|                                               |                                      |                |  |     |                |   |        |              |     |   |          |       
|Total acquired intangible assets               |                                      |                |  |     |                | $ | 32,082 |              |     | $ | (8,483   | )      |   | $ | 23,599 |       
|                                               |                                      |                |  |     |                |   |        |              |     |   |          |       



|                    |  |   |        | 
|------------------- |  | - | ------ | 
|2005                |  | $ | 22,518 | 
|2006                |  |   | 17,637 | 
|2007                |  |   | 16,566 | 
|2008                |  |   | 14,653 | 
|2009                |  |   | 11,165 | 
|2010 and thereafter |  |   | 40,365 | 

65



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


(10) INCOME TAXES




|                            |         |      |        |        |      |   |        |        |   |   |      |      |  
|--------------------------- | ------- | ---- | ------ | ------ | ---- | - | ------ | ------ | - | - | ---- | ---- | -
|                            |         | 2004 |        |        | 2003 |   |        | 2002   |  
|                            |         |      |        |        |      |   |        |        |  
|Current:                    |         |      |        |        |      |   |        |        |   |   |      |     
|                            | Federal |      | $      | 3,140  |      |   | $      | 3,662  |   |   | $    |     |  
|                            | State   |      |        | 476    |      |   |        | 523    |   |   |      | 179  |  
|                            | Foreign |      |        | 2,133  |      |   |        | 161    |   |   |      |     |  
|                            |         |      |        |        |      |   |        |        |  
|Total current               |         |      | 5,749  |        |      |   | 4,346  |        |   |   | 179  |     
|                            |         |      |        |        |      |   |        |        |  
|Deferred (benefit):         |         |      |        |        |      |   |        |        |   |   |      |     
|                            | Federal |      |        | (3,771 | )    |   |        | (2,672 | ) |   |      | 271  |  
|                            | State   |      |        | (648   | )    |   |        |       |   |   |      |     |  
|                            | Foreign |      |        | 251    |      |   |        | (56    | ) |   |      | (540 | )
|                            |         |      |        |        |      |   |        |        |  
|Total deferred              |         |      | (4,168 | )      |      |   | (2,728 | )      |   |   | (269 | )   
|                            |         |      |        |        |      |   |        |        |  
|Total tax expense (benefit) |         | $    | 1,581  |        |      | $ | 1,618  |        |   | $ | (90  | )   
|                            |         |      |        |        |      |   |        |        |  





|                               |                                   |      |         |         |      |   |         |        |  
|------------------------------ | --------------------------------- | ---- | ------- | ------- | ---- | - | ------- | ------ | -
|                               |                                   | 2004 |         |         | 2003 |  
|                               |                                   |      |         |         |      |  
|Deferred tax assets:           |                                   |      |         |         |      |   |         |       
|                               | Inventories                       |      | $       | 3,041   |      |   | $       | 2,111  |  
|                               | Net operating loss carryforwards  |      |         | 49,229  |      |   |         | 26,676 |  
|                               | Tax credits                       |      |         | 12,301  |      |   |         | 7,310  |  
|                               | Property and equipment            |      |         | 405     |      |   |         | 1,765  |  
|                               | Compensation and accrued reserves |      |         | 4,314   |      |   |         | 785    |  
|                               | Other                             |      |         | 2,872   |      |   |         | 923    |  
|                               |                                   |      |         |         |      |  
|Total deferred tax assets      |                                   |      | 72,162  |         |      |   | 39,570  |       
|                               |                                   |      |         |         |      |  
|Deferred tax liabilities:      |                                   |      |         |         |      |   |         |       
|                               | Deferred gain                     |      |         | (1,398  | )    |   |         |       |  
|                               | Intangible assets                 |      |         | (49,524 | )    |   |         | (4,788 | )
|                               |                                   |      |         |         |      |  
|Total deferred tax liabilities |                                   |      | (50,922 | )       |      |   | (4,788  | )     
|                               |                                   |      |         |         |      |  
|Net deferred tax asset         |                                   |      | 21,240  |         |      |   | 34,782  |       
|Less: valuation allowance      |                                   |      | (62,468 | )       |      |   | (39,570 | )     
|                               |                                   |      |         |         |      |  
|Total                          |                                   | $    | (41,228 | )       |      | $ | (4,788  | )     
|                               |                                   |      |         |         |      |  

