<PAGE>   1

                       SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C.  20549

                                  FORM 10-KSB

[X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

For the fiscal year ended December 31, 1996

[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

For the transition period from                  to                  .
                               ----------------    -----------------

Commission file number 0-15086

                             XYBERNAUT CORPORATION
          -----------------------------------------------------------
                 (Name of small business issuer in its charter)


                Delaware                                     54-1799851
-----------------------------------------              --------------------
     (State or other jurisdiction of                    (I.R.S. Employer
      incorporation or organization)                   Identification No.)

 12701 Fair Lakes Circle, Fairfax, VA                        22033
-----------------------------------------              --------------------
(Address of principal executive offices)                  (Zip Code)

Issuer's telephone number, including area code:     (703) 631-6925


Securities registered under Section 12(b) of the Exchange Act: none

Securities registered under Section 12(g)
of the Exchange Act:          Common stock, $.01 par value
                              Warrants to purchase Common stock

         Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.

                                                      Yes    X    No
                                                           -----     -----

         Check if there is no disclosure of delinquent filers in response to
Item 405 of Regulation S-B is not contained in this form, and no disclosure
will be contained, to the best of registrant's knowledge, in definitive proxy
or information statements incorporated by reference in Part III of this Form
10-KSB or any amendment to this Form 10-KSB:  X

         State issuer's revenues for its most recent fiscal year:  $1,093,341

         The aggregate market value at February 3, 1997 of the Common stock of
the issuer, its only class of voting stock, was $42,777,336, of which
$19,153,566 was held by non-affiliates, calculated on the basis of the closing
price of such stock on the National Association of Securities Dealers Automated
Quotation System Small Cap Market on that date.  Such market value of
non-affiliates excludes shares owned by all executive officers and directors
(but includes shares owned by their spouses); this should not be construed as
indicating that all such persons are affiliates.

         The number of shares outstanding of the issuer's Common stock as at
March 24, 1996 was 14,259,112


                      DOCUMENTS INCORPORATED BY REFERENCE

Portions of the issuer's Prospectus dated July 18, 1996 are incorporated by
reference into Items 13 in Part III of this Report.

Transitional Small Business Disclosure Format   Yes         No   X
                                                    -----      -----



                                       1
<PAGE>   2
                                     PART I

ITEM 1.          BUSINESS.

INTRODUCTION

         Xybernaut Corporation (the "Company") is engaged in the research,
development and commercialization of mobile computer systems, services and
related software solutions designed to enhance all aspects of personal
productivity, especially in commercial, industrial and military applications.
The Company's current mobile computing product is the patented Mobile
Assistant(R)II, which is a full function body-worn, voice-controlled "586"
computer with a head- mounted video display providing true computing mobility
through hands-free operation ("Mobile Assistant(R)II").  With the speed,
memory, processing, multimedia and communications capabilities of a desktop
personal computer ("PC") in a lightweight unit, the Mobile Assistant(R) series
combines full function PC features with hands-free operation and simultaneous
user mobility.  The Mobile Assistant(R) series is a combination of hardware and
software specifically designed for body-worn mobile computing (The "Mobile
Assistant(R) series"). The Mobile Assistant(R) series with application software
is designed to allow workers with minimal training to perform complex and time
consuming tasks such as maintenance, repair and inspection of complex
technological and mechanical systems, retrieval and analysis of medical
information from remote locations, and coordination of remote commercial and
industrial activities and military field operations, in a more efficient manner
than current technology allows. Purchasers of the previous generation "486"
Mobile Assistant(R) ("Mobile Assistant(R)") have included, among others, AT&T,
Eaton Corporation, Battelle Memorial Institute, PRC Inc., SRI International,
Rockwell International, Martin Marietta (now Lockheed Martin), IAI Elta
Electronics, Bently Nevada Corporation, Genesis Technology Group, Inc. and the
United States Army. In March 1996, Rockwell International, which manufactured
the computing unit utilized in the Mobile Assistant(R), licensed from the
Company the right to manufacture and market mobile computers utilizing certain
intellectual property and related technical know-how which has been developed
by the Company.

         The Mobile Assistant(R) series utilizes technologically advanced
features such as real time two-way video and audio communications through radio
frequency transmissions, integrated cellular linkups and conventional telephone
lines, global positioning system tracking capabilities and access to
information through the Internet and World Wide Web.  The head-mounted display
unit includes a two-way audio system, weighs less than 16 ounces and currently
presents a monochrome image that is approximately equivalent to that of a 15"
VGA monitor at a distance of approximately two feet.  The body-worn computing
unit is designed to allow operation in environmental conditions in which
conventional portable computers could not previously operate, weighs less than
three pounds and is capable of running software applications designed for
Microsoft(R) Windows(R)3.11, Windows(R)95, Windows(R) NT(TM), DOS and SCO
UNIX(R).

         The Company intends to utilize its software development expertise,
acquired through custom programming, including development of a graphical user
interface and neutral data storage systems for United States intelligence
agencies, to create software toolkits to assist its customers in developing
applications.  Software toolkits can provide a cost-effective platform for
user-customized programs for the storage, processing and retrieval of
information necessary for specific commercial, industrial, military and other
applications.  The Company intends to integrate its hardware and software
capabilities to provide total mobile computing solutions, thereby capitalizing
on all aspects of the Company's expertise.

         The Company was incorporated in Virginia as Contemporary Products &
Services, Inc. in November 1990 and changed it's name to Computer Products &
Services, Inc. in November 1992.  In April 1996 the Company merged with
Xybernaut Corporation, a Delaware corporation, in order to change its name and
reincorporate in Delaware.





                                      -2-
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         In July 1996, the Company acquired 100% of the issued and outstanding
shares of Tech International of Virginia, Inc. ("Tech Virginia").  Tech
Virginia is the former Virginia business unit of Tech International.  In
December 1994, Tech International spun-off its Virginia business unit as Tech
Virginia, and Tech Virginia was thereafter incorporated in Delaware in June
1994.

         To keep investors informed of the Company's future plans and
objectives, this Annual Report on Form 10-KSB (and other reports and statements
issued by the Company and its officers from time to time) contain certain
statements concerning the Company's future results, future performance,
intentions, objectives, plans and expectations that are or may be deemed to be
"forward-looking statements".  The Company's ability to do this has been
fostered by the Private Securities Litigation Reform Act of 1995 which provides
a "safe harbor" for forward-looking statements to encourage companies to
provide prospective information so long as those statements are accompanied by
meaningful cautionary statements identifying important factors that could cause
actual results to differ materially from those discussed in the statement.  The
Company believes it is in the best interests of investors to take advantage of
the "safe harbor" provisions of that Act.  Such forward-looking statements are
subject to a number of known and unknown risks and uncertainties that, in
addition to general economic and business conditions could cause the Company's
actual results, performance, and achievements to differ materially from those
described or implied in the forward-looking statements.  Factors that could
cause or contribute to such differences include, but are not limited to, the
Company's ability to profit from the Mobile Assistant(R)II as expected (see
"Products and Product Development"), the Company's ability to meet competition
(see "Competition"), the Company's ability to maintain superior technological
capability, foreseeing changes and continuing to identify, develop and
commercialize innovative and competitive products and systems (see "Research
and Development"), the Company's ability to penetrate different markets and
successfully expand its market base (see "Marketing and Sales"), the Company's
ability to attract and retain technologically qualified personnel, particularly
in the areas of research and development (see "Employees"), and the Company's
ability to generate cash flows and obtain financing to support its operations
and growth (see "Management's Discussion and Analysis of Financial Condition
and Results of Operations" in Item 7 of this Annual Report on Form 10-KSB).

INDUSTRY OVERVIEW

         Since the introduction of the first large mainframe computers in the
1950's, there has been an ongoing evolution in computer hardware to reduce size
and increase performance and functionality.  The commercialization of mobile
computing products combined with significant increases in the number and scope
of software applications has resulted in a multi-billion dollar market.  The
Company sees the next phase in this evolution to be body-worn, voice-activated
computers, which will provide hands-free portability.  The Company believes it
is in the forefront of the development of mobile computing technology and that
the potential to develop a substantial market for its mobile computing hardware
and software products is demonstrated by the substantial historic and projected
growth in all forms of mobile and portable computers. According to MarkIntel, a
service which compiles market research reports, total revenues from the overall
portable computer market (20 pounds or lighter), will have an average annual
growth of approximately 13% to over $23 billion through the year 2000.
MarkIntel reports that notebook computers (i.e. weighing from 5 to 8 pounds)
currently constitute over 70% of portable units sold. MarkIntel also states
that sub-notebook computers (3 to 5 pounds) currently constitute approximately
15% of sales of portable computers and are expected to increase to almost 19%
of sales by the year 2000.  Mini-computing and communication devices (3 pounds
or less, and which still are considered to be in an evolutionary cycle) are
projected by MarkIntel to experience an average annual revenue growth rate of
33%.  The Company believes that these projected figures demonstrate the
significant potential size of this still-evolving market for various forms of
mobile and portable computers.

         In conjunction with the changes in computer hardware, a similar
evolution has occurred in computer software to move from processing data to
providing information.  Mainframe computers were initially used to process vast
amounts of data such as population statistics, corporate accounting
information, etc., for users.  With personal computers came software to provide
information to users in the form of analysis, relationships, etc.  The Company
believes that providing "how to" knowledge to users is the next step in the
evolution of the computer software and one that is well suited for use with
body-worn computers.





                                      -3-
<PAGE>   4
BUSINESS STRATEGY

         The Company's objective is to be the leading provider of voice-
activated, hands-free mobile computing systems and related software solutions
to enhance productivity in a wide variety of applications for commercial,
industrial and military customers.  To achieve this objective, the Company
intends to pursue the following strategies:

         Provide Custom Software Solutions for Diverse Customer Needs.  The
Company intends to continue the development, or acquisition of, software
toolkits enabling its customers to more rapidly create customized software
applications for use with the Mobile Assistant(R) series and on a
stand-alone basis.  These toolkits will be designed to provide prepackaged
application expertise that incorporates the end user's existing programs,
procedures and technical documentation, thereby permitting the cost-effective
development of productivity-enhancing software applications by customers.  The
Company believes that revenues from custom software and other application
development toolkits will become an important contributor to operating margins
in the future.

         Penetrate Target Markets Through OEMS, VARs and Direct Sales.  The
Company believes that its mobile computing technology is especially well suited
for the repair and maintenance of complex commercial, industrial and military
equipment and facilities.  The Company intends to penetrate its target markets
through effective use of original equipment manufacturers ("OEMs") and
value-added resellers ("VARs") that demonstrate comprehensive market knowledge
in those markets. Through the use of approved OEMs and VARs, the Company
intends to leverage internal marketing and sales resources, and achieve rapid
foreign and domestic market penetration resulting in a diversified customer
base.

         Achieve and Maintain Technology Leadership.  The Company is committed
to achieving and maintaining technological superiority of the Mobile
Assistant(R) series and its other mobile computing products through the
continuous reassessment of product performance and the utilization and
integration of state of the art hardware and software technologies.  The
Company believes that the substantial expenditure of time and effort in
developing the Mobile Assistant(R)II has resulted in a set of core
competencies which provide the Company with a solid foundation in the
hands-free mobile computing industry.  The Company intends to maintain this
advantage through ongoing research and development, which will ensure that the
Mobile Assistant(R) series will continue to provide a full range of PC
capabilities, including two-way video communication and access to the Internet,
intranets, remote databases and other computerized reference resources.

         Commitment to Open Architecture.  The Company utilizes standard PC
hardware and software architectures and designs its products using open systems
technologies, including industry standard operating systems and open system
computer platforms.  The Company continually evaluates the feasibility of
integrating its software and hardware products with new technologies as these
are developed and accepted in the marketplace.  The Company anticipates that
its current products will be upgraded to incorporate, and its future products
designed using, open architectures to allow use with existing and emerging
standards in hardware and software technology.

         Leverage Core Competencies.  The Company believes its core
competencies, which have been developed since its inception, are the
integration and adaptation of innovative computer hardware and software
technologies and related services into hands-free mobile computing
products that enhance end user productivity.  The Company will seek to expand
applications for its technologies and to capitalize on the breadth of its
expertise by assisting its customers in the development of new hardware and
software products.  Consistent with this strategy, the Company will continue to
focus on integration of hands-free mobile computing hardware with internally
developed, or acquired, custom software applications and hardware products.

         Develop and Strengthen Strategic Alliances.  The Company has
established and intends to continue to establish strategic alliances
with selected VARS, OEMs and hardware, service and software vendors. The
benefits that the Company receives from these associations include access to a
larger potential customer base and to complementary technologies, and reduced
capital investment through utilization of outside resources.  The Company
currently has strategic supplier relationships with Hi-Tech Manufacturing
("HTM"), which manufactures the Mobile Assistant(R)II computing units, and
Greenway Technologies, which manufactures head-mounted displays to the
Company's





                                      -4-
<PAGE>   5
proprietary design.  In March 1996, Rockwell International, which manufactured
the computing unit utilized in the Mobile Assistant(R), licensed from the
Company the right to manufacture and market mobile computers utilizing certain
intellectual property and related technical know-how which has been developed
by the Company.  The Company has been pursuing, and will continue to pursue,
additional  strategic associations to enhance its product offerings and expand
its  marketing activities.

PRODUCTS AND PRODUCT DEVELOPMENT

         The Company's principal existing and proposed products and
applications are summarized in the following table.



<TABLE>
<CAPTION>
====================================================================================================================
      PRODUCT NAME                   DESCRIPTION/FUNCTION                              APPLICATIONS
--------------------------------------------------------------------------------------------------------------------
 <S>                     <C>                                           <C>
 MOBILE ASSISTANT(R)     Body-worn, hands-free, voice-activated        Hands-free access to information while
 SERIES INTEGRATED       battery powered integrated hardware and       performing tasks in conditions that require
 MOBILE COMPUTING        software computer system utilizing a head-    full mobility.
 SYSTEM                  mounted display.
--------------------------------------------------------------------------------------------------------------------
 CELLULAR AND RADIO      Used for hands-free access with cellular      Hands-free access to information stored on
 COMMUNICATIONS          phones or radio links for wireless            databases, the Internet and intranets, or
 TOOLKIT*                communications anywhere in the world through  to audio and/or video communications on
                         telephone, modem or Internet lines.           remote work sites.
--------------------------------------------------------------------------------------------------------------------
 VOICE USER              Software tools and procedures to integrate    Hands-free, voice-activated applications
 INTERFACE(TM)           voice navigation capability into existing     with accurate voice navigation and a simple
 TOOLKIT*                applications or applications under            voice interface on the Mobile Assistant(R)
                         development or for a computer system.         series or other computer platforms
--------------------------------------------------------------------------------------------------------------------
 AUDIOVISUAL             Camera and communication hardware with        Capture, transfer or communication of audio
 COMMUNICATIONS          voice-controlled software to allow            and/or video information on a real time or
 TOOLKIT*                hands-free capture, transmission and          delayed basis.
                         reception of video information and two-way
                         teleconferencing.
--------------------------------------------------------------------------------------------------------------------
 DATA CONVERSION         Software standards and procedures on          Conversion of information or existing hard
 TOOLKIT*                converting hard copy, digital, audio and/or   copy, digital, audio and/or video
                         visual data into suitable form for inclusion  information to neutral format.
                         in a neutral database for operation.
--------------------------------------------------------------------------------------------------------------------
 MICROCOSM VOICE*        A software shell for consistent navigation    Creation of maintenance, repair and
                         through, and presentation of, existing        operation applications by linking existing
                         computer files regardless of original         computer files without reprogramming or
                         format, hardware or software.                 altering data in existing files or
                                                                       databases.
--------------------------------------------------------------------------------------------------------------------
 PRESENTATION MANAGER*   Graphical user interface and navigation       Expansion of the scope of information
                         software toolkit for user customization of    available on job sites allowing performance
                         applications with a consistent, easy-to-use   of an expanded range of tasks with minimum
                         interface to the user.  Uses HTML software    training by accessing information utilizing
                         similar to that used on the Internet.         a consistent methodology and format.
====================================================================================================================
</TABLE>


                                      -5-
<PAGE>   6
<TABLE>
<CAPTION>
====================================================================================================================
      PRODUCT NAME                   DESCRIPTION/FUNCTION                              APPLICATIONS
--------------------------------------------------------------------------------------------------------------------
<S>                      <C>                                           <C>
 MOBILE COUNTER(TM)*     Bar-code readers combined with software and   Performance of continuous or periodic
                         voice recognition to interface with           hands-free counting and inspection of
                         customized and existing inventory             inventories with minimum personnel, time
                         applications.                                 and training.
====================================================================================================================
</TABLE>


*  Product under development.