66



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|                                                                                      |                                                    |      |       |        |      |   |        |       |   |   |        |       | 
|------------------------------------------------------------------------------------- | -------------------------------------------------- | ---- | ----- | ------ | ---- | - | ------ | ----- | - | - | ------ | ----- | 
|                                                                                      |                                                    | 2004 |       |        | 2003 |   |        | 2002  |  
|                                                                                      |                                                    |      |       |        |      |   |        |       |  
|Tax benefit at U.S. statutory rate                                                    |                                                    | $    | 1,280 |        |      | $ | (1,520 | )     |   | $ | (298   | )    
|Effect of permanent differences:                                                      |                                                    |      |       |        |      |   |        |       |   |   |        |      
|                                                                                      | Non-deductible in-process research and development |      |       |       |      |   |        | 3,292 |   |   |        | 1,182 | 
|                                                                                      | Tax effect of international operations             |      |       | (1,165 | )    |   |        | (954  | ) |   |        |      | 
|                                                                                      | Non-deductible acquisition costs                   |      |       | 676    |      |   |        |      |   |   |        |      | 
|                                                                                      | Non-deductible amortization of intangibles         |      |       | 559    |      |   |        |      |   |   |        |      | 
|State income taxes, net of federal benefit                                            |                                                    |      | (244  | )      |      |   | 346    |       |   |   | 179    |      
|Change in valuation allowance, excluding change related to stock
    option exercises |                                                    |      | 22    |        |      |   | 592    |       |   |   | (1,031 | )    
|Other non-deductible items, net                                                       |                                                    |      | 453   |        |      |   | (138   | )     |   |   | (122   | )    
|                                                                                      |                                                    |      |       |        |      |   |        |       |  
|Total                                                                                 |                                                    | $    | 1,581 |        |      | $ | 1,618  |       |   | $ | (90    | )    
|                                                                                      |                                                    |      |       |        |      |   |        |       |  







67



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|     |       
|---- | ------
|(11) | LEASES



|                    |  |   |       | 
|------------------- |  | - | ----- | 
|2005                |  | $ | 8,694 | 
|2006                |  |   | 6,908 | 
|2007                |  |   | 5,596 | 
|2008                |  |   | 5,397 | 
|2009                |  |   | 4,891 | 
|2010 and thereafter |  |   | 8,098 | 





|     |  |   |       | 
|---- |  | - | ----- | 
|2005 |  | $ | 1,698 | 
|2006 |  |   | 845   | 
|2007 |  |   | 845   | 
|2008 |  |   | 482   | 
|2009 |  |   | 321   | 



|     |                
|---- | ---------------
|(12) | RETIREMENT PLAN





|     |                         
|---- | ------------------------
|(13) | STOCK COMPENSATION PLANS



| |                   
| | ------------------
| | Stock Option Plans



68



---



##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)




|                                                          |  |           |       |   |                 |          |                 |          |  |   |       | 
|--------------------------------------------------------- |  | --------- | ----- | - | --------------- | -------- | --------------- | -------- |  | - | ----- | 
|                                                          |  |           |       |   |                 | Weighted |                
|                                                          |  |           |       |   |                 | Average  |                
|                                                          |  | Number    |       |   | Range of        |          |                 | Exercise | 
|                                                          |  | of Shares |       |   | Exercise Prices |          |                 | Price    | 
|                                                          |  |           |       |   |                 |          |                 |          | 
|Outstanding as of January 1, 2002                         |  |           | 1,883 |   |                 | $        | 4.37 to $43.63  |          |  | $ | 14.85 | 
|Granted                                                   |  |           | 404   |   |                 | $        | 11.10 to $16.51 |          |  | $ | 13.09 | 
|Exercised                                                 |  |           | (205  | ) |                 | $        | 5.13 to $24.13  |          |  | $ | 9.50  | 
|Cancelled                                                 |  |           | (158  | ) |                 | $        | 8.53 to $33.63  |          |  | $ | 15.15 | 
|                                                          |  |           |       |   |                 |          |                 |          | 
|Outstanding as of December 31, 2002                       |  |           | 1,924 |   |                 | $        | 4.37 to $43.63  |          |  | $ | 15.08 | 
|Granted                                                   |  |           | 925   |   |                 | $        | 16.47 to $38.07 |          |  | $ | 21.11 | 
|Issued in connection with Cylink acquisition              |  |           | 170   |   |                 | $        | 0.20 to $25.00  |          |  | $ | 12.63 | 
|Exercised                                                 |  |           | (653  | ) |                 | $        | 4.63 to $24.13  |          |  | $ | 13.69 | 
|Cancelled                                                 |  |           | (177  | ) |                 | $        | 0.20 to $33.63  |          |  | $ | 17.78 | 
|                                                          |  |           |       |   |                 |          |                 |          | 
|Outstanding as of December 31, 2003                       |  |           | 2,189 |   |                 | $        | 4.37 to $43.63  |          |  | $ | 17.03 | 
|Granted                                                   |  |           | 946   |   |                 | $        | 21.70 to $24.35 |          |  | $ | 22.19 | 
|Issued in connection with Rainbow and Datakey acquisition |  |           | 1,999 |   |                 | $        | 8.83 to $43.32  |          |  | $ | 20.58 | 
|Exercised                                                 |  |           | (766  | ) |                 | $        | 5.85 to $33.63  |          |  | $ | 14.95 | 
|Forfeitures                                               |  |           | (99   | ) |                 | $        | 5.85 to $45.29  |          |  | $ | 26.71 | 
|Cancelled                                                 |  |           | (68   | ) |                 | $        | 5.85 to $45.29  |          |  | $ | 26.71 | 
|                                                          |  |           |       |   |                 |          |                 |          | 
|Outstanding as of December 31, 2004                       |  |           | 4,201 |   |                 | $        | 4.37 to $45.29  |          |  | $ | 19.88 | 
|                                                          |  |           |       |   |                 |          |                 |          | 
|Exercisable as of December 31, 2004                       |  |           | 2,695 |   |                 | $        | 4.37 to $45.29  |          |  | $ | 19.60 | 
|                                                          |  |           |       |   |                 |          |                 |          | 



|                         |  |           |       |                     |                  |  |                     |          |  |   |           |          |  |          |       |  |  |   |       | 
|------------------------ |  | --------- | ----- | ------------------- | ---------------- |  | ------------------- | -------- |  | - | --------- | -------- |  | -------- | ----- |  |  | - | ----- | 
|                         |  |           |       | Options Outstanding |                  |  | Options Exercisable |         
|                         |  |           |       |                     |                  |  |                     |         
|                         |  |           |       | Weighted            |                  |  | Weighted            |          |  |   |           | Weighted | 
|                         |  |           |       | Average             |                  |  | Average             |          |  |   |           | Average  | 
|                         |  | Number    |       |                     | Remaining        |  |                     | Exercise |  |   | Number    |          |  | Exercise |      
|Range of Exercise Prices |  | of Shares |       |                     | Contractual Life |  |                     | Price    |  |   | of Shares |          |  | Price    |      
|                         |  |           |       |                     |                  |  |                     |          |  |   |           |          |  |          |      
|$4.37 to $11.17          |  |           | 711   |                     |                  |  | 6.71                |          |  | $ | 8.56      |          |  |          | 587   |  |  | $ | 8.52  | 
|$11.25 to $18.25         |  |           | 1,300 |                     |                  |  | 5.89                |          |  | $ | 14.91     |          |  |          | 1,008 |  |  | $ | 14.78 | 
|$18.60 to $26.00         |  |           | 1,595 |                     |                  |  | 8.71                |          |  | $ | 22.48     |          |  |          | 618   |  |  | $ | 23.23 | 
|$27.13 to $35.40         |  |           | 262   |                     |                  |  | 7.78                |          |  | $ | 30.46     |          |  |          | 154   |  |  | $ | 30.00 | 
|$35.43 to $45.29         |  |           | 333   |                     |                  |  | 6.13                |          |  | $ | 42.46     |          |  |          | 328   |  |  | $ | 42.56 | 
|                         |  |           |       |                     |                  |  |                     |          |  |   |           |          |  |          |      
|                         |  |           | 4,201 |                     |                  |  |                     |          |  |   |           |          |  |          | 2,695 |  |  |   |       | 
|                         |  |           |       |                     |                  |  |                     |          |  |   |           |          |  |          |      





| |                             
| | ----------------------------
| | Employee Stock Purchase Plan