         The Mobile Assistant(R) series is a combination of hardware and
software specifically designed for body- worn mobile computing.  A patent has
been issued by the U.S. Patent and Trademark Office regarding certain aspects
of the Mobile Assistant(R) series.

         In order to address the market, which the Company believes exists for
body-worn mobile computers, the Mobile Assistant(R) series has been designed
with four key features:

          -    Compact, lightweight and rugged hardware specifically designed
               for mobile, body-worn use

          -    Easy to use human interface and expert systems

          -    Voice command control

          -    Head-worn miniature display

          Compact Hardware for Mobile, Body-Worn Use.  The Mobile
Assistant(R)II currently utilizes primarily off-the-shelf miniaturized hardware
components in a body-worn computing package weighing approximately two pounds.
Design features of the Mobile Assistant(R)II currently include:

          -    "586" computer running at 133 MHz

          -    Extended Data Output EDO RAM (currently ranging from 8 Mb to
               32 Mb)

          -    Internal hard disk (currently ranging from 810 Mb to 2.1Gb)

          -    Protected internal dual PC Card readers (industry-standard
               peripheral cards)

         -    Enclosure to allow use in a wide range of environmental conditions

          -    Advanced-technology battery and power management

          -    Serial, parallel, keyboard and printer ports and infrared
               (industry standard IrDA) ports

          -    Compatibility with DOS, Windows(R) 3.11(TM), Windows(R) 95,
               Windows(R) NT(TM) and SCO UNIX(R) operating systems

          -    Integrated pointing device (mouse)


         The base system Mobile Assistant(R)II utilizes advanced nickel metal
hydride batteries to provide an estimated three to four hour use before
recharging.  Spare batteries also can be carried on the user's belt to provide
additional use time.  The Company also offers lithium-ion batteries that
provide an estimated six to eight hour use before recharging.





                                      -6-
<PAGE>   7
         As a full-featured PC, the Mobile Assistant(R)II has external serial
and parallel ports, and ports for a keyboard, printer and monitor to allow for
independent use as a desktop PC.  The Mobile Assistant(R)II has a modular
design for the incorporation of a wide range of capabilities including a
portable CD ROM reader, a bar code reader, a battery- operated printer, still
and motion video cameras, global positioning technology, cellular and radio
frequency communications and interfaces for medical and test equipment.

         Easy to Use Human Interface and Expert Systems.  The presentation and
means of navigation for Mobile Assistant(R) series applications are being
developed based on designs which served as a model for use by the United States
Department of Defense and several United States federal agencies.  Using a
United States federal secure network similar to the internet, and with
consistent screens and navigation techniques, this software allows personnel
from one agency to easily access the information gathered by another agency,
regardless of the computer platform or operating system used.  Previously, this
benefit was unavailable largely because of the learning time required for an
analyst at one agency to learn other agencies' presentation and navigation
methods.

         Voice Command Control.  The Mobile Assistant(R)II supports
state-of-the-art voice recognition software, hardware and algorithms to
communicate digitized speech as input to the processor through an integrated
analog-to-digital/digital-to-analog circuit.  Significant user training
generally is not required because the operable vocabulary is created in advance
to be recognizable by a wide range of users.  The system can be programmed to
"learn", on the fly during real-time field use.  The speaker-independent
approach works well for the menu and button-driven programs used in the Mobile
Assistant(R)II.  System accuracy is improved greatly since the words and
phrases for each menu screen can be predetermined, preoccupied and used to
limit recognition ranges to the screen at hand.

         An integrated pointing device (mouse) is installed in the Mobile
Assistant(R)II for environments where voice navigation is not possible.  The
combination of voice recognition and head-worn display provides the user of the
Mobile Assistant(R)II with hands-free access to information and the ability to
apply this information to operations and tasks with direct lines of sight and
tactile access.

         Head-Worn Miniature Display.  The Mobile Assistant(R)II uses a
lightweight, head-worn miniature display designed by the Company, which
currently is offered in monochrome 640  X  480 pixel (VGA) 256 gray scale
resolution.  It is anticipated that this display will be offered in the future
by the Company in color VGA, monochrome 800x600 pixel (SVGA) and 1280  X  1024
pixel resolution, color SVGA and eventually in color resolutions exceeding
those planned for High-Definition TV.  All displays are approximately one
square inch in size and use advanced optics to present an image to the user
that is equivalent to a 15" desktop monitor at a distance of two feet. These
displays are available in monocular form, and can be worn on a mounting device
similar to a runner's visor or sunglasses, or on helmets, hardhats, soft
baseball caps or similar headgear. These high quality, miniature displays
present information in a heads-mounted display format without completely
occluding vision.

         Development of Software Packages.  Initially, development of software
designed for use with the Mobile Assistant(R) series was targeted primarily at
specific military uses.  The Company has identified the proprietary software
packages described in "Business -- Products and Product Development."

MARKETING AND SALES

         Markets

         The Company's marketing efforts are designed to increase awareness of
and demand for its products in the commercial, industrial and military markets.
The following are examples of selected horizontal and vertical markets that
initially are being, or will be, addressed by the Company:

                 Commercial Maintenance and Repairs.  Information from the
         United States Bureau of Labor Statistics and Bureau of Census
         indicates that as of 1996 there were more than 5,460,000 commercial
         mechanics and technicians in the United States, all of which the
         Company believes are potential users of the Mobile Assistant(R) series
         and the Company's other products.  There are many sources of savings
         available





                                      -7-
<PAGE>   8
         from use of the Mobile Assistant(R) series and the Company's other
         products in maintenance and repair operations such as: less formal
         training is required for a similar level of performance, the
         time required for diagnostic and repair tasks is reduced as "just in
         time" refreshers and improved technical information can be provided,
         and personnel can address a wider range of complex tasks or products
         with the same level of basic training.  While these savings can be
         realized in most industries, the Company anticipates that these
         savings will be most immediate and apparent in those industries that
         require a large investment in equipment and machinery, including the
         transportation, automotive, construction, power generation, health
         services, agriculture and the military.  In industries such as
         construction or mining, the Company believes downtime on critical
         equipment can cost over $75,000 per day.  Accordingly, a reduction
         measured in minutes or hours of downtime in these industries can, in
         the Company's view, provide ample cost justification for a Mobile
         Assistant(R)II.  The telecommunications industry is expected to be a
         prime candidate for mobile computing systems given the industry's
         complex technologies, increased competition and assets spread over a
         wide geographic area. The Mobile Assistant(R)II can provide needed
         knowledge to workers on the top of a telephone pole, at a remote relay
         station or in a conduit tunnel.  Crew locations can be monitored and
         coordinated in the field with the Mobile Assistant(R)II through
         optional global positioning system technology.  Crews at remote
         locations can consult with experts using two-way audio and/or video
         communications.

                 Healthcare.  It is estimated that over 13.9% of the U.S. Gross
         Domestic Product, or $1 trillion, is spent annually on healthcare,
         with an estimated 25% of such expenses consumed by administrative
         expenses.  According to the National Center for Health Statistics,
         United States, 1994, the United States has over 6,000 hospitals and
         over 540 health maintenance organizations.  According to the United
         States Department of Labor, in 1994 there were approximately 4,714,000
         healthcare workers in the United States.  The Company believes that
         many of the current processing and data systems used in healthcare,
         both in institutions and in the field, are not well developed or
         integrated and that hands-free mobile computing systems could reduce
         expenses and increase efficiency in this industry.  The Mobile
         Assistant(R)II is believed to present great potential in field medical
         operations by providing on-board and remote diagnostics, audio and/or
         video communication with doctors for emergency procedures, and
         transmission of locations for helicopter pickup through global
         positioning systems integrated into the Mobile Assistant(R)II.
         Another anticipated benefit of the Company's hands-free mobile
         computing technologies is that fewer healthcare personnel will be
         needed to perform complex tasks.  By providing remote delivery of
         medical information, the Company's hands-free mobile computing systems
         can become a key component within both managed care and telemedicine
         organizations, which are two key submarkets developing within the
         healthcare industry.

                 Education.  The Company believes that its mobile computing
         systems are well suited for educational applications.  The Mobile
         Assistant(R)II is especially suited for hands-free applications, such
         as laboratory work, field research and dissections and has the
         potential to serve as a mobile student workstation.  In addition, it
         can provide an ideal computing and control platform for special
         education and handicapped needs.

                 Military.  There are several potential military applications
         for the Company's hands-free mobile computing systems, including
         intelligence, maintenance and field operations.  The military has long
         been an early adopter of advanced weapons technologies and, as a
         result, was one of the first sectors to experience problems with the
         ability of personnel to maintain, diagnose and repair the advanced
         technology employed in both weapons and equipment.  These problems
         have been compounded by the downsizing of the United States military
         and related budget constraints.  As a result, even greater pressure
         will be placed upon the military to maintain its equipment and weapons
         platforms with fewer personnel.  The Company believes that most of the
         estimated 700,000 military maintenance personnel in the United States
         could be made more efficient and productive by the Company's
         hands-free mobile computing systems.





                                      -8-
<PAGE>   9
                 The United States military's increasingly sophisticated
         weapon systems require volumes of operational and technical manuals
         and have dramatically increased the importance of maintenance.  The
         United States Army has purchased the Mobile Assistant(R) and has
         tested its use in the maintenance and repair of the AH64 Apache Attack
         helicopter.  The Apache can send and receive maintenance data via an
         industry standard electrical interface which can be read by an
         optional interface for the Mobile Assistant(R).  Operating and
         performance data can be downloaded directly from the Apache and the
         Mobile Assistant(R) can be used to diagnose existing and potential
         maintenance and repair problems.  The Company anticipates that
         manufacturers of complex military equipment increasingly will
         incorporate integrated data collection and transmission capabilities
         into their technologies to reduce downtime, repair and maintenance
         related costs.

                 The ability to deliver information to soldiers in combat field
         operations is the focus of several development programs sponsored by
         the United States Army.  The Army has been conducting simulated combat
         maneuvers using body-worn computing components, including those
         provided by the Company, to determine effectiveness for use in
         coordinating troop locations and movements, determining enemy
         locations, and using global positioning systems to provide coordinates
         for artillery, helicopter pickup and air support.

         Marketing

         Because the Company's products are frequently combined with products
from other manufacturers to form integrated information systems, the Company
believes that it is more effective to sell principally through VARs with
defined market niche expertise and presence as well as to end users.  The
Company believes that by forming relationships with VARs and OEMs who supply
various submarkets and types of end users, serve customers or have in-place
sales and distribution channels that identify new customers and sales
opportunities, the Company is able to reach end users more rapidly in a variety
of industries.


         To ensure VAR and OEM capabilities, the Company intends to offer
detailed in-house training sessions to prepare and update personnel for field
sales and training.  In addition, the Company is developing comprehensive
sales and operations manuals to be used by VARs and OEMs.

         The Company's marketing and sales employees are responsible for
implementing direct marketing plans and sales programs, coordinating sales
activities with VARs and OEMs and customer service.

Sales and Backlog

         As of December 31, 1996 the Company had sold and delivered
approximately $1.2 million of Mobile Assistant(R) systems since its commercial
introduction, and had a purchase order backlog of approximately $99,000 which
the Company anticipates will be shipped prior to June 30, 1997, although there
can be no assurance of shipment by such date. Customers who have placed orders
for units in the past include, among others, AT&T, Eaton Corporation, Battelle
Memorial Institute, PRC Inc., SRI International, Rockwell International, Martin
Marietta (now Lockheed Martin), IAI Elta Electronics, Bently Nevada
Corporation, Genesis Technology Group, Inc. and the United States Army.
Purchase orders are cancelable by the customers without penalty and are not
binding upon the customer.  At June 30, 1996, the Company reported a backlog of
$1,250,000, which included approximately $606,000 in orders from Rockwell and
$641,000 in orders from Neurosystems. The Rockwell order was cancelled in
connection with the development of their system under the license from the
Company and this amount was removed from backlog. After delays by Neurosystems
in scheduling shipment dates for the delivery of the Mobile Assistant(R), the
Company removed this amount from backlog.  Between June 30, 1996 and December
31, 1996, approximately $447,000 of orders were booked and $348,000 of products
were shipped.





                                      -9-
<PAGE>   10


         In the quarter ended December 31, 1997, Company management decided to
emphasize the Mobile Assistant(R)II over the Mobile Assistant(R) to better
address those customers who needed the higher capacity and speed of the Mobile
Assistant(R)II.  This decision resulted in a low level of bookings for that
quarter as the Company does not accept purchase orders unless the delivery of
those purchase orders with high-quality product in a timely manner can be
reasonably assured.  When the Mobile Assistant(R)II is in full production,
which Company management currently expects will be in the quarter ending June
30, 1997, the Company will be in a position to accept a greater number of
purchase orders and expects that bookings and backlog will increase at that
time.

Rockwell International License Agreement

         In March 1996, Rockwell International, which manufactured the computing
unit utilized in the Mobile Assistant(R), and the Company entered into a
non-exclusive five-year license agreement (the "License Agreement").  Pursuant
to the License Agreement, Rockwell International has been granted the
nonexclusive worldwide (excluding Germany and Japan) rights to manufacture,
sell, distribute, lease or repair under the Rockwell International name
portable computers meeting certain operating specifications utilizing and
limited to the technical information and intellectual property (including
patent) rights which have been developed by the Company as of the effective
date of the License Agreement with regard to the Mobile Assistant(R).  The
License Agreement provided for initial consideration of $1,695,000, which
consisted of $300,000 in cash and the release of the Company from an obligation
to pay Rockwell International $1,395,000 pursuant to a purchase order between
the Company and Rockwell International.  In addition, Rockwell is obligated to
pay royalty payments to the Company through August 31, 2001 for each product
Rockwell International sells under this license. Pursuant to the License
Agreement, Rockwell International is obligated to provide the Company with
computing units meeting certain specifications on price, performance and
delivery terms no less favorable than offered by Rockwell International to any
other customer.  Upon the termination of the License Agreement pursuant to its
terms, Rockwell International will receive an irrevocable, unrestricted,
perpetual license to certain of the Company's intellectual property rights
related to mobile computers including data, designs, methodology, processes and
procedures as granted in, and as of the effective date of, the License
Agreement, with the exception of manufacturing rights in Germany and Japan.
While the Company's patent counsel has advised the Company that this License
Agreement is not directly dependent on the Company's patent position, an
adverse determination by the Patent Office with respect to the pending
reexamination of the Company's patent for the Mobile Assistant(R) series or any
other material adverse development concerning such patent or the Company's
other intellectual property rights could have a material adverse effect upon
the Company's future rights under the License Agreement.