69



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##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)






|     |                                                
|---- | -----------------------------------------------
|(14) | SEGMENTS OF THE COMPANY AND RELATED INFORMATION





|                                                                                             |                     |      |         |         |      |   |        |        |   |   |        |        |  
|-------------------------------------------------------------------------------------------- | ------------------- | ---- | ------- | ------- | ---- | - | ------ | ------ | - | - | ------ | ------ | -
|                                                                                             |                     | 2004 |         |         | 2003 |   |        | 2002   |  
|                                                                                             |                     |      |         |         |      |   |        |        |  
|Revenue from external customers:                                                             |                     |      |         |         |      |   |        |        |   |   |        |       
|                                                                                             | Embedded security   |      | $       | 56,009  |      |   | $      | 19,269 |   |   | $      | 18,292 |  
|                                                                                             | Enterprise security |      |         | 145,591 |      |   |        | 46,925 |   |   |        | 13,943 |  
|                                                                                             |                     |      |         |         |      |   |        |        |  
|Consolidated revenues                                                                        |                     | $    | 201,600 |         |      | $ | 66,194 |        |   | $ | 32,235 |       
|                                                                                             |                     |      |         |         |      |   |        |        |  
|Significant non-cash items other than depreciation and
    amortization expense:             |                     |      |         |         |      |   |        |        |   |   |        |       
|                                                                                             | Embedded security   |      | $       | 5,119   |      |   | $      | 6,330  |   |   | $      | 3,375  |  
|                                                                                             | Enterprise security |      |         | 2,622   |      |   |        | 3,351  |   |   |        |       |  
|                                                                                             |                     |      |         |         |      |   |        |        |  
|Consolidated significant non-cash items other than depreciation
    and amortization expense |                     | $    | 7,741   |         |      | $ | 9,681  |        |   | $ | 3,375  |       
|                                                                                             |                     |      |         |         |      |   |        |        |  
|Operating income (loss):                                                                     |                     |      |         |         |      |   |        |        |   |   |        |       
|                                                                                             | Embedded security   |      | $       | (12,326 | )    |   | $      | (6,711 | ) |   | $      | (4,227 | )
|                                                                                             | Enterprise security |      |         | 13,403  |      |   |        | 1,434  |   |   |        | 2,683  |  
|                                                                                             |                     |      |         |         |      |   |        |        |  
|Consolidated operating income (loss)                                                         |                     | $    | 1,077   |         |      | $ | (5,277 | )      |   | $ | (1,544 | )     
|                                                                                             |                     |      |         |         |      |   |        |        |  
|Depreciation and amortization:                                                               |                     |      |         |         |      |   |        |        |   |   |        |       
|                                                                                             | Embedded security   |      | $       | 12,122  |      |   | $      | 1,382  |   |   | $      | 2,180  |  
|                                                                                             | Enterprise security |      |         | 11,472  |      |   |        | 7,481  |   |   |        | 857    |  
|                                                                                             |                     |      |         |         |      |   |        |        |  
|Consolidated depreciation and amortization                                                   |                     | $    | 23,594  |         |      | $ | 8,863  |        |   | $ | 3,037  |       
|                                                                                             |                     |      |         |         |      |   |        |        |  

70



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##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)


|                                                                              |                     |      |       |        |      |   |        |        |   |   |      |        |  
|----------------------------------------------------------------------------- | ------------------- | ---- | ----- | ------ | ---- | - | ------ | ------ | - | - | ---- | ------ | -
|                                                                              |                     | 2004 |       |        | 2003 |   |        | 2002   |  
|                                                                              |                     |      |       |        |      |   |        |        |  
|Income (loss) income from continuing operations before income
    taxes:      |                     |      |       |        |      |   |        |        |   |   |      |       
|                                                                              | Embedded security   |      | $     | (7,084 | )    |   | $      | (6,632 | ) |   | $    | (3,794 | )
|                                                                              | Enterprise security |      |       | 10,848 |      |   |        | 2,162  |   |   |      | 2,919  |  
|                                                                              |                     |      |       |        |      |   |        |        |  
|Consolidated income (loss) from continuing operations before
    income taxes |                     | $    | 3,764 |        |      | $ | (4,470 | )      |   | $ | (875 | )     
|                                                                              |                     |      |       |        |      |   |        |        |  





|                       |                     |      |         |         |      |   |        |        |  |   |        |        | 
|---------------------- | ------------------- | ---- | ------- | ------- | ---- | - | ------ | ------ |  | - | ------ | ------ | 
|                       |                     | 2004 |         |         | 2003 |   |        | 2002   | 
|                       |                     |      |         |         |      |   |        |        | 
|Geographic Information |                     |      |         |         |      |   |        |        |  |   |        |       
|Revenues:              |                     |      |         |         |      |   |        |        |  |   |        |       
|                       | United States       |      | $       | 155,892 |      |   | $      | 58,321 |  |   | $      | 28,945 | 
|                       | All other countries |      |         | 45,708  |      |   |        | 7,873  |  |   |        | 3,290  | 
|                       |                     |      |         |         |      |   |        |        | 
|Total                  |                     | $    | 201,600 |         |      | $ | 66,194 |        |  | $ | 32,235 |       
|                       |                     |      |         |         |      |   |        |        | 
|Long-lived assets:     |                     |      |         |         |      |   |        |        |  |   |        |       
|                       | United States       |      | $       | 11,975  |      |   | $      | 5,478  |  |   | $      | 1,140  | 
|                       | France              |      |         | 4,922   |      |   |        |       |  |   |        |       | 
|                       | All other countries |      |         | 3,765   |      |   |        | 313    |  |   |        | 585    | 
|                       |                     |      |         |         |      |   |        |        | 
|Total                  |                     | $    | 20,662  |         |      | $ | 5,791  |        |  | $ | 1,725  |       
|                       |                     |      |         |         |      |   |        |        | 



(15) SIGNIFICANT CUSTOMERS AND CONCENTRATIONS






71



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##### 



SAFENET, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)






(16) INCOME (LOSS) PER SHARE




|                                                                           |  |      |        |  |      |   |        |      |  |   |       |  
|-------------------------------------------------------------------------- |  | ---- | ------ |  | ---- | - | ------ | ---- |  | - | ----- | -
|                                                                           |  | 2004 |        |  | 2003 |   |        | 2002 | 
|                                                                           |  |      |        |  |      |   |        |      | 
|Numerator  basic and diluted Income (loss) from
    continuing operations |  | $    | 2,183  |  |      | $ | (6,088 | )    |  | $ | (785  | )
|                                                                           |  |      |        |  |      |   |        |      | 
|Denominator:                                                               |  |      |        |  |      |   |        |      |  |   |       |  
|Weighted average number of shares outstanding  basic                      |  |      | 21,816 |  |      |   | 11,350 |      |  |   | 7,730 |  
|                                                                           |  |      |        |  |      |   |        |      | 
|Effect of dilutive stock options                                           |  |      | 821    |  |      |   |       |      |  |   |      |  
|                                                                           |  |      |        |  |      |   |        |      | 
|Weighted average number of shares outstanding  diluted                    |  |      | 22,637 |  |      |   | 11,350 |      |  |   | 7,730 |  
|                                                                           |  |      |        |  |      |   |        |      | 
|Basic income (loss) from continuing operations per share                   |  | $    | 0.10   |  |      | $ | (0.54  | )    |  | $ | (0.10 | )
|                                                                           |  |      |        |  |      |   |        |      | 
|Diluted income (loss) from continuing operations per share                 |  | $    | 0.10   |  |      | $ | (0.54  | )    |  | $ | (0.10 | )
|                                                                           |  |      |        |  |      |   |        |      | 