KEY SUPPLIERS

         The Company currently has subcontracted the manufacture of the
body-worn computing unit, headset and battery portions of the Mobile
Assistant(R)II unit to third-party vendors.  These components are currently
assembled and integrated with the software applications for the Mobile
Assistant(R) at the Company's headquarters, and the Company intends to
outsource the final assembly, integration and test functions during the coming
fiscal year to allow for the shipment of products directly to customers.  The
Company currently has an agreement with HTM for the manufacture and supply of
the body-worn computing unit of the Mobile Assistant(R)II.  HTM purchases and
manages parts and components inventory, manufactures computer boards, and
assembles and tests the body-worn computing unit of the Mobile Assistant(R)II.
HTM also provides warranty coverage and warranty service for the body-worn
unit.  Per the agreement, HTM will only order material pursuant to and based
upon the Company's purchase orders.  The agreement between HTM and the Company
is terminable by mutual agreement of the parties.  Under the terms of the
License Agreement, Rockwell International is obligated to provide the Company
with processing units and body-worn computing systems on the most
favorable pricing, system performance and delivery terms available to any
Rockwell International customer.  The Company has purchased head-mounted
displays ("HMD") from Kopin for the Mobile Assistant(R) at a fixed unit cost
pursuant to an initial agreement dated July 14, 1994 and an interim agreement
which expired in August 1996.  To date, a new contract has not been completed
and there can be no assurance that the Company and Kopin will reach a mutually
satisfactory agreement for the sale of head-mounted displays subsequent to the
expiration of the interim agreement or pursuant to the initial agreement.  The
Company has designed a proprietary HMD for both the Mobile Assistant(R) and the
Mobile Assistant(R)II that is being manufactured by Greenway Engineering using
purchased and fabricated parts.  Greenway is contracted to purchase and manage
parts and components inventory, manufacture computer boards, and assemble and
test the HMD of the Mobile Assistant(R)II, as well as obtain Federal





                                      -10-
<PAGE>   11
Communications Commission certification for the Mobile Assistant(R)II system

         Most of the parts and components for the Mobile Assistant(R)II are
off-the-shelf PC components that are available in high quantity from multiple
vendors.  The Company uses the Active Matrix Liquid Crystal Display ("AMLCD")
from one supplier in its HMD and is currently redesigning the HMD to have the
ability to use AMLCDs from additional suppliers.  Custom-designed components
and Application Specific Integrated Circuits are being utilized to reduce
weight, size and power consumption of the Mobile Assistant(R) as well as to
increase its capabilities and performance.

PRODUCTION

         Since its IPO, the Company has taken steps to finalize the development
of the Mobile Assistant(R)II and prepare for full-scale production.  Molds for
cases and tooling for production have been developed and Company management
currently expects that full-scale production will begin during the quarter
ending June 30, 1997.  Initial production of high-technology products, such as
the Mobile Assistant(R)II, involves a number of complex steps and delays in
initiating production to ensure that the product meets quality criteria are
common in the high-technology industry.  If the start of full-scale production
of the Mobile Assistant(R)II is delayed past the quarter ending June 30, 1997,
such delay will have an adverse effect on revenues for the twelve months ending
December 31, 1997.  See "Management's Discussion and Analysis".

WARRANTIES

         The Company currently provides customers with a parts and labor
warranty for 90 days and a one-year warranty on parts only.  Warranty services
for the Mobile Assistant(R) are provided by Rockwell International and warranty
services for the Mobile Assistant(R)II are provided by HTM.  Warranty services
for the Kopin HMD are provided by Kopin, and warranty services for the
Company's HMD are provided by Greenway Engineering, except for the AMLCD, which
is provided by its manufacturer.

COMPETITION

         The Company anticipates that ultimately it will face widespread
competition from other portable computing systems manufacturers.  Several other
companies are engaged in the manufacture and development of body-mounted or
hand-held computing systems which can also compete with the Mobile Assistant(R)
series, including InterVision, Phoenix Group, ViA Inc., Texas Microsystems,
Telxon, Norand and a consortium of Litton and TRW.  Personal digital assistants
and laptop and notebook computers also are products that could compete against
the Mobile Assistant(R) series in applications where hands-free,
voice-activated operation is not required.  Some of these computers are
manufactured by major domestic and foreign computer manufacturers which possess
far more resources than the Company and can be expected to compete vigorously
with the Company for the market at which the Mobile Assistant(R) series is
directed.  The Company is aware of at least three competitors which have
introduced hands-free mobile computing systems that compete directly with the
Mobile Assistant(R) series. There can be no assurance the Company will be able
to compete successfully against its competitors or that the competitive
pressures faced by the Company will not adversely affect its financial
performance.

INTELLECTUAL PROPERTY

         The Company relies on a combination of patent, trade secret, copyright
and trademark laws and contractual restrictions to establish and protect its
proprietary rights.  The Company has entered into confidentiality and invention
assignment agreements with its employees, and enters into non-disclosure
agreements with its suppliers, VARS, OEMs and actual and potential customers to
limit access to and disclosure of its proprietary information.  The Company has
registered its Mobile Assistant(R) and Xybernaut(R) trademarks on the Principal
Register of the United States Patent and Trademark Office ("Patent Office").





                                      -11-
<PAGE>   12

         In April, 1994 U.S. patent number 5,305,244 ("hands-free,
user-supported portable computers") (the "Patent") for the Mobile Assistant(R)
series was granted to the Company.  This patent was previously assigned to the
Company by several employees of the Company.  In September 1995, the Company
received a notification from the Patent Office entitled "office action in
reexamination," which indicated that certain claims under the Patent were
subject to reexamination and were preliminarily rejected.  The reexamination of
the Patent was initiated as a result of a request from one of the Company's
competitors.

         In May, 1996 the Patent Office issued a Notice of Intent to Issue
Reexamination Certificate and Reexamination Reasons for
Patentability/Confirmation with respect to the September 1995 reexamination
wherein it concluded that the Company's claims are patentable with respect to
the issues raised by that request for reexamination. This Reexamination
Certificate was issued in July 1996.

         On April 16, 1996, a second reexamination request was filed with the
Patent Office, by the same competitor of the Company which filed the first such
request in September 1995, and in September 1996 the Company received a
notification from the Patent Office entitled "office action in reexamination,"
which indicated that certain claims under the Patent were subject to
reexamination and were preliminarily rejected.  The Company has been advised by
its patent counsel, who is the Company's Secretary and a director, that it is
common for the Patent Office to grant reexamination requests, which ordinarily
are accompanied by a preliminary rejection.  Once a reexamination request is
granted, the patent holder has an opportunity to respond, both in writing and
in person, with respect to the reexamination and preliminary rejection.  The
Company filed a written response to this request for reexamination and
preliminary rejection on November 25, 1996.  Subsequently, representatives of
the Company, including legal counsel, met with representatives of the Patent
Office to discuss the status of the matter.

         The Company has been advised by its patent counsel handling this
matter that even if the Company's patent claims ultimately are rejected, the
Company has pending other patent applications which the Company believes it
may rely upon to assist in the protection of the Company's proprietary rights.
However, there is no assurance that any patent will be granted to the Company
or upheld in the future.

         The Company has notified several of its competitors of the existence
of the Patent, which the Company's counsel believes may have been infringed by
each of such competitors.  In the event that the second reexamination request
for the Patent is upheld, the Company intends to take any and all appropriate
measures, including legal action, necessary to maintain and enforce its rights
under the Patent and to recover any damages suffered as a result of any alleged
infringement.

         A second patent application for related mobile computing technology
was filed on October 2, 1995 in the United States by certain employees of the
Company.  Further, eight additional patent applications have been filed in the
United States since the Company's initial public offering ("IPO").  All patents
obtained by Company employees under pending and future applications have been
and will be assigned to the Company under existing invention agreements.

         The Company also has applied for patent protection for its hands-free,
body-worn mobile computing technology under the laws of European countries as
well as The People's Republic of China, Japan, Republic of Korea, Republic of
China (Taiwan), Canada and Australia.

RESEARCH AND DEVELOPMENT

         Research and development expenditures for the year ended December 31,
1996 and for the nine months ended December 31, 1995 were $1,773,015 and
$910,182, respectively.  These expenditures consist primarily of personnel
engaged in the research and design of new hardware and software products, test
components, consulting fees, equipment and purchase software costs required to
conduct the Company's development activities.





                                      -12-
<PAGE>   13


EMPLOYEES AND CONSULTANTS

         As of December 31, 1996, the Company had 38 full-time and 5 part-time
employees, and had consulting arrangements with 3 individuals or firms for
advice and assistance on selected technical and business issues.  Of the
Company's full-time employees, 3 are executive officers, 10 are technical and
administrative support employees, 9 are engaged in research and development, 3
are engaged in assembly and testing and 13 are engaged in sales and marketing.
None of the Company's employees are represented by a union and management
believes that the Company's relations with its employees are good.

         The Company has entered into a consulting agreement with Dr. Steven A.
Newman, a director of the Company, whereby Dr.  Newman has agreed to provide
negotiating, strategic planning, financial advisory and general management
services to the Company through 1998.  The agreement originally provided for a
fee of $1,000 per day or $5,000 per week for services performed pursuant to
statements of work approved by the Company's President or Board of Directors.
To minimize expenses to the Company under this contract, the agreement was
subsequently modified to provided for a fixed monthly fee of $12,500 and a
grant of 50,000 warrants, each to purchase one share of the Common stock of
the Company (the "Common stock") at $2.38 per share and expiring on January 1,
2003. Dr. Newman's consulting agreement provides for an automatic three-year
renewal unless terminated in writing by either party on or before
October 31, 1998.  Dr. Newman's consulting agreement also provides for
termination at his option in the event of a change of control (which is defined
as Edward Newman ceasing to serve as Chairman of the Company's Board of
Directors or its President and Chief Executive Officer) and that upon any such
termination Dr. Newman is entitled to at least two years of compensation
pursuant to his agreement.  Services rendered by Dr. Newman will be subject to
periodic review by the Board of Directors.  Dr. Newman received payments in
1996 for accrued salaries and expenses related to his employment with Tech
Virginia and provides consulting services to Tech Virginia without contract at
a fixed payment of $1,000 per month.

         In 1996, the Company entered into a two-year consulting agreement with
Victor J. Lombardi whereby Mr. Lombardi agreed to provide business development
and marketing services to the Company in exchange for warrants which entitle
Mr. Lombardi to purchase 100,000 shares of Common stock at $6.00 per share
through December 31, 1999.

         In May 1995, the Company entered into a three-year consulting agreement
with Dr. Andrew Heller whereby Dr. Heller agreed to provide strategic planning,
business management, strategic product development and market and financial
introductions services to the Company.  In consideration of services rendered
by Dr. Heller to the Company prior to that time and as an inducement to enter
into the consulting agreement, Dr. Heller was granted 100,000 shares of Common
stock which were valued at $5 per share for financial reporting purposes.

ITEM 2.          DESCRIPTION OF PROPERTY.

         The Company's office and development facility consists of 10,303
square feet located at 12701 Fair Lakes Circle, Fairfax, Virginia.  The
Company's current lease is for a three-year term expiring November 1997 and
requires monthly rent of approximately $13,750.  The lease is renewable at the
Company's option for an additional three years.

         The Company leases approximately 2,900 square feet located at 164
Townsend Street, San Francisco, California which is used as the Company's
design and prototype center.  The initial lease term is for twelve months
ending September 1997 and requires monthly rent of $4,445 plus a pro-rata share
of building utilities and services.  The lease is renewable at the Company's
option for an additional two year period.

         To minimize lodging expenses for visiting employees and consultants,
the Company leases an apartment located at 4401 Sedgehurst Drive, #301,
Fairfax, Virginia 22033 pursuant to a month to month lease requiring monthly
rent of $975.  The Company must give at least 45 days prior written notice
before termination of the lease.  In addition, the Company also leases an
apartment for the same purpose located at 12112 C Tall Shadows Lane, Fairfax,
Virginia.  The lease is for a twelve and a half month period expiring December
1997 and requires monthly rent of $935.  The Company must give at least 30 days
prior written notice before termination of the lease.

         The Company leases approximately 650 square feet of office space at FM
Building 102, 7-39-5 Nishikamata, Ohta-ku, Tokyo 144, Japan, for use as its Far
East representative office.  The initial lease term is for two years ending
April 1999 at a base rent of approximately $1,700 per month and is renewable at
the Company's option for an additional two year period.





                                      -13-
<PAGE>   14
ITEM 3.          LEGAL PROCEEDINGS.

         The Company is not a party to any litigation and is not aware of any
pending or threatened litigation.  A second "office action in reexamination"
has been filed with the Patent Office regarding the Company's claims under the
Patent for the Mobile Assistant(R) series.  See "Business - Intellectual
Property."

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

         None.

                                    PART II

ITEM 5.          MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

         On July 18, 1996, the Company successfully completed its IPO and sold
2,415,000 Units at a price of $5.50 per Unit.  Each Unit consisted of one share
of Common stock and one warrant ("Warrant") to purchase a share of Common stock
at $9.00 ("Unit").  Units were traded on the NASDAQ SmallCap Market from July
18, 1996 until August 20, 1996, at which time the Units were delisted from the
exchange.  The Common stock and Warrants have traded separately on the NASDAQ
SmallCap Market since July 29, 1996.

         As of December 31, 1996, there are approximately 1,200 holders of
Common stock.  There have been no cash dividends paid on the Company's Common
stock to date and the Company does not anticipate the payment of dividends in
the foreseeable future.

         The table below sets forth by quarter, for the year ended December 31,
1996, the high and low market prices of the Company's Units, Common stock and
Warrants.


<TABLE>
<CAPTION>
                              Units            Common stock               Warrants
                         High      Low        High        Low          High         Low
                         ----      ---        ----        ---          ----         ---
 <S>                     <C>       <C>        <C>         <C>          <C>          <C>
 1st Quarter 1996        --        --         --          --           --           --


 2nd Quarter 1996        --        --         --          --           --           --


 3rd Quarter 1996        19        9 1/4      12          4 1/2        6 1/4        1 3/8

 4th Quarter 1996        N/A       N/A        4 7/8       1 1/2        2 1/4        5/8
</TABLE>


ITEM 6.          MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                 AND RESULTS OF OPERATIONS


OVERVIEW

         The Company was incorporated as a Virginia company in October 1990 and
commenced active operations in November 1992 as Computer Products & Services,
Inc. to develop, manufacture and sell mobile computing systems.   Since
commencing operations, the Company has incurred significant operating losses.
In April 1996, the Company was merged with Xybernaut Corporation in order to
change the company name and reincorporate in Delaware.  In July 1996, the
Company successfully completed the IPO of its Common stock and Warrants which
are traded on the NASDAQ SmallCap Market.





                                      -14-
<PAGE>   15
         The Company has derived its revenues from sales of the Mobile
Assistant(R), less volume discounts, and from consulting services related to
the Mobile Assistant(R), application software for the Mobile Assistant(R), and
other computer platforms.  During the year ended December 31, 1996, the Company
derived approximately 85% of its revenues from sales of the Mobile
Assistant(R), as well as fees related to licensing agreements, and 15% of its
revenues from consulting services.  During the nine months ended December 31,
1995, the Company derived approximately 65% of its revenues from sales of the
Mobile Assistant(R) and 35% of its revenues from consulting services.  In the
future, the Company expects to derive additional revenues from the sale of
software development toolkits, software runtime modules and additional optional
components of the Mobile Assistant(R) series.  Revenues from sales to
customers, VARs and OEMs are recognized when products are shipped.  The
Company's sales agreements generally do not involve any significant obligations
to customers subsequent to delivery except as provided in separate service or
support agreements.  Revenues from future software sales will be recognized at
the time the software master is delivered in accordance with Statement of
Position No. 91-1.  Cost of sales include the cost of components for the Mobile
Assistant(R) series, direct labor and overhead expense, manuals, diskettes and
duplication, packaging materials, assembly, paper goods and shipping.

         The Company intends to continue expenditures on research and
development of additional products, including software development toolkits.
Research and development consist primarily of personnel engaged in the research
and design of new products, test components, consulting fees and equipment
costs required to conduct the Company's development activities.  Software
development costs are expensed as incurred until technological feasibility is
established in accordance with Statement of Financial Accounting Standards No.
86 (Accounting for the Costs of Computer Software to be Sold, Leased or
Otherwise Marketed), after which any additional costs are capitalized until the
software is ready for release.  The Company has expensed all software
development costs to date.  Research and development expenses for the year
ended December 31, 1996 and for the nine months ended December 31, 1995 were
$1,773,015 and $910,182, respectively, none of which was capitalized.

         The Company's consolidated financial statements, for all periods
presented, include the results of operations of Tech Virginia, a wholly-owned
subsidiary that supplies software and consulting services to the United States
government and others.  In July 1996, the Company exercised its option to
purchase all of the capital stock of Tech Virginia for $50,000.  The
consolidated financial statements contain eliminations for all material
transactions between the Company and Tech Virginia for all periods presented.