72



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##### 



SCHEDULE II  VALUATION AND QUALIFYING
ACCOUNTS


Years Ended December 31, 2004, 2003 and 2002


|                                                     |      |                        |   |        |            |  |   |           |   |  |            |        |  |          |         |        |         |  |   |      |   |  |   |        | 
|---------------------------------------------------- | ---- | ---------------------- | - | ------ | ---------- |  | - | --------- | - |  | ---------- | ------ |  | -------- | ------- | ------ | ------- |  | - | ---- | - |  | - | ------ | 
|                                                     |      | Balance at             |   |        | Charged to |  |   | Other     |   |  |            |        |  |          | Balance |       
|                                                     |      | Beginning              |   |        | Costs and  |  |   | Additions |   |  | Deductions |        |  |          |         | at End |        
|                                                     |      | of Year                |   |        | Expenses   |  |   | (a)       |   |  | (b)        |        |  | Recovery |         |        | of Year | 
|                                                     |      |                        |   |        |            |  |   |           |   |  |            |        |  |          |         |        |         | 
|                                                     |      | (Amounts in thousands) |  
|Allowance for
    doubtful accounts:                 |      |                        |   |        |            |  |   |           |   |  |            |        |  |          |         |        |         |  |   |      |   |  |   |       
|                                                     | 2004 |                        | $ | 940    |            |  | $ | 857       |   |  | $          | 715    |  |          | $       | (248   | )       |  | $ |     |   |  | $ | 2,264  | 
|                                                     | 2003 |                        |   | 224    |            |  |   | 24        |   |  |            | 775    |  |          |         | (83    | )       |  |   |     |   |  |   | 940    | 
|                                                     | 2002 |                        |   | 150    |            |  |   | 74        |   |  |            |       |  |          |         |       |         |  |   |     |   |  |   | 224    | 
|Reserve for obsolete inventory:                      |      |                        |   |        |            |  |   |           |   |  |            |        |  |          |         |        |         |  |   |      |   |  |   |       
|                                                     | 2004 |                        |   | 1,275  |            |  |   |          |   |  |            |       |  |          |         | (242   | )       |  |   | (307 | ) |  |   | 726    | 
|                                                     | 2003 |                        |   | 958    |            |  |   | 418       |   |  |            |       |  |          |         | (101   | )       |  |   |     |   |  |   | 1,275  | 
|                                                     | 2002 |                        |   | 482    |            |  |   | 476       |   |  |            |       |  |          |         |       |         |  |   |     |   |  |   | 958    | 
|Warranty reserve:                                    |      |                        |   |        |            |  |   |           |   |  |            |        |  |          |         |        |         |  |   |      |   |  |   |       
|                                                     | 2004 |                        |   | 259    |            |  |   | 494       |   |  |            | 3,423  |  |          |         | (463   | )       |  |   | (521 | ) |  |   | 3,192  | 
|                                                     | 2003 |                        |   | 50     |            |  |   |          |   |  |            | 209    |  |          |         |       |         |  |   |     |   |  |   | 259    | 
|                                                     | 2002 |                        |   | 50     |            |  |   |          |   |  |            |       |  |          |         |       |         |  |   |     |   |  |   | 50     | 
|Valuation allowance
    for deferred tax
    assets: |      |                        |   |        |            |  |   |           |   |  |            |        |  |          |         |        |         |  |   |      |   |  |   |       
|                                                     | 2004 |                        |   | 39,570 |            |  |   | 22        |   |  |            | 22,876 |  |          |         |       |         |  |   |     |   |  |   | 62,468 | 
|                                                     | 2003 |                        |   | 8,141  |            |  |   | 592       |   |  |            | 30,837 |  |          |         |       |         |  |   |     |   |  |   | 39,570 | 
|                                                     | 2002 |                        |   | 9,172  |            |  |   | (1,031    | ) |  |            |       |  |          |         |       |         |  |   |     |   |  |   | 8,141  | 






|    |                                                                                            
|--- | -------------------------------------------------------------------------------------------
|(a) | Represents reserves acquired through purchase business
    combinations and other additions



|    |  |                                                                        
|--- |  | -----------------------------------------------------------------------
|(b) |  | Deductions represent write-offs of specifically identified
    accounts

73



---



##### 





|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|ITEM 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
    ACCOUNTING AND FINANCIAL DISCLOSURE





|         |                        
|-------- | -----------------------
|ITEM 9A. | CONTROLS AND PROCEDURES

















74



---



##### 



PART III




|         |                                                   
|-------- | --------------------------------------------------
|ITEM 10. | DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT





|         |                       
|-------- | ----------------------
|ITEM 11. | EXECUTIVE COMPENSATION





|         |                                                                                                   
|-------- | --------------------------------------------------------------------------------------------------
|ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
    MANAGEMENT AND RELATED STOCKHOLDER MATTERS





|         |                                               
|-------- | ----------------------------------------------
|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS





|         |                                       
|-------- | --------------------------------------
|ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND SERVICES



PART IV




|         |                                                                    
|-------- | -------------------------------------------------------------------
|ITEM 15. | EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
    FORM 8-K









| |     |  |  |                                                                                                                                         |  |         
| | --- |  |  | --------------------------------------------------------------------------------------------------------------------------------------- |  | --------
| | 2A  |  |  | Agreement and Plan of Merger dated September 9, 2004 by and
    among the Registrant, Snowflake Acquisition Corp. and Datakey,
    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)
| | 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)

75



---



##### 



| |      |  |  |                                                                                                                                                                                                                   |  |           
| | ---- |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------
| | 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 Agreement with Carole D. Argo                                                                                                                                                                          |  | I/B/R(3)  
| | 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) 
| | 10O  |  |  | Amendment to Employment Agreement with Anthony Caputo                                                                                                                                                             |  | I/B/R(3)  
| | 10P  |  |  | Employment Agreement with Kenneth A. Mueller                                                                                                                                                                      |  | I/B/R(3)  
| | 10Q  |  |  | Lease for premises at 371 Van Ness Way, Torrence, California,
    dated October 2, 1997, between Surf Management Associates
    and Mykotronx, Inc.                                                               |  | I/B/R/(15)
| | 10R  |  |  | Lease for premises at 8 Hughes, Irvine, California, between
    Alton Irvine Partners, LLC and Rainbow Technologies, Inc.                                                                                         |  | I/B/R/(16)
| | 10S  |  |  | Lease for premises at 50 Technology Drive, Irvine, California,
    dated April 14, 2000, between The Irvine Company and
    Rainbow Technologies, Inc.                                                            |  | I/B/R/(17)
| | 10T  |  |  | Lease for premises at 357 and 359 Van Ness Way, Torrenece,
    California, dated May 1, 2002, between Surf Management
    Associates and Mykotronx, Inc.                                                          |  | I/B/R/(18)
| | 21   |  |  | Subsidiaries of Registrant                                                                                                                                                                                        |  |           
| | 23.1 |  |  | Consent of Ernst & Young LLP, independent registered
    public accounting firm                                                                                                                                   |  |           
| | 31.1 |  |  | Certification pursuant to 18 U.S.C. Section 1350, as
    adopted pursuant to Section 906 of the Sarbanes-Oxley Act
    of 2002                                                                                    |  |           
| | 31.2 |  |  | Certification pursuant to 18 U.S.C. Section 1350, as
    adopted pursuant to Section 906 of the Sarbanes-Oxley Act
    of 2002                                                                                    |  |           
| | 32.1 |  |  | Certification pursuant to 18 U.S.C. Section 1350, as
    adopted pursuant to Section 906 of the Sarbanes-Oxley Act
    of 2002                                                                                    |  |           
| | 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 Schedule TO filed by the
    Registrant with the SEC on September 21, 2004 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 Form 10Q for the quarterly
    period ended September 30, 2004 and incorporated herein by
    reference                
|
| | (4) | Filed as an exhibit to the Registration Statement on
    Form S-18 (File No. 33-28673) of the Registrant and
    incorporated herein by reference.
|
| | (5) | Filed as an exhibit to Form 10-Q for the quarterly period
    ended June 30, 2003 and incorporated herein by reference.                           
|
| | (6) | Filed as an exhibit to the Registration Statement on
    Form S-1 (File No. 33-52066) of the Registrant and
    incorporated herein by reference. 