         The Company's consolidated financial statements do not contain a
provision for income tax expense due to net operating losses since inception.
Subject to realization, the Company has generated net operating losses that can
be used to offset taxable operating income in the future.  The Company's future
operations, if profitable, will be subject to income tax expense not previously
incurred by the Company (see Note 9 to Consolidated Financial Statements).  At
December 31, 1996, the Company had approximately $7,266,000 of net operating
loss carry forwards for federal income tax purposes which expire in 2012.  The
use of these carry forwards may be limited in any one year under Internal
Revenue Code Section 382 if significant ownership changes occur in the future.





                                      -15-
<PAGE>   16
RESULTS OF OPERATIONS

         In connection with its IPO, the Company changed from a fiscal year
ending March 31 to a fiscal year ending December 31, effective December 31,
1995.  The following table sets forth certain consolidated financial data as a
percentage of revenues for the year ended December 31, 1996 and the nine month
period ended December 31, 1995.


<TABLE>
<CAPTION>
                                                 YEAR ENDED                  NINE MONTHS ENDED
                                                DECEMBER 31,                   DECEMBER 31,
                                             ------------------            --------------------
                                                    1996                            1995
                                           ----------------------        -------------------------
 <S>                                              <C>                            <C>
 Revenues .............................              100.0%                         100.0%
 Cost of Sales ........................               98.9                           74.8
                                                    ------                         ------
   Gross margin .......................                1.1                           25.2
                                                    ------                         ------
 Operating expenses:
   Sales and marketing ................              131.9                          108.9
   General and administrative .........              197.4                          260.2
   Research and development ...........              162.2                          258.1
                                                    ------                         ------
 Total operating expenses .............              491.5                          627.2
                                                    ------                         ------
 Interest income (expense) ............               11.2                           (5.3)
                                                    ------                         ------
 Net loss .............................             (479.2)%                       (607.2)%
                                                    ------                         ------
</TABLE>


YEAR ENDED DECEMBER 31, 1996 AND NINE MONTHS ENDED DECEMBER 31, 1995

         Revenues.  Revenues for the year ended December 31, 1996 were
$1,093,341, an increase of $740,693, or 210%, compared to $352,648 for the nine
months ended December 31, 1995.  This increase resulted primarily from
increased sales of the Mobile Assistant(R) as well as fees related to licensing
agreements.  Increased discounts on sales of the Mobile Assistant(R) resulted
in a reduction of average selling prices and a corresponding reduction in
overall gross margin.

         Cost of sales.  The cost of sales for the year ended December 31, 1996
was $1,081,197, an increase of $817,576, or 310%, compared to $263,621 for the
nine months ended December 31, 1995.  This increase resulted primarily from
increased sales of the Mobile Assistant(R) and an allowance to reduce December
31, 1996 inventory balances of the Mobile Assistant(R) to net realizable value
due to the release of the Mobile Assistant(R)II.

         Research and development expenses.  Research and development expenses
for the year ended December 31, 1996 were $1,773,015, an increase of $862,833,
or 95%, compared to $910,182 for the nine months ended December 31, 1995.  This
increase reflects the Company's ongoing research and development efforts,
including the addition of new personnel, the operation of the design center in
California, the internal development of a head-mounted display, the
development of a new body-worn computing unit and head mounted display and
planning and development for software toolkits.

         Sales and marketing expenses.  Sales and marketing expenses for the
year ended December 31, 1996 were $1,442,146, an increase of $1,058,186, or
276%, compared to $383,960 for the nine months ended December 31, 1995.  This
increase resulted mainly from increases in personnel, related travel,
infrastructure costs to support sales, VAR training programs, customer service,
additional marketing programs to support the launch of new products, and public
and investor relations efforts, and expenses related to the establishment of a
representative office in Tokyo, Japan and negotiations with potential licensees
in Far East and Europe.





                                      -16-
<PAGE>   17
         General and administrative expenses.  General and administrative
expenses for the year ended December 31, 1996 were $2,158,212, an increase of
$1,240,679, or 135%, compared to $917,533 for the nine months ended December
31, 1995.  The increase reflects personnel costs and related expenses necessary
to support the Company's business infrastructure, the amortization of issuance
costs related to the private placement of the April 1996 Debentures and the
November 1995 Debentures (collectively, the "Debentures"), and an increase in
legal, consulting and travel expenses.

         Interest income (expense), net.  Net interest income for the year
ended December 31, 1996 was $122,693, an increase of $141,235 compared to net
interest expense of ($18,542) for the nine months ended December 31, 1995.
This increase is primarily the result of interest income from the investment of
proceeds from the IPO plus the reversal of $25,000 for interest expense that
was previously accrued for the Debentures but converted into stock upon the
closing of the IPO, offset by $71,750 in interest costs related to the
Debentures and loans of issuance fees for the Debentures.

         Net loss.  As a result of the factors described above, the net loss
for the year ended December 31, 1996 was $5,238,536, an increase of $3,097,346,
or 145% compared to $2,141,190 for the nine months ended December 31, 1995.
Although the Company was subject to taxation during the year ended December 31,
1996 and the nine months ended December 31, 1995, the Company incurred net
losses during these periods and no provision for taxes was made.

LIQUIDITY AND CAPITAL RESOURCES

         Since its inception until the completion of the IPO, the Company
financed its operations from the private sale of its securities, from vendor
credit and from short-term loans received from management, stockholders and
others.

         From October 1994 to August 1995 the Company raised $1,243,476 from
the private sale of shares of Common stock at $6.00 per share.  In November
1995, the Company raised $1,505,000 through the private placement of the
November 1995 Debentures and in April 1996, the Company raised $1,000,000
through the private placement of the April 1996 Debentures.  The Company
received $1,201,718 though the private sale of common stock and $2,143,642 from
the November 1995 Debentures and the April 1996 Debentures net of offering
costs.  Placement fees in respect of the issuances of the Debentures of
$270,500 were carried by the Company as interest-bearing loans and were repaid
from the proceeds of the IPO.  On July 18, 1996, the Company completed the IPO
of its Common stock and realized net proceeds of $10,825,652 after related
expenses.

         For the year ended December 31, 1996, the Company's operating
activities used cash of $5,133,942 compared to $1,400,230 for the nine months
ended December 31, 1995.  The net use of cash during the year ended December
31, 1996 was primarily the result of a $5,238,536 net loss and an increase in
assets of $879,570, offset by a $300,000 licensing fee of which $50,000 was
taken into 1996 revenue, an increase in accounts payable and accrued expenses
of $177,619, depreciation and amortization of $264,699 and a provision for
write-down of inventory of $202,440.  Cash used for investing activities for
the year ended December 31, 1996 was $536,613, primarily the result of $315,257
for the acquisition of property and equipment, $114,618 related to obtaining
and maintaining patents and $106,738 in capitalized tooling costs.  Proceeds
from the Company's financing activities for the year ended December 31, 1996
were $11,436,856 and consisted of $13,282,500 of gross proceeds from the IPO,
$1,000,000 from the issuance of the April 1996 Debentures, and $340,000 from
other notes and loans, offset by payments for issuance costs of $2,561,149
related to the IPO and Debentures and $591,161 in repayment of outstanding
notes and loans.  As a result of the above, cash and cash equivalents on hand
as of December 31, 1996 was $6,274,967, an increase of $5,766,301 from the
$508,666 of cash on hand as of December 31, 1995.

         For the nine months ended December 31, 1995, the Company's operating
activities used cash of $1,400,230.  The use of cash by operations for the nine
months ended December 31, 1995 was primarily the result of a $2,141,190 net
loss and $240,709 of cash used by inventories, offset by $671,500 of non-cash
charges for Common stock issued for services and an increase in accounts
payable and accrued expenses of $334,304.  Cash used by





                                      -17-
<PAGE>   18
investing activities in the nine months ended December 31, 1995 was primarily
$33,958 for the acquisition of property and equipment and $45,998 related to
the acquisition of patents.  Proceeds from the Company's financing activities
in the nine months ended December 31, 1995 consisted primarily of $1,505,000
raised through the sale of the November 1995 Debentures, $247,476 from the
issuance of stock and $325,000 from other notes and loans of $185,924, offset
by $98,608 in deferred financing expenses in connection with the Debentures and
stock issuances and $138,732 in repayment of outstanding notes and loans.

         At December 31, 1996, the Company had no material capital commitments
and working capital of $6,412,314.

         The Company anticipates that its working capital requirements and
operating expenses will increase as the Company expands production and sales of
the Mobile Assistant(R), continues to establish a full sales, service and
marketing function, expands the Company's ongoing research and development
efforts, and develops the support structure for these activities.  The timing
of increases in personnel, research and development expenses, the amount of
working capital consumed by operations and competitive pressures on gross
margins will impact the magnitude and timing of the Company's cash
requirements.  Absent closing any additional financings, the remaining
proceeds from the IPO are currently expected to be sufficient to meet the
Company's working capital needs and operating expenses until at least July
1997.  To meet working capital needs thereafter, the Company intends to use
funds from operations, to obtain a working capital line of credit, and/or
complete additional financings. It is the opinion of the Company's management
that additional funding arrangements are readily available to the Company and
the execution of any such arrangement will depend on timing, market conditions
and the final terms and conditions of such arrangements.  Full production of
the Mobile Assistant(R)II is expected to begin in the quarter ending June 30,
1997 and receivables from sales of the Mobile Assistant(R)II are expected to
provide collateral for borrowing facilities at that point.  Although there can
be no assurance that such facilities will be available, the Company intends to
seek to establish secured borrowing facilities at such time as appropriate
collateral is available.  The Company's management believes that the
combination of cash on hand, operating cash flow, and outside funding will
provide sufficient liquidity to meet the Company's cash requirements until at
least March 1998. However, there can be no assurance that the Company can or
will obtain sufficient funds from operations or from a working capital line of
credit or from closing additional financings on terms acceptable to the
Company.

POSSIBLE IMPACT ON NEAR-TERM REVENUES

         The Company has agreements with third-party suppliers to manufacture
and supply the body-worn computing unit, the head mounted display and the
batteries for the Mobile Assistant(R)II. Full-scale production by these
suppliers is expected to begin in the quarter ending June 30, 1997.  In the
event that the start of full-scale production is delayed for any reason,
revenues for the year ending December 31, 1997 will be adversely affected.

POSSIBLE NON-CASH FUTURE CHARGE

         In connection with the Company's IPO, the representative of the
underwriters for the transaction (the "Representative") has required the
Company's officers, directors and certain other stockholders to deposit an
aggregate of 1,800,000 shares of Common stock, of which 1,707,210 are owned by
directors and officers of the Company, into an escrow account (the "Escrowed
Shares").  The Escrowed Shares will be subject to release to such stockholders
in increments over a three-year period only in the event the Company's gross
revenues and earnings (loss) per share for the 12-month periods ending
September 30, 1997, 1998 and 1999 equal or exceed targets which have been
established through negotiations with the Representative (the "Performance
Targets").  If the Performance Targets are not met in any of the relevant
12-month periods (and the price of the Common stock has not met or exceeded the
price described below), the Escrowed Shares will be cancelled and returned to
the Company in amounts which have been agreed upon between the Representative
and the Company for each period and canceled.  In addition to the foregoing,
all then Escrowed Shares will be released to the stockholders if the closing
price of the Common stock as





                                      -18-
<PAGE>   19
reported on the NASDAQ SmallCap Market following this offering equals or
exceeds $11.00 for 25 consecutive trading days or 30 out of 35 consecutive
trading days during the period ending September 30, 1999.  In the event any
Escrowed Shares held by officers, employees or consultants are released, the
difference between the initial offering price and the market value of such
shares at the time of release will be deemed to be additional compensation
expense to the Company.  If the price of the Common stock at the time of any
release of the Escrowed Shares is greater than the value of the Common stock at
the time of the IPO, an earnings charge could result which would have the
effect of reducing or eliminating any earnings per share and could have a
negative effect on the market price for the Common stock.  The earnings per
share target calculation will be based on the average number of shares issued
and outstanding during each period, but excluding shares issued pursuant to the
Representative's option to purchase units of Common stock and Warrants issued
during the Company's IPO ("Unit") at a price of $9.075 per Unit (165% of the
offering price of the Units) during a period of four years commencing one year
from the closing of the IPO, extraordinary items, or compensation expense
charged to the Company related to the release of the Escrowed Shares.

         Given the expected start of full-scale production in the quarter
ending June 30, 1997, the Company's management believes that it is likely that
the Company's gross revenues and allowable losses will not meet the Performance
Targets for the 12-month period ending September 30, 1997.  Accordingly, the
release of the escrow shares for this period is only likely if the stock price
equals or exceeds $11.00 for 25 consecutive trading days or 30 out of 35
consecutive trading days prior to September 30, 1997.  If conditions are not
met for release from escrow, then 300,000 shares of stock will be returned to
the Company on September 30, 1997 and canceled, resulting in no earnings impact
and a commensurately lower number of outstanding shares.

ITEM 7. FINANCIAL STATEMENTS.

Index to Financial Statements

<TABLE>
<S>                                                                                <C>
Report of Independent Accountants                                                  F-1
Consolidated Balance Sheets - December 31, 1996 and 1995                           F-2
Consolidated Statements of Operations - Year ended December 31, 1996
  and nine months ended December 31, 1995                                          F-3
Consolidated Statements of Stockholders' Equity (Deficit) - Year ended
  December 31, 1996 and nine months ended December 31, 1995                        F-4
Consolidated Statements of Cash Flows - Year ended December 31, 1996
  and nine months ended December 31, 1995                                          F-5
Notes to Financial Statements                                                      F-6
</TABLE>





                                      -19-
<PAGE>   20
                               AUDITOR'S OPINION


                       REPORT OF INDEPENDENT ACCOUNTANTS



To the Board of Directors
  of Xybernaut Corporation and Subsidiary


We have audited the accompanying consolidated balance sheets of Xybernaut
Corporation and Subsidiary (the Company) as of December 31, 1996 and 1995,
and the related consolidated statements of operations, stockholders'
equity (deficit), and cash flows for the year ended December 31, 1996 and the
nine month period ended December 31, 1995.  These financial statements are the
responsibility of the Company's management.  Our responsibility is to express
an opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards.  Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement.  An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements.  An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide reasonable basis
for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Xybernaut
Corporation and Subsidiary as of December 31, 1996 and 1995, and the
consolidated results of their operations and their cash flows for the year
ended December 31, 1996 and the nine month period ended December 31, 1995, in
conformity with generally accepted accounted principles.




McLean, VA
March 31, 1997








                                      F-1

<PAGE>   21



                             XYBERNAUT CORPORATION
                          CONSOLIDATED BALANCE SHEETS


<TABLE>
<CAPTION>
                                                              December 31,          December 31,
                                                                  1996                  1995
                                                              -------------         -------------
<S>                                                             <C>                  <C>
                           ASSETS

Current assets:
   Cash and cash equivalents                                    $ 6,274,967           $   508,666
   Accounts receivable                                              427,790                90,725
   Inventories                                                      402,381               249,950
   Prepaid and other current assets                                 197,711                20,617
                                                              --------------        --------------
               Total current assets                               7,302,849               869,958
                                                              --------------        --------------

Fixed assets:
   Property and equipment, net of accumulated depreciation
               of $126,139 in 1996 and $75,508 in 1995              323,828                88,802
                                                              --------------        --------------


Other assets:
   Patent costs, net of accumulated amortization
               of $82,588 in 1996 and $31,017 in 1995               247,612               184,565
   Debenture issuance costs, net of accumulated amortization
               of $0 in 1996 and $24,815 in 1995                          -               196,542
   Tooling costs                                                    106,738                     -
   Other                                                             33,547                53,671
                                                              --------------        --------------
               Total other assets                                   387,897               434,778
                                                              --------------        --------------
               Total assets                                     $ 8,014,574           $ 1,393,538
                                                              ==============        ==============

                       LIABILITIES AND
               STOCKHOLDERS' EQUITY (DEFICIT)

Current liabilities:
   Notes and loans payable                                      $     7,849           $   263,425
   Accounts payable                                                 250,944               420,801
   Deferred licensing revenue (see note 8)                           60,000                     -
   Accrued expenses                                                 571,742               224,266
                                                              --------------        --------------
               Total current liabilities                            890,535               908,492
                                                              --------------        --------------

Long-term liabilities:
   Notes and loans payable                                           44,080                72,999
   Debentures                                                             -             1,505,000
   Deferred licensing revenue (see note 8)                          190,000                     -
                                                              --------------        --------------
               Total long-term liabilities                          234,080             1,577,999
                                                              --------------        --------------
               Total liabilities                                  1,124,615             2,486,491
                                                              --------------        --------------

Commitments and contingencies
Stockholders' equity (deficit):
   Common stock, $.01 par value                                     142,591               103,725
     Authorized: 30,000,000 shares in 1996 and
     16,001,500 in 1995
     Issued: 14,259,112 shares in 1996 and
     10,372,489 in 1995
   Additional paid-in capital                                    15,520,245             2,337,663
   Accumulated deficit                                           (8,772,877)           (3,534,341)
                                                              --------------        --------------
               Total stockholders' equity (deficit)               6,889,959            (1,092,953)
                                                              --------------        --------------
               Total liabilities and stockholders'
                 equity (deficit)                               $ 8,014,574           $ 1,393,538
                                                              ==============        ==============
</TABLE>

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

                                      F-2
<PAGE>   22

                             XYBERNAUT CORPORATION
                     CONSOLIDATED STATEMENTS OF OPERATIONS


<TABLE>
<CAPTION>
                                                               Year ended        Nine months ended
                                                              December 31,          December 31,
                                                                  1996                  1995
                                                            ----------------     -----------------
<S>                                                           <C>                   <C>
Revenue:
   Product sales and leases                                   $     928,732         $     227,793
   Consulting and license                                           164,609               124,855
                                                            ----------------     -----------------
               Total revenue                                      1,093,341               352,648

Cost of sales                                                     1,081,197               263,621
                                                            ----------------     -----------------
               Gross margin                                          12,144                89,027

Operating expenses:
   Sales and marketing                                            1,442,146               383,960
   General and administrative                                     2,158,212               917,533
   Research and development                                       1,773,015               910,182
                                                            ----------------     -----------------
               Total operating expenses                           5,373,373             2,211,675
                                                            ----------------     -----------------

               Operating loss                                    (5,361,229)           (2,122,648)

Interest income (expense), net                                      122,693               (18,542)
                                                            ----------------     -----------------

               Net loss                                       $  (5,238,536)        $  (2,141,190)
                                                            ================     =================

Net loss per common and common equivalent
  shares outstanding                                          $       (0.47)        $       (0.21)
                                                            ================     =================

Weighted average number of common and
  common equivalent shares outstanding                           11,121,594             9,993,120
                                                            ================     =================
</TABLE>



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


                                      F-3

<PAGE>   23
                             XYBERNAUT CORPORATION
           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)

<TABLE>
<CAPTION>
                                     Xybernaut        Tech Virginia         CPSI
                                   -------------      -------------     -------------
                                                                                                 Total
                                     Number of         Number of         Number of             number of
                                    common stock      common stock      common stock          common stock
                                       shares            shares            shares                shares
                                   -------------      -------------     -------------        -------------
<S>                                 <C>                   <C>            <C>                   <C>
Balance, March 31, 1995                    -                 300          10,176,000           10,176,300
Shares issued                              -                 -                41,246               41,246
Shares issued for
   services and
   incentives                              -                 -               154,943              154,943
Net loss                                   -                 -                   -                    -
                                   -------------      -------------     -------------        -------------

Balance, December 31, 1995                 -                 300          10,372,189           10,372,489
Merger between Xybernaut
   and CPSI                         10,372,789               -           (10,372,789)                 -
Shares issued pursuant
   to IPO                            2,415,000               -                   -              2,415,000
Shares issued pursuant
   to conversion of
   debentures                        1,431,427               -                   -              1,431,427
Shares issued pursuant
   to redemption of
   warrants                             20,000               -                   -                 20,000
Shares issued for
   services and
   incentives                           19,896               -                   600               20,496
Acquisition of Tech Virginia               -                (300)                -                   (300)
Net loss                                   -                 -                   -                    -
                                   -------------      -------------     -------------        -------------

Balance, December 31, 1996          14,259,112               -                   -             14,259,112
                                   =============      =============     =============        =============
</TABLE>


<TABLE>
<CAPTION>
                                        Total
                                      value of            Additional                                Total
                                    common stock           paid-in           Accumulated        stockholders'
                                       shares              capital             deficit             equity
                                   -------------       -------------        -------------      -------------
<S>                                  <C>                <C>                 <C>                <C>
Balance, March 31, 1995               $101,763          $ 1,317,434         $(1,393,151)       $    26,046
Shares issued                              412              247,064                 -              247,476
Shares issued for
   services and
   incentives                            1,550              773,165                 -              774,715
Net loss                                   -                    -            (2,141,190)        (2,141,190)
                                   -------------       -------------        -------------      -------------

Balance, December 31, 1995            $103,725            2,337,663          (3,534,341)        (1,092,953)
Merger between Xybernaut
   and CPSI                                -                    -                   -                 -
Shares issued pursuant
   to IPO                               24,150           10,818,337                 -           10,842,487
Shares issued pursuant
   to conversion of
   debentures                           14,314            2,290,244                 -            2,304,558
Shares issued pursuant
   to redemption of
   warrants                                200               34,800                 -               35,000
Shares issued for
   services and
   incentives                              205               89,201                 -               89,406
Acquisition of Tech Virginia                (3)             (50,000)                -              (50,003)
Net loss                                   -                    -            (5,238,536)        (5,238,536)
                                   -------------       -------------        -------------      -------------

Balance, December 31, 1996            $142,591          $15,520,245         $(8,772,877)       $ 6,889,959
                                   =============       =============        =============      =============
</TABLE>

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

                                      F-4

<PAGE>   24





                             XYBERNAUT CORPORATION
                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                      Year ended             Nine months ended
                                                                     December 31,                December 31,
                                                                         1996                       1995
                                                                 ------------------          -----------------
<S>                                                                <C>                        <C>
Cash flows from operating activities:
   Net loss                                                        $   (5,238,536)            $   (2,141,190)

   Adjustments to reconcile net loss to net cash
    used in operating activities:
      Depreciation and amortization                                       264,699                     87,795
      Provision for write-down of inventory                               202,440                          -
      Noncash charges for stock and options
        issued for services                                                89,406                    671,500
      Increase in assets:
        Inventories                                                      (354,871)                  (240,709)
        Accounts receivable                                              (337,065)                   (73,891)
        Prepaid and other current assets                                 (177,094)                   (14,623)
        Other assets                                                      (10,540)                   (23,416)
      Increase in liabilities:
        Accounts payable and accrued expenses                             177,619                    334,304
        Deferred licensing revenue                                        250,000                          -
                                                                 ------------------          -----------------
         Net cash used in operating activities                         (5,133,942)                (1,400,230)
                                                                 ------------------          -----------------

Cash flows from investing activities:
   Acquisition of property and equipment                                 (315,257)                   (33,958)
   Acquisition of patents and related costs                              (114,618)                   (45,998)
   Capitalization of tooling costs                                       (106,738)                         -
                                                                 ------------------          -----------------
         Net cash used in investing activities                           (536,613)                   (79,956)
                                                                 ------------------          -----------------

Cash flows from financing activities:
   Proceeds from:
      Issuance of stock                                                         -                    247,476
      Initial public offering                                          13,282,500                          -
      Debentures                                                        1,000,000                  1,505,000
      Notes and loans                                                     340,000                    325,000
   Payments for:
      Notes and loans                                                    (591,161)                  (139,076)
      Acquisition of Tech Virginia (see note 2)                           (33,334)                         -
      Intial public offering & debenture fees                          (2,561,149)                   (70,857)
      Common stock issuance costs                                               -                    (27,751)
                                                                 ------------------          -----------------
         Net cash provided by financing activities                     11,436,856                  1,839,792
                                                                 ------------------          -----------------

Net increase in cash and cash equivalents                               5,766,301                    359,606

Cash and cash equivalents, beginning of period                            508,666                    149,060
                                                                 ------------------          -----------------

Cash and cash equivalents, end of period                           $    6,274,967             $      508,666
                                                                 ==================          =================
</TABLE>





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

                                      F-5

<PAGE>   25



                             XYBERNAUT CORPORATION

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  ORGANIZATION AND BUSINESS ACTIVITY:

THE COMPANY:

  Xybernaut Corporation (the "Company") was originally incorporated in Virginia
in October 1990 as Contemporary Products & Services, Inc. and changed its name
to Computer Products & Services, Inc. ("CPSI") in 1992.  In April 1996, the
Company was merged with Xybernaut Corporation to change the Company name and
reincorporate in Delaware.  Since the commencement of operations in November
1992, the Company has engaged in the research, development and
commercialization of products intended to bridge the widening gap between
people and knowledge. The first product to be commercialized by the Company is
the proprietary portable computer technology and related software applications
embodied in its Mobile Assistant(R) product. Additional software products are
planned for development and use on the Mobile Assistant(R) and other personal
computers.

  On July 18, 1996, the Company successfully completed the Initial Public
Offering ("IPO") of its  common stock and warrants (NASDAQ symbol XYBR and
XYBRW) which are traded on the NASDAQ SmallCap Market.

  The Company was a development stage enterprise through March 31, 1995.
Subsequently, the Company has commenced principal operations and, accordingly,
these financial statements are not presented in compliance with Statement of
Financial Accounting Standard No. 7 which describes the financial presentation
for development stage enterprises.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

FISCAL YEAR:

  In connection with its IPO, the Company changed from a fiscal year ending
March 31 to a fiscal year ending December 31, effective December 31, 1995.  As
a result, these financial statements include consolidated operations for the
twelve months ended December 31, 1996 and for the nine months ended December
31, 1995.

PRINCIPLES OF CONSOLIDATION:

  The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiary, Tech International of Virginia Inc. ("Tech
Virginia").  In connection with the IPO, the Company exercised its option to
acquire all of the capital stock of Tech Virginia.  Financial statements prior
to the exercise of the option reflect the combined financial position and
results of operations of the Company and Tech Virginia.  All significant
intercompany accounts and transactions have been eliminated.

CASH AND CASH EQUIVALENTS:

  The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents.

INVENTORIES:

  Inventories, consisting principally of component parts held for resale, are
stated at the lower of cost or market, with cost determined by the first-in,
first-out method.  As of December 31, 1996 and 1995, the allowance to reduce
inventory  balances to net realizable value was $202,440 and $0, respectively.





                                      F-6
<PAGE>   26
PROPERTY, EQUIPMENT, FURNITURE AND FIXTURES:

  Property, equipment, furniture and fixtures are stated at cost and are
depreciated on a straight-line basis over the estimated useful lives of the
assets, as follows:

<TABLE>
 <S>                                       <C>
 Equipment .............................   3-5 years
 Furniture and fixtures ................   5 years
 Demonstrator units ....................   2 years
 Leasehold improvements ................   3 years
</TABLE>

  Expenditures for maintenance and repairs are charged directly to the
appropriate operating account at the time the expense is incurred. Expenditures
determined to represent additions and betterments are capitalized.

SOFTWARE DEVELOPMENT COSTS:

  The Company's policy is to capitalize software development costs when
technological feasibility has been established, based on a detailed program
design that is complete, has been confirmed and for which no high-risk
development issues remain.

  The establishment of technological feasibility and the ongoing assessment of
the recovery of capitalized software costs requires considerable judgment by
management with respect to certain external factors including, but not limited
to, technological feasibility, anticipated future gross revenues, estimated
economic life and changes in software and hardware technologies.
Capitalization of software costs will cease when the software is available for
general release to customers, at which time amortization of the costs begins.
These costs will be amortized using the greater of the amount computed using
the straight-line method over the remaining estimated economic life of the
product or the ratio of current gross revenues from the product to the total of
current and anticipated future gross revenues from the product. Since the
Company is currently in the planning and development phase for software
toolkits, no costs have been capitalized to date.

INTANGIBLE ASSETS:

  Patent costs consist of legal fees, filing fees and other direct costs
incurred in obtaining and maintaining patents and are amortized on a
straight-line basis over a five-year period.

TOOLING COSTS:

  Tooling costs consist of reimbursed expenses to third-party vendors for molds
to be used exclusively in the manufacturing of the Company's proprietary
head-mounted display ("HMD") and the computing unit for the Mobile Assistant(R)
II.  Capitalized tooling costs will be transferred to inventory based on the
estimated total number of HMDs and computing units to be produced from the
molds.  No costs have been transferred to inventory as of December 31, 1996.

IMPAIRMENT OF LONG-LIVED ASSETS:

  Management of the Company monitors the carrying value of long-lived assets
for potential impairment on an on-going basis.  Potential impairment would be
determined by comparing the carrying value of these assets with their related,
expected future net cash flows. Should the sum of the related, expected future
net cash flows be less than the carrying value, management would determine
whether an impairment loss should be recognized. An impairment loss would be
measured by the amount by which the carrying value of the asset exceeds the
future discounted cash flows.

REVENUE RECOGNITION AND WARRANTIES:

  Product sales are recorded on shipment pursuant to a valid customer purchase
order. For equipment shipped under equipment rental or leasing agreements,
revenue is recognized on a straight-line basis over the term of the rental or
lease agreement. Consulting revenue is recognized as the services are performed
pursuant to a written agreement with the client. The Company generally provides
a 90 day warranty on parts and labor and a one year warranty on parts. The
Company's suppliers for the computing unit and the head mounted display provide
the Company with similar warranties and as a result warranty reserves are
immaterial.





                                      F-7
<PAGE>   27
RESEARCH AND DEVELOPMENT PROGRAMS:

  Research and development costs are charged to operations as incurred,
including the cost of components purchased for testing and product development
that are saleable but are intended for development work only.

INCOME TAXES:

  Deferred income tax assets and liabilities are computed annually for
differences between the financial statement and income tax bases of assets and
liabilities that will result in taxable or deductible amounts in the future.
Such deferred income tax asset and liability computations are based on enacted
tax laws and rates applicable to periods in which the differences are expected
to affect taxable income.  Income tax expense is the tax payable or refundable
for the period plus or minus the change during the period in deferred income
tax assets and liabilities.

NET LOSS PER COMMON AND COMMON EQUIVALENT SHARES:

  The net loss per common and common equivalent share is based on the weighted
average number of common and common equivalent shares outstanding during the
period. All stock issuances within one year prior to the Company's initial
public offering have been included in the calculation of common equivalent
shares outstanding as if they were outstanding for all periods presented, using
the treasury stock method assuming the common stock value in a Unit (see note
5) was $5.00.

ESCROWED SHARES

  Escrowed shares, if any, are considered issued and outstanding and reported
as such on the balance sheet.  For purposes of computing the net loss per
common and common equivalent share, they are not considered outstanding until
the conditions for their release are met.

FAIR VALUE OF FINANCIAL INSTRUMENTS:

  The carrying amounts of financial instruments including cash and cash
equivalents, accounts receivable and accounts payable approximated fair value
as of December 31, 1996 and 1995, because of the relatively short maturity of
these instruments. The carrying value of the notes and loans payable and the
debentures approximated fair value as of December 31, 1996 and 1995, based upon
market prices for the same or similar debt issues.

ACCOUNTING STANDARDS ISSUED

  The Financial Accounting Standards Board has issued Statement of Financial
Accounting Standards No. 125 ("SFAS 125") regarding accounting and reporting
for transfers and servicing of financial assets and extinguishments of
liabilities.  Under SFAS 125, after transfer of financial assets, an entity
recognizes the financial and servicing assets it controls and the liabilities
it has incurred, derecognizes financial assets when control has been
surrendered, and derecognizes liabilities when extinguished.  This statement
provides consistent standards for distinguishing transfers of financial assets
that are sales from transfers that are secured borrowings and is effective for
transactions occurring after December 31, 1996.

  In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 128 ("SFAS 128"), "Earnings per share",
effective for fiscal years ending after December 15, 1997.  SFAS 128 replaces
the presentation of primary earnings per common share ("EPS") with basic EPS,
with the principal difference being common stock equivalents are not considered
in computing basic EPS.  SFAS 128 also eliminates the modified treasury stock
method, and requires the reconciliation of the numerator and denominator used
in computing basic and diluted EPS.  The Company has not yet determined the
effect of SFAS 128 on the Company's EPS, but expects that the affect will not
be material.





                                      F-8
<PAGE>   28





USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS:

  The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.

RECLASSIFICATIONS:

  Certain items in the 1995 financial statements have been reclassified to
conform to 1996 presentation for consistency purposes.

3.  PROPERTY AND EQUIPMENT:

  Property and equipment consists of the following:



<TABLE>
<CAPTION>
                                                          DECEMBER 31,            DECEMBER 31,
                                                             1996                     1995
                                                          ------------            ------------
 <S>                                                      <C>                       <C>
 Equipment ......................................         $  227,068                $  75,660
 Furniture and fixtures .........................             44,814                   22,191
 Demonstrator units .............................             53,144                   29,600
 Leasehold improvements .........................            124,941                   36,859
                                                          -----------               ----------
                                                             449,967                  164,310
 Less accumulated depreciation ..................           (126,139)                 (75,508)
                                                          -----------               ----------
                                                          $  323,828                $  88,802
                                                          ===========               ==========
</TABLE>

  Depreciation expense for the year ended December 31, 1996 and for the nine
months ended December 31, 1995 was $80,231 and $37,227, respectively. For the
year ended December 31, 1996, fully depreciated demonstrator units for $29,600
and the related accumulated depreciation were eliminated.

4.  DEBT:

  Effective November 17, 1995, the Company sold $1,505,000 principal amount of
7% Convertible Debentures due in 1997 (the "November 1995 Debentures") and paid
a placement fee of 10% to the placement agent in the form of an
interest-bearing promissory note due at the time of the IPO.  On April 16,
1996, the Company sold $1,000,000 principal amount of 7% Convertible Debentures
due in 1997 (the "April 1996 Debentures") and paid a placement fee of 12% to
the placement agent in the form of an interest-bearing promissory note due at
the time of the IPO.

  Under the terms of these debentures, the Company had the right to redeem all
debentures, at a price equal to 105% of principal, plus accrued interest, if
the IPO had not occurred within one year after the closing date.  The November
1995 Debentures and the April 1996 Debentures were to convert into Units (see
note 5) upon a successful IPO by the Company at the rate of one Unit for each
$1.75 in principal.  The November 1995 Debentures and the April 1996 Debentures
were converted into 1,431,427 Units on July 18, 1996, concurrent with the
Company's IPO.

5.  STOCKHOLDERS' EQUITY:

INITIAL PUBLIC OFFERING

  On July 18, 1996, the Company completed its IPO and sold 2,415,000 Units at a
price of $5.50 per Unit.  Each Unit consisted of one share of common stock and
one warrant to purchase a share of common stock at $9.00 ("Unit").  Gross
proceeds from the sale of the Units were $13,282,500 and net proceeds after
expenses were $10,842,487.





                                      F-9
<PAGE>   29


  At the completion of the offering, the underwriter received an option to
purchase 210,000 Units at a price equal to 165% of the unit offering price per
unit during a period of four years commencing one year from  July 18, 1996.

  In connection with this offering, the Company's officers and directors and
certain stockholders deposited an aggregate of 1,800,000 shares of common stock
of the Company in an escrow account ("Escrowed Shares"). The common stock in
the escrow account is subject to release to such stockholders in increments
over a three year period only in the event the Company's gross revenues and
earnings (loss) per share for the twelve month periods ending September 30,
1997, 1998 and 1999 meet or exceed certain performance targets. If the
performance targets are not met in any of the twelve month periods ending
September 30, 1997, 1998, or 1999, the Escrowed Shares will be returned to the
Company.  In addition to the foregoing, all Escrowed Shares will be released to
the shareholders if certain stock price targets are met.  The market value of
any Escrowed Shares held by officers, employees or consultants at the time they
are released will be deemed to be additional compensation expense to the
Company.

REINCORPORATION

  On January 25, 1996, the shareholders of CPSI approved the exchange of their
common stock for shares of Xybernaut Corporation, a Delaware Corporation, on a
one-for-one basis to change the Company name and reincorporate in Delaware.
All references in the consolidated financial statements, including the number
of shares and per share amounts, have been retroactively adjusted.  The Company
completed this exchange in April 1996 prior to the completion of the IPO.
Additionally, 30,000,000 shares of common stock and 5,000,000 shares of
preferred stock of Xybernaut Corporation have been authorized.  No such shares
were issued or outstanding at December 31, 1995.

OUTSTANDING COMMON STOCK:

  The Company's outstanding common stock is summarized below:

<TABLE>
<CAPTION>
                                                                              NUMBER OF SHARES ISSUED
                                                     DEC 31, 1995                 AND OUTSTANDING
                                                    -------------            -------------------------
                                                         NUMBER
                                       PAR VALUE       OF SHARES             DECEMBER 31, DECEMBER 31,
                                       PER SHARE       AUTHORIZED                1995         1996
                                    -------------    ------------            -----------  ------------

 <S>                                       <C>        <C>                       <C>              <C>
 Computer Products & Services Inc.:
   Class A ............................    $0.01      15,000,000                9,867,326        ---
   Class B ............................    $0.01       1,000,000                  504,863        ---
 Tech International of Virginia, Inc...    $0.01           1,500                      300        ---

</TABLE>



<TABLE>
<CAPTION>
                                                                              NUMBER OF SHARES ISSUED
                                                   DEC 31, 1996                   AND OUTSTANDING
                                                   ------------              -------------------------
                                                       NUMBER
                                       PAR VALUE     OF SHARES               DECEMBER 31,   DECEMBER 31,
                                       PER SHARE     AUTHORIZED                  1995           1996
                                     ------------   -----------              -----------   ------------

 <S>                                     <C>         <C>                        <C>        <C>
 Xybernaut Corporation:
   Common stock .......................    $0.01     30,000,000                  ---         14,259,112
   Preferred stock ....................   no par      5,000,000                  ---                ---
</TABLE>


  Class A and Class B shares of CPSI were identical except that Class B
shares were nonvoting.

  Under the terms of the Company's Articles of Incorporation, the Board of
Directors may determine the rights, preferences, and terms of the Company's
authorized but unissued shares of preferred stock.

  During the nine months ended December 31, 1995, the Company issued 41,246
Class A shares and 154,943 Class B shares. The Class A shares issued were
pursuant to private placement offerings at $6.00 per share and the Class B
shares were issued as incentives to consultants, two of whom are also board
members. For financial reporting purposes, the Class B shares were valued at
$5.00 per share and operations were charged a total of $774,715 to account for
the issuance of these shares.



                                      F-10
<PAGE>   30


  During the year ended December 31, 1996, the Company issued 19,896 shares of
common stock in exchange for services provided by either employees or
independent contractors.  For financial reporting purposes, these shares were
valued at an average of $4.49 per share and operations were charged a total of
$89,406 to account for the issuance of these shares.

OUTSTANDING WARRANTS:

  At December 31, 1996, outstanding warrants pursuant to the IPO were 2,415,000
and outstanding warrants pursuant to the conversion of the November 1995
Debentures and the April 1996 Debentures were 1,431,427.  These 3,846,427
warrants entitle the holder to purchase one share of the Company's common stock
at an exercise price of $9.00 and expire on July 17, 1999.  For the year ended
December 31, 1996, 110,000 warrants were issued to consultants for services to
be rendered. These warrants allow the holder to purchase one share of the
Company's common stock at an exercise price of between $4.25 and $6.00, which
were at least equal to the fair market value of the common stock at date of
grant.

6.  STOCK OPTIONS:

  On April 18, 1996, the Board of Directors approved, effective January 1,
1996, the Company's 1996 Omnibus Stock Incentive Plan (the "Plan"). Under the
Plan, the Company has reserved 650,000 shares of common stock for issuance of
both incentive and non-qualified options, restricted stock awards and stock
appreciation rights ("SARs"). The Plan is administered by the Compensation
Committee of the Board of Directors.  The Company will seek approval from its
stockholders to establish an additional stock option plan that will reserve
1,000,000 shares of common stock for issuance of both incentive and
non-qualified options, restricted stock awards and SARs at the May 7, 1997
annual meeting of shareholders.  Additional options above the maximum 650,000
have been granted contingent on such approval.  Options under this plan become
exercisable, beginning one year after the date granted, in five equal annual
installments.  No option may be granted at a price less than the stock's fair
market value on the date of the grant.

  Prior to the approved Plan, the Company's Board of Directors approved 250,000
of non-Plan stock options which become exercisable, beginning one year after
the date granted, in five equal annual installments.

   Information on options is as follows:

<TABLE>
<CAPTION>
                                                         SHARES
                                                          UNDER             RANGE OF
                                                         OPTION         EXERCISE PRICES
                                                        --------        ---------------
 <S>                                                   <C>         <C>
 Outstanding at March 31, 1995....................       250,000       $            .01
 Granted..........................................       305,530                   6.00
                                                        --------       ----------------
 Outstanding at December 31, 1995.................       555,530               .01-6.00
 Granted..........................................       542,000             2.00-12.00
 Canceled.........................................      (103,600)                  6.00
                                                        --------       ----------------
 Outstanding at December 31, 1996.................       993,930       $      .01-12.00
                                                        ========       ================
</TABLE>

  As of December 31, 1996, a total of 162,106 options were exercisable and no
options had been exercised.  The weighted average exercise price for the
options granted during 1996 was $6.46.

  In October 1995, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS No. 123") effective for fiscal years beginning after
December 15, 1995.  SFAS No. 123 established financial accounting and reporting
standards for stock-based compensation plans.  The Company has adopted the
disclosure-only provisions of SFAS No. 123.  In accordance with the provisions
of SFAS No. 123, the Company applies APB Opinion 25 and related interpretations
in accounting for its Plan and, accordingly, does not recognize compensation
expense.



                                      F-11
<PAGE>   31


  Had compensation expense for the Company's plan been determined based on the
fair value at the grant date for awards in 1996 and 1995 consistent with the
provisions of SFAS No. 123, the Company's net loss and net loss per common and
common equivalent shares outstanding would have been the pro forma amounts
indicated below:

<TABLE>
<CAPTION>
                                                 YEAR ENDED            NINE MONTHS ENDED
                                               DECEMBER 31,              DECEMBER 31,
                                                   1996                     1995
                                           -----------------           -------------
 <S>                                       <C>                         <C>
 Net loss - as reported ..................  $  (5,238,536)             $  (2,141,190)
 Net loss - pro forma ....................  $  (5,508,736)             $  (2,211,590)
 Net loss per share - as reported ........  $        (.47)             $        (.21)
 Net loss per share - pro forma ..........  $        (.50)             $        (.22)
                                            --------------             --------------
</TABLE>

  The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option-pricing model with the following weighted-average
assumptions used for grants in 1996 and 1995: dividend yield of 0%; expected
volatility of 60%; risk-free interest rate of 5.92% in 1996 and 6.63% in 1995;
and expected lives of 3 years.

7.  SIGNIFICANT CUSTOMERS:

  The percentages of total revenue from sales to customers in excess of 10% of
the total for each period were as follows:

<TABLE>
<CAPTION>
                     YEAR ENDED      NINE MONTHS ENDED
                    DECEMBER 31         DECEMBER 31,
                        1996                1995
                    -----------      -----------------
 <S>                     <C>             <C>
 Customer A ...........   64%             15%
 Customer B ...........   24%
 Customer C ...........                   18%
 Customer D ...........                   19%
</TABLE>


8.  LICENSING AGREEMENT:

  In March 1996, the Company entered into a non-exclusive five-year licensing
agreement with Rockwell International.  Pursuant to this agreement, the Company
was granted a price reduction of $1,395,000 related to a purchase order issued
in 1995 and received an initial cash payment of $300,000 that was recorded as
deferred licensing revenue and is being recognized as revenue on a
straight-line basis over the five year term.  Revenue of  $50,000 related to
this licensing agreement was recognized for the year ended December 31, 1996.

9.  INCOME TAXES:

  For the year ended December 31, 1996 no income tax benefit has been provided
because the losses could not be carried back and realization of the benefit of
the net operating losses carried forward was not assured.

  At December 31, 1996, the Company has approximately $7,266,000 of net
operating loss carryforwards for federal income tax purposes. These losses
expire in 2012. The use of these carryforwards may be limited in any one year
under Internal Revenue Code Section 382 if significant ownership changes occur
in the future.

   Net deferred tax assets are comprised of the following:

<TABLE>
<CAPTION>
                                                 DECEMBER 31,     DECEMBER 31,
                                                    1996              1995
                                                 ------------     ------------
 <S>                                            <C>               <C>
 Excess of book over tax depreciation .......   $    30,000       $  (1,000)
 Net operating loss carryforwards ...........     2,758,000         830,000
 Adjustment to accrual basis of accounting ..        56,000          84,000
 Accrued vacation ...........................        11,000             ---
 Deferred revenue ...........................        95,000             ---
 Tax credit carryforwards ...................        63,000          30,000
 Less valuation allowance ...................    (3,013,000)       (943,000)
                                                ------------      ----------
   Net deferred tax asset ...................           ---             ---
                                                ============      ==========
</TABLE>





                                      F-12
<PAGE>   32
10.  COMMITMENTS AND CONTINGENCIES:

LEASE COMMITMENTS:

  During 1994 and 1995, the Company began leasing its operating facilities and
certain equipment under various operating leases expiring on various dates
through 2001. Future minimum payments under noncancelable operating leases at
December 31, 1996 are:

<TABLE>
<CAPTION>
     YEAR ENDING DECEMBER 31,
     ------------------------
          <S>                                           <C>
          1997 ......................................... $262,018
          1998 .........................................   73,822
          1999 .........................................   52,964
          2000 .........................................    7,917
          2001 .........................................    1,863
</TABLE>

  Total rental expense charged to operations for the year ended December 31,
1996 and for the nine months ended December 31, 1995 was $202,812 and $135,075,
respectively.

PURCHASE AGREEMENTS:

  The Company has agreements with certain suppliers to purchase specialized
parts and components necessary to produce the Mobile Assistant(R). Failure of
any of these parties to comply with the terms and conditions of existing
agreements could adversely affect the Company's ability to complete and deliver
Mobile Assistant(R) units.

PATENTS:

  The Company considers its patents, trade secrets, and other intellectual
property and other proprietary information to be an important factor in its
business prospects. In September 1995, the Company received a notification from
the United States Patent and Trademark Office ("PTO") entitled "office action
in re-examination" which indicated that the Company's claims under its existing
patent for the Mobile Assistant(R) were subject to re-examination and had been
preliminary rejected. During 1996, this preliminary rejection was overturned.
In April 1996 a second re-examination request was filed with the PTO.  Based
upon the advice of its patent counsel, who also is a director of the Company,
the Company believes that the re-examination will not result in any adverse
action with respect to the patent. In October 1995, the Company filed a patent
application covering additional embodiments and extensions of the technologies
used in the Mobile Assistant(R).  In addition, eight additional patent
applications have been filed with the PTO since the Company's IPO.

11.  RELATED PARTY TRANSACTIONS:

  In April 1995 a shareholder exercised an option to purchase 510,000 shares of
Class A Common Stock directly from the Company's President and majority
stockholder under an agreement dated February 28, 1994. These shares were
purchased at $0.05 per share.

  The Company uses a director of the Company as its Patent Counsel. The Company
paid cash of $93,250 in 1996 and paid cash or issued stock of $135,904 in 1995
for services performed by its Patent Counsel.

12.  CONCENTRATION OF CREDIT RISK ARISING FROM CASH DEPOSITS:

  The Company's December 31, 1996 cash and cash equivalent balance includes
approximately $2 million of cash invested in a pool of United States Government
and Agency Securities.  The amount in excess of insurance provided by the
Federal Deposit Insurance Company is approximately $1.9 million.





                                      F-13
<PAGE>   33




13.  SUPPLEMENTAL CASH FLOW DISCLOSURES:

  During the nine months ended December 31, 1995, the Company incurred a note
payable of $150,500 related to costs of issuing the November 1995 Debentures.
During the year ended December 31, 1996, the Company received loans of $220,000
from a financial institution secured by Company assets, and $120,000 from two
April 1996 Debenture holders.  These loans, as well as the $150,500 note
payable incurred during the nine months ended December 31, 1995, were repaid at
the time of the IPO.

  During 1996, the Company acquired Tech Virginia for $50,000, of which $33,334
was paid in cash and $16,666 remains as a note payable at December 31, 1996.

  During the nine months ended December 31, 1995, the Company issued $103,725
of Class B common stock for services provided in connection with patents and
$670,990 of Class B common stock for other services and incentives. During
1996, the Company issued $89,406 of common stock for services provided by
either employees or independent contractors.

  During 1996, the Company's cash payments for interest totaled $71,750.

14.  FINANCING ARRANGEMENTS:

  The present cash balances of the Company are expected to be sufficient to
meet the Company's current cash needs until July 1997.  The Company has
received several offers of financing for up to $10 million and is in the
process of negotiating the terms of those financings.  The company has also
received a financing commitment, on terms satisfactory to the Company and
subject only to satisfactory documentation, from a funding source for an amount
ranging from $3.0 to $3.4 million of gross proceeds.  This commitment expires
on April 30, 1997.  It is the opinion of the Company's management that
such funding arrangements are readily available to the Company and the
execution of any such arrangements is a decision that will depend on timing,
market conditions and the final terms and conditions of such arrangements.
Production of the Mobile Assistant(R) II is expected to begin in the quarter
ending June 30, 1997, and receivables from sales of the Mobile Assistant(R) II
are expected to provide collateral for borrowing facilities at that point.
Although there can be no assurance that such facilities will be available, the
Company intends to seek to establish secured borrowing facilities at such time
as appropriate collateral is available.  The company's management believes that
the combination of cash on hand, operating cash flows, and outside funding will
provide sufficient liquidity to meet the Company's cash requirements until at
least March 1998.





                                      F-14

<PAGE>   34

ITEM 8.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
           FINANCIAL DISCLOSURE.

           None.
                                    PART III

ITEM 9.         DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS,
                COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT.

DIRECTORS AND EXECUTIVE OFFICERS

           The directors and executive officers of the Company are as follows:

<TABLE>
 Name                                      Age     Position
 ----                                      ---     --------
 <S>                                       <C>     <C>
 Edward G. Newman                          53      President, Chief Executive Officer and Chairman of
                                                   the Board of Directors
 John F. Moynahan                          39      Senior Vice President, Chief Financial Officer,
                                                   Treasurer and Director
 John W. Williams                          54      Senior Vice President and Chief Operating Officer
 Lt. Gen. Harry E. Soyster (Ret.)(1)       61      Director
 James J. Ralabate, Esq.                   69      Secretary and Director
 Keith P. Hicks, Esq.(2)                   74      Director
 Steven A. Newman, M.D. (1)(2)             51      Director
 Phillip E. Pearce (1)(2)                  68      Director
 Jacques Rebibo                            57      Director
 Eugene J. Amobi                           52      Director
</TABLE>

----------
(1)      Member of the Compensation Committee.
(2)      Member of the Audit Committee.

         Officers are appointed by and served at the discretion of the Board of
Directors.  Each director holds office until the next annual meeting of
stockholders or until a successor has been duly elected and qualified.

         Edward G. Newman has been the Company's President since March 1993,
Chief Executive Officer and Chairman of the Board of Directors since December
1994, and a director since 1990.  Mr. Newman served as Treasurer of the Company
from 1993 to 1994.  From 1984 to 1992 Mr. Newman was President of ElectroTech
International Corporation, a software consulting firm. From 1973 to 1981 Mr.
Newman was employed by Xerox Corporation in several management positions in
office systems strategy, legal systems and international financial systems.
Mr. Newman served with the Central Intelligence Agency from 1966 to 1972.  Mr.
Newman also has been an Executive Vice President of Tech International since
1990, and a director and Chief Executive Officer of Tech Virginia since 1994.
See "Certain Transactions." Mr. Newman is a graduate of the University of
Maryland (B.A. 1971) and the University of New Haven (M.B.A.  1984).  Mr.
Newman is the brother of Steven A. Newman, M.D., a director of the Company.

         John F. Moynahan joined the Company in October 1994, has served as a
director since January 1995 and currently serves as the Company's Senior Vice
President, Chief Financial Officer and Treasurer.  From 1992 to 1994 Mr.
Moynahan was Vice President and Treasurer of Joy Technologies Inc., a
publicly-traded machinery and pollution control equipment manufacturer.  From
1990 to 1992 he was Vice President and Chief Financial Officer of Sym-Tek
Systems, Inc., a publicly-traded high technology company.  Prior to that time,
Mr. Moynahan was Treasurer of Fisher Scientific Group, Inc., a publicly-traded
medical, health and research equipment manufacturer and distributor.  Mr.
Moynahan is a graduate of Colgate University (B.A. 1979) and New York
University (M.B.A. 1982).

         John W. ("Wes") Williams joined the Company in May 1996 and currently
serves as the Company's Senior Vice President and Chief Operating Officer.
From 1994 to 1996, Mr. Williams was Director of Advanced Concepts of the CACD
Division of Rockwell International, and from 1991 to 1994 he was Director of
Programs of Tecom



                                      -20-
<PAGE>   35
Industries, a subsidiary of Tech-Sym Corporation. Prior to 1991, Mr. Williams
served as International Marketing Manager, Deputy Director of Navigation
Systems Engineering and Avionics Integration Manager for Magnavox Advanced
Products and Systems Company.  Mr.  Williams is a graduate of California State
University (B.S. 1980, M.B.A., 1982).

         Lt. Gen. Harry E. Soyster (Ret.) has been a director of the Company
since January 1995.  He is currently Director of Washington Operations and Vice
President of International Operations of Military Professional Resources,
Incorporated. From 1988 until his retirement in 1991, Lieutenant General
Soyster (Ret.) was the Director of the United States Defense Intelligence
Agency.  Prior to that time, he was Commander of the United States Army
Intelligence and Security Command and a Deputy Assistant Chief of Staff for
Intelligence, Department of the Army.  Lieutenant General Soyster (Ret.) is a
graduate of the United States Military Academy at West Point (B.S. 1957), Penn
State University (M.S. 1963), the University of Southern California (M.S. 1973)
and the National War College (1977).

         James J. Ralabate, Esq. has been a director of the Company since
January 1995 and currently serves as the Company's Secretary.  Mr. Ralabate has
been in the private practice of patent law since 1982.  Prior to that time, Mr.
Ralabate was General Patent Counsel for Xerox Corporation, responsible for
worldwide patent licensing and litigation, and an examiner for the Patent
Office.  Mr. Ralabate is intellectual property counsel to the Company, and is a
graduate of Canisius College (B.S. 1950) and The American University (J.D.
1959).

         Keith P. Hicks, Esq. has been a director of the Company since July
1994 and currently is a principal in C&H Properties and the owner of Hicks
Bonding Co., Hicks Auctioneering Co. and Hicks Cattle Company. Mr. Hicks is a
graduate of the University of Denver (B.A.1954) and LaSalle University School
of Law (L.L.B. 1969).

         Steven A. Newman, M.D. has been a director of the Company since
January 1995 and a consultant to the Company since January 1996.  See "Business
- Employees and Consultants." Dr. Newman was Executive Vice President and
Secretary of the Company from December 1994 through October 1995.  Dr. Newman
also provides business, management and administrative consulting services to
medical groups.  Dr. Newman was President of Fed American, Inc., a mortgage
banking firm, from 1988 to 1991. In connection with the bankruptcy of Sandco
American Inc., a real estate development company in California of which he was
the principal and guarantor, Dr.  Newman declared personal bankruptcy and was
discharged from liabilities in 1992. Dr. Newman has been a director of Tech
International since 1990, and a director and an employee of Tech Virginia since
1994.  See "Certain Transactions." Dr. Newman is a graduate of Brooklyn College
(B.A. 1967) and the University of Rochester (M.D. 1972).  Dr. Newman is the
brother of Edward G.  Newman, the Company's President, Chief Executive Officer
and Chairman of the Board of Directors.

         Phillip E. Pearce has been a director of the Company since October
1995.  Mr. Pearce has been an independent business consultant with Phil E.
Pearce & Associates, Chairman and Director of Financial Express Corporation
since 1990 and since 1988 has been a principal of Pearce-Henry Capital Corp.
Prior to 1988 Mr. Pearce was Senior Vice President and a director of E.F.
Hutton, Chairman of the Board of Governors of the National Association of
Securities Dealers, a Governor of the New York Stock Exchange and a member of
the Advisory Council to the United States Securities and Exchange Commission on
the Institutional Study of the Stock Markets.  Mr. Pearce also is a director of
RX Medical Services, Inc., a publicly-traded operator of medical diagnostic
facilities and clinical laboratories, InfoPower International, Inc., a software
development company and Starbase Company, a software development company.  Mr.
Pearce is a graduate of the University of South Carolina (B.A. 1953) and
graduated from the Wharton School of Investment Banking at the University of
Pennsylvania.

         Jacques Rebibo has been a director of the Company since January 1996.
Since 1983, Mr. Rebibo has been Chairman of the Board and a director of
Selfware, Inc., a software development and consulting firm, and since 1991 has
been President, Chief Executive Officer and a director of Mortgage Investment
Corporation, a mortgage banking firm.  Prior to 1983, Mr. Rebibo was President
of Rebibo and Chorazy, a financial planning firm, and Executive Vice President
of Systematics General Corporation, a publicly-traded manufacturer and
distributor of computer systems.  Mr. Rebibo was a director of Fairfax Bank &
Trust from 1985 through 1995.  Mr.  Rebibo is a graduate of Memphis State
University (B.S. 1962) and the University of Maryland (M.A. 1964).


                                      -21-
<PAGE>   36
         Eugene J. Amobi has been a director of the Company since January 1996.
Since 1983, Mr. Amobi has been President, a director and a principal stockholder
of Tech International, which provides engineering, technical support and
consulting services to government and domestic and international commercial
clients.  Mr. Amobi has been president and director of Tech Virginia since its
spin-off from Tech International.  Prior to 1983, Mr. Amobi was a Senior
Engineer with E.I. DuPont de Nemours and a Managing Director of Stanley
Consultants, an international engineering consulting firm.  Mr. Amobi is a
graduate of The Technion, Israel Institute of Technology (BS 1969), Princeton
University (MS 1970) and Syracuse University (MBA 1973).

ADVISORY BOARD

         The Advisory Board was established to provide council and support to
the Board of Directors.  Its members include:

         Maarten Heybroek has been an advisor to the Board of Directors since
1992.  Since 1986, Mr. Heybroek has been employed by Citibank, as Chief of Staff
and Controller for consumer banking activities in Central Europe and, most
recently, as Director, Compliance and Risk Management for Citibank's United
States consumer banking operations.  Prior to that time, Mr. Heybroek was
Director, Finance-European Operations and then Director, Corporate Finance for
Intergraph Corporation, a publicly-traded computer hardware and software firm,
and with Xerox Corporation in a variety of financial and management positions.
Mr. Heybroek is a graduate of Pace University.

         Dr. Andrew Heller is an advisor to the Board of Directors for a
three-year term through May 5, 1998.  Since 1989 Dr. Heller has been Chairman
and Chief Executive Officer of Heller Associates, a consulting firm to high
technology companies.  From 1990 to 1993 Dr. Heller was Chairman and Chief
Executive Officer of HaL Computer Systems, Inc., a software and hardware
systems development company.  From 1966 to 1989 Dr. Heller was employed by IBM
(where he was the youngest person ever to be selected as an IBM Fellow) in a
variety of positions including Corporate Director of Advanced Technology
Systems, member of the Executive Committee on Technology, member of the
Technical Review Board, and General Manager, Advanced Workstation Independent
Business Unit. While at IBM, Dr. Heller created and ran the business unit that
created the AIX (UNIX) operating system for IBM and the RISC RS/6000 family of
workstations and servers, from which the current Power PC was developed.  Dr.
Heller is a director of Rambus, Inc., Cross/Z, Inc., Network Translation, Inc.,
EPR, Inc., Eco Instrumentation, Inc. and UDI Software, Inc.  Dr. Heller has a
three-year consulting agreement with the Company whereby Dr. Heller has agreed
to provide strategic planning, business management, strategic product
development and market and financial introduction services to the Company.  See
"Business - Employees and Consultants."

         Gerald Jeffery Olivet represents the first investor in the Company
through private placement of equity.  Mr. Olivet is a financial consultant and
manager for investments in the commercial real estate market, public markets
and international manufacturing and sales business. He graduated from Arizona
State University in May of 1985 with a Bachelor of Science Degree in business.

         General Richard H. Thompson (ret.) retired from the U.S. Army in 1987
after 43 years of service.  His last assignment was as the Commander of the
U.S. Army Material Command, an organization of 132,000 personnel at 171
locations worldwide with an annual budget in excess of $35 billion.  Since his
retirement, General Thompson has served on the Board of Directors of several
companies, has consulted with many others, and has participated as a member of
several Study Groups for the National Academy of Sciences and the House of
Representatives. He is currently the Chairman and Chief Executive Officer and
actively engaged in the operations of three companies he has established:
Thompson Delstar Inc., TMI Asia, and TDIS.

         Dr. Will Stackhouse joined the Company in September 1996 and directs
strategic partnerships, planning and technologies.  Dr. Stackhouse held
technology leadership positions with MCI and served on two Boards of Directors,
Geodynamics Corporation and IEEE-USA. Dr. Stackhouse was a colonel in the U. S.
Air Force, where he served as director of several satellite and
telecommunications projects at the Jet Propulsion Laboratory and the Pentagon,
including the multi-billion dollar MILSTAR and AFSATCOM programs, and was a
highly-decorated





                                      -22-
<PAGE>   37
fighter pilot.  In 1979 he received national recognition from the President's
Commission for the Handicapped for his outstanding research and services to
the handicapped.  In January 1991 he received a "Laurel" from Aviation Week and
Space Technology for his efforts in "advancing critical U.S. based
technologies."  In October 1991 he received a "Professional Achievement Award"
from IEEE for his work in advanced high-resolution digital systems.  Dr.
Stackhouse holds a B.S. in Engineering Science from the USAF Academy, a Masters
of Science in Engineering Mechanics from the University of Michigan and a
Doctor of Philosophy degree in Engineering Design and Bio-Engineering from
Oxford University (England).

         Frances C. Newman, wife of President Edward G. Newman, was a cofounder
of the corporation.  Mrs. Newman has previously been a member of the board of
directors, and currently serves as both assistant secretary to the board and
manages facilities and community relations.  Mrs. Newman previously held senior
management positions in the areas of office management, business systems and
marketing for Electro-Tech International Corporation and Tech International.
She received a BA from the University of Maryland in 1969.

         Vice Admiral Stephan F. Loftus (ret.) retired from the United States
Navy in May of 1994. Prior to that he served as the Deputy Chief of Naval
Operations (Logistics).  Vice Admiral Loftus held previous positions with the
U.S. Navy as Commander, Fleet Air Mediterranean; Director, Office of Budget and
Reports; and Director, Office of Program Appraisal. Vice Admiral Loftus
presently serves as Executive Vice President of Quarterdeck Investment
Partners, Inc. (specializing in merger/acquisitions) and The Spectrum Group (a
strategic planning group).  He consults for Lockheed Martin Corporation, SAIC,
Johns Hopkins University - Applied Physics Lab, Systems Planning Corporation,
and Global Planning Corporation.  He is on the Board of Directors of AMSEC,
Inc. and LLD, Inc., and serves as a member of the Logistics Panel for the
Defense Science Board.  Also, Admiral Loftus serves as the Chairman of the
Board of Trustees at NMCCG Foundation.

ITEM 10.         EXECUTIVE COMPENSATION.

EXECUTIVE COMPENSATION

         Summary Compensation Table.  The following sets forth the annual and
long-term compensation for services in all capacities to the  (i) for the
fiscal year ended December 31, 1996, for the nine month transitional year ended
December 31, 1995 and the fiscal years ended March 31, 1995 and 1994 of Edward
G. Newman, the 's President, Chief Executive Officer and Chairman of the Board
of Directors, and (ii) for the fiscal year ended December 31, 1996, for the
transitional year dated December 31, 1995 and the fiscal years ended March 31,
1995 and 1994 of John F. Moynahan, the Company's Vice President, Chief
Financial Officer, Treasurer and a director.  No other officer of the Company
received annual salary and bonus exceeding $100,000 during the relevant
periods.

                                      -23-
<PAGE>   38
                           SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>



                                                                                          LONG TERM
                                                                                         COMPENSATION
                                                                                           AWARDS(1)
                                                          ANNUAL COMPENSATION (1)        ------------
      NAME AND                                    ------------------------------------     OPTIONS        ALL OTHER
 PRINCIPAL POSITION                    YEAR            SALARY                BONUS         (SHARES)      COMPENSATION
 ------------------               --------------  -----------------    ---------------   ------------   --------------
 <S>                                   <C>           <C>                    <C>             <C>            <C>
 Edward G. Newman                      1996           $236,949(1)(2)        $- 0 -           - 0 -         $- 0 -
 President and Chief Executive         1995*          $112,500              $- 0 -           - 0 -         $- 0 -
 Officer and Chairman of the           1995           $ 68,750              $- 0 -           - 0 -         $- 0 -
 Board of Directors                    1994           $ 26,500              $- 0 -           - 0 -         $- 0 -

 John F. Moynahan                      1996           $139,688              $- 0 -           - 0 -         $- 0 -
 Vice President, Chief Financial       1995*          $105,000              $- 0 -           - 0 -         $- 0 -
 Officer and Treasurer                 1995           $ 64,167              $- 0 -          200,000        $- 0 -
                                       1994             ---                   ---             ---

</TABLE>

(1) Compensation does not include $50,084 paid to Frances C. Newman, wife of
    Edward G. Newman in 1996.

(2) The total compensation for 1996 includes $87,314 paid by Tech of Virginia,
    as payment of accrued salaries and expenses, and $149,635 paid by Xybernaut
    Corporation.

---------
*   Transitional year ended December 31, 1995.

Option Grants Table.  The following table sets forth information on grants of
stock options during fiscal 1996 to John W. Williams, Vice President and Chief
Operating Officer; Phillip E. Pearce, a director; Jacques Rebibo, a director;
Harry E. Soyster, a director; and Keith P. Hicks, a director.  All such options
are exercisable to purchase shares of common stock.


<TABLE>
<CAPTION>
                                      Options granted    Percent of total         Exercise or
                                                        options granted to         base price
 Name                                     (shares)       employees in year         ($/Share)         Expiration date
                                      ---------------   ------------------        -----------        ---------------
 <S>                                         <C>                 <C>                   <C>          <C>
 John W. Williams                            50,000              9.2%                  $6.00        April 22, 2006
 Phillip E. Pearce                           50,000              9.2%                  $6.00        June 14, 2006
 Jacques Rebibo                              50,000              9.2%                  $6.00        June 14, 2006
 Harry S. Soyster                            25,000              4.6%                  $6.00        June 14, 2006
 Keith P. Hicks                              50,000              9.2%                  $6.00        June 14, 2006
</TABLE>





                                      -24-
<PAGE>   39
Fiscal Year-End Options/Option Values Table.

<TABLE>
<CAPTION>
                                               Number of Securities
                                            underlying unexercised options         Value of unexercised in-the-money
                                                at fiscal year-end                Options at fiscal year-end ($) (1)
                                           -------------------------------        ----------------------------------
 Name                                        Exercisable     Unexercisable          Exercisable      Unexercisable
                                           --------------  ---------------        --------------- ------------------
<S>                                              <C>          <C>                       <C>               <C>


 John W. Williams                                 0             50,000                   0                 0
 Phillip E. Pearce                                0             50,000                   0                 0
 Jacques Rebibo                                   0             50,000                   0                 0
 Harry S. Soyster                                 0             25,000                   0                 0
 Keith P. Hicks                                   0             50,000                   0                 0
                                                  -             ------                   -                 -

                                                  0            225,000                   0                 0
</TABLE>

         All of the foregoing options will vest pro-rata over the five-year
period ending either in April 2001 or June 2001.  None of the foregoing options
were exercisable within 60 days of December 31, 1996.

         The Company has no retirement, pension or profit sharing program for
the benefit of its directors, officers or other employees, but the Board of
Directors may recommend one or more such programs for adoption in the future.

PROFIT SHARING PROGRAM

         The Company intends to establish a profit sharing program to be
administered by the Board of Directors.  Under this program, which will remain
in effect for five years unless extended by the Board of Directors, executives,
key employees and consultants will be eligible to participate in a cash bonus
pool.  The amount of the cash bonus pool will be determined annually and will
be up to 10% of the amount by which the Company's pretax income exceeds 10% of
stockholders' equity.

COMPENSATION OF DIRECTORS

         The Company currently does not pay or accrue salaries or consulting
fees to outside directors for each board or committee meeting attended.  While
it is the Company's intention to establish such payments eventually, it does
not anticipate doing so in the foreseeable future.  Any payments when
implemented will be comparable to those made by companies of similar size and
developmental stage.  The Company also has adopted an Omnibus Stock Incentive
Plan in which directors are eligible to participate and the Company may use
stock options to reward.  See "Omnibus Stock Incentive Plan." Steven A. Newman,
Andrew Heller, and Jacques Rebibo have entered into consulting agreements with
the Company.  See "Business-Employees and Consultants."

EMPLOYMENT AGREEMENTS

         The Company has entered into employment agreements with Edward G.
Newman and John F. Moynahan.  Mr. Newman's employment agreement provides for a
three-year term through December 31, 1998; initial annual base compensation of
$150,000 subject to a minimum annual increase to $190,000 on January 1, 1997
and of at least the annual increase in the United States Consumer Price Index
("CPI") plus two percent annually thereafter, an annual cash bonus in an amount
to be determined by the Board of Directors; and a $2,000,000 life insurance
policy payable to his designated beneficiaries.  Mr. Newman received payments
in 1996 for accrued salaries and expenses related to his employment with Tech
Virginia and continues to provide services to Tech Virginia without contract at
a fixed





                                      -25-
<PAGE>   40
payment of $1,000 per month.

         Mr. Moynahan's employment agreement provides for a three-year term
through December 31, 1998; initial annual base compensation of $140,000 subject
to a minimum annual increase to $150,000 on January 1, 1997 and of at least the
annual increase in the CPI thereafter, and an annual cash bonus in an amount to
be determined by the Board of Directors.

         The employment agreements with Mr. Newman and Mr. Moynahan also
entitle them to participate in all benefits which the Company may offer to its
executive officers and employees.  The Company anticipates that such benefits
will include an automobile, health insurance and expense reimbursement.  Each
of the employment agreements renews for an additional three-year term unless
terminated in writing by either party on or before October 31, 1998.  Each of
the employment agreements also provides for termination at the option of the
employee in the event of a change of control (which is defined as Mr. Edward
Newman ceasing to serve as either the Chairman of the Company's Board of
Directors or its president and chief executive officer) and that upon any such
termination the employee is entitled to at least two years of annual
compensation under his employment agreement.

OMNIBUS STOCK INCENTIVE PLAN

         The 1996 Omnibus Stock Incentive Plan (the "Incentive Plan") was
adopted by the Company's Board of Directors effective January 1, 1996.  The
Incentive Plan provides for the granting of incentive stock options ("Incentive
Stock Options") within the meaning of Section 422 of the Internal Revenue Code
of 1986, as amended (the "Code"), nonqualified stock options, stock
appreciation rights ("SARs") and grants of shares of Common stock subject to
certain restrictions ("Restricted Stock") up to a maximum of 650,000 shares to
officers, directors, employees and others.  Incentive Stock Options can be
awarded only to employees of the Company at the time of the grant.  No options,
SARs or restricted stock ("Restricted Stock") may be granted under the
Incentive Plan subsequent to December 31, 2006.

         The Incentive Plan is administered by the Compensation Committee of
the Board of Directors (subject to the authority of the full Board of
Directors), which determines the terms and conditions of the options, SARs and
Restricted Stock granted under the Incentive Plan, including the exercise
price, number of shares subject to the option and the exercisability thereof.
Messrs. Steven A. Newman, Soyster and Pearce currently are the members of the
Compensation Committee.  The Company will seek approval from its shareholders
at the annual meeting on May 7, 1997 to establish a second incentive plan,
similar to the Incentive Plan, which will provide, among other things, for up to
one million additional shares for options, SARs and grants.

         The exercise price of all Incentive Stock Options granted under the
Incentive Plan must equal at least the fair market value of the Common stock on
the date of grant.  In the case of an optionee who owns stock possessing more
than ten percent of the total combined voting power of all classes of stock of
the Company ("Substantial Stockholders"), the exercise price of Incentive Stock
Options must be at least 110% of the fair market value of the Common stock on
the date of grant.  The exercise price of all nonqualified stock options
granted under the Incentive Plan shall be determined by the Compensation
Committee.  The term of any Incentive Stock Option granted under the Incentive
Plan may not exceed ten years, or, for Incentive Stock Options granted to
Substantial Stockholders, five years.  The Incentive Plan may be amended or
terminated by the Board of Directors, but no such action may impair the rights
of a participant under a previously granted option.

         The Incentive Plan provides the Board of Directors or the Compensation
Committee the discretion to determine when options granted thereunder shall
become exercisable and the vesting period of such options.  Upon termination of
a participant's employment or relationship with the Company, all options
terminate and no longer are exercisable unless termination is due to death or
disability, in which case the options are exercisable within one year of
termination.

         The Incentive Plan provides that upon a change in control of the
Company, all previously granted options and SARs immediately shall become
exercisable in full and all Restricted Stock immediately shall vest and any
applicable restrictions shall lapse.  The Incentive Plan defines a change of
control as the consummation of a tender





                                      -26-
<PAGE>   41
offer for 25% or more of the outstanding voting securities of the Company, a
merger or consolidation of the Company into another corporation less than 75%
of the outstanding voting securities of which are owned in aggregate by the
stockholders of the Company immediately prior to the merger or consolidation,
the sale of substantially all of the Company's assets other than to a
wholly-owned subsidiary, or the acquisition by any person, business or entity
other than by reason of inheritance of over 25% of the Company's outstanding
voting securities.  The change of control provisions of the Incentive Plan may
operate as a material disincentive or impediment to the consummation of any
transaction which could result in a change of control.

         The Incentive Plan provides the Board of Directors or the Compensation
Committee discretion to grant SARs in connection with any grant of options.
Upon the exercise of a SAR, the holder shall be entitled to receive a cash
payment in an amount equal to the difference between the exercise price per
share of options then exercised by him and the fair market value of the Common
stock as of the exercise date.  The holder is required to exercise options
covering the number of shares, which are subject to the SAR so exercised.  SARs
are not exercisable during the first six months after the date of grant, and
may be transferred only by will or the laws of descent and distribution.

         The Incentive Plan also provides the Board of Directors or the
Compensation Committee discretion to grant to key persons shares of Restricted
Stock subject to certain limitations on transfer and substantial risks of
forfeiture.

         As of December 31, 1996 a total of 993,930 options were outstanding,
743,930 of which are counted against the number of shares subject to issuance
under the Incentive Plan. Additional options above the current maximum of
650,000 shares have been granted contingent upon such approval.  Each of the
outstanding options has an exercise price at least equal to the fair market
value of the Common stock on the date of grant with the exception of 200,000
shares which are subject to acquisition by an officer of the Company and 50,000
shares which are subject to acquisition by an employee of the Company at $0.0l
per share over the period 1995 through 1999.  As of December 31, 1996, there
were no SARs outstanding and there have been no grants of Restricted Stock
other than 10,000 shares granted to Mr. Williams. All outstanding options vest
on a pro-rata basis over a five-year period.

ESCROWED SHARES

         As a condition to the IPO, Royce Investment Group, the Representative
has required the Company's stockholders to deposit the Escrowed Shares, which
are 1,800,000 shares of Common stock, of which 1,707,210 shares are owned by
officers and directors of the Company, in escrow pursuant to an escrow
agreement with Continental Stock Transfer & Trust Company, the escrow agent and
the Representative.  The Escrowed Shares will be subject to incremental release
to the depositing stockholders based upon the Company's total revenues and net
earnings (loss) for the 12-month periods ending September 30, 1997, 1998 and
1999.  The Escrowed Shares will be released in the amounts set forth below only
upon the achievement by the Company of the following Performance Targets:

             -   300,000 shares if the Company achieves gross revenues of at
         least $20,000,000 and a net loss, if any, not in excess of $500,000
         for the 12 months ending September 30, 1997;

             -   750,000 shares if the Company achieves gross revenues of at
         least $45,000,000, and earnings per share of at least $1.00 for the 12
         months ending September 30, 1998;

             -   750,000 shares if the Company achieves gross revenues of at
         least $90,000,000 and earnings per share of at least $1.25 for the 12
         months ending September 30, 1999.

         Notwithstanding the foregoing, if at any time the closing bid price of
the Common stock reported on The Nasdaq SmallCap Market equals or exceeds
$11.00 per share for 25 consecutive trading days or for 30 out of 35
consecutive trading days (the "Nasdaq Price Target") during the period ending
September 30, 1999, all Escrowed Shares then remaining in escrow will be
released from the escrow and returned to the stockholders.





                                      -27-
<PAGE>   42

         The Escrowed Shares will be subject to incremental release only in the
event the Company achieves the Performance Targets in the 12 months ending
September 30, 1997, 1998 and/or 1999.  In addition, upon achieving the Nasdaq
Price Target at any time during the period ending September 30, 1999 all then
Escrowed Shares will be released.  If the Performance Targets are not met in
any of the relevant 12-month periods (and the price of the Common stock has not
met or exceeded the price described above prior to the expiration of the
applicable 12-month period), the Escrowed Shares in the amounts stated above
will be returned to the Company and cancelled.  The earnings per share
calculation will be based on the fully diluted earnings per share, but
excluding shares issued pursuant to the Unit Purchase Option, extraordinary
items, or any compensation expense charged to the Company related to the
release of the Escrowed Shares.  The determination of earnings per share will
be made in accordance with generally accepted accounting principles and will be
based on the financial statements of the Company filed pursuant to the
Securities Exchange Act of 1934, as amended.  Escrowed shares are not
transferable or assignable although they may be voted by the holder.

         The Performance Targets and the Nasdaq Price Target were determined by
negotiation between the Company and the Representative and do not imply or
predict any future performance by the Company.  The market value of any
Escrowed Shares held by office, employees or consultants at the time they are
released will be deemed to be additional compensation expense to the Company.
Upon such an occurrence the Company will recognize a potentially material
charge to income which could reduce or eliminate earnings, if any.  The amount
of compensation expense recognized by the Company will not affect the Company's
total stockholders' equity or working capital.

         Given the expected start of full-scale production in the quarter
ending June 30, 1997, the Company's management believes that it is likely that
the Company's gross revenues and allowable losses will not meet the Performance
Targets for the 12-month period ending September 30, 1997.  Accordingly, the
release of the escrow shares for this period is only likely if the stock price
equals or exceeds $11.00 for 25 consecutive trading days or 30 out of 35
consecutive trading days prior to September 30, 1997.  If conditions are not
met for release from escrow, then 300,000 shares of stock will be returned to
the Company on September 30, 1997 and canceled, resulting in no earnings impact
and a commensurately lower number of outstanding shares.

ITEM 11.         SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS.

PRINCIPAL STOCKHOLDERS

         The following table sets forth, as of December 31, 1996, certain
information as to the beneficial ownership of the Common