76



---



##### 





| |     |                                                                                                                                                                               
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (7) | Filed as an exhibit to Form 10-K for the fiscal year ended
    December 31, 1996 and incorporated herein by reference.                                                        
|
| | (8) | Filed as an exhibit to Form 10-Q for the quarterly period
    ended September 30, 1996 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
    July 28, 1999 and incorporated herein by reference.



|     |                                                                                                                                                                                          
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | 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.           
|    
|(11) | Filed as an exhibit to the Form 10-Q for the quarterly
    period ended September 30, 2002 and incorporated herein by
    reference.                                                     
|    
|(12) | Filed as an exhibit to the Registration Statement on
    Form S-3 (File No. 333-106084) of the Registrant and
    incorporated herein by reference.                                      
|    
|(13) | Filed as an exhibit to the Registration Statement on
    Form S-8 (File No. 333-98029) of the Registrant and
    incorporated herein by reference.                                       
|    
|(14) | 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.             
|    
|(15) | Filed as an exhibit to the Form 10-K of Rainbow
    Technologies, Inc. (File No. 0-16641) for the fiscal year
    ended December 31, 1999 and incorporated herein by
    reference.      
|    
|(16) | Filed as an exhibit to the Form 10-K of Rainbow
    Technologies, Inc. (File No. 0-16641) for the fiscal year
    ended December 31, 2000 and incorporated herein by
    reference.      
|    
|(17) | Filed as an exhibit to the Form 10-Q of Rainbow
    Technologies, Inc. (File No. 0-16641) for the quarterly
    period ended September 30, 2002 and incorporated herein by
    reference.
|    
|(18) | Filed as an exhibit to the Form 10-K of Rainbow
    Technologies, Inc. (File No. 0-16641) for the fiscal year
    ended December 31, 2002 and incorporated herein by
    reference.      

77



---



##### 



SIGNATURES






| |              
| | -------------
| | SAFENET, INC.



| |     |                      
| | --- | ---------------------
| | By: | /s/ Anthony A. Caputo

| |                                     
| | ------------------------------------
| |                                     
| | Anthony A. Caputo                   
| | Chairman and Chief Executive Officer





|                                               |  |                                                                                                    |  |                |  | 
|---------------------------------------------- |  | -------------------------------------------------------------------------------------------------- |  | -------------- |  | 
|Signature                                      |  | Title                                                                                              |  | Date          
|                                               |  |                                                                                                    |  |               
|                                              
|/s/ Anthony A. CaputoAnthony
    A. Caputo     |  | Chairman and Chief Executive Officer                                                               |  | March 16, 2005
|                                              
|/s/ Kenneth A. MuellerKenneth
    A. Mueller   |  | Senior Vice President and Chief Financial Officer (Principal
    Financial and Accounting Officer) |  | March 16, 2005
|                                              
|/s/ Thomas A. BrooksThomas
    A. Brooks       |  | Director                                                                                           |  | March 16, 2005
|                                              
|/s/ Shelley A. HarrisonShelley
    A. Harrison |  | Director                                                                                           |  | March 16, 2005
|                                              
|/s/ Ira A. Hunt, Jr.Ira
    A. Hunt, Jr.       |  | Director                                                                                           |  | March 16, 2005
|                                              
|/s/ Bruce R. ThawBruce
    R. Thaw             |  | Director                                                                                           |  | March 16, 2005
|                                              
|/s/ Andrew E. ClarkAndrew
    E. Clark         |  | Director                                                                                           |  | March 16, 2005
|                                              
|/s/ Walter W. StraubWalter
    W. Straub       |  | Director                                                                                           |  | March 16, 2005
|                                              
|/s/ Arthur L. MoneyArthur
    L. Money         |  | Director                                                                                           |  | March 16, 2005

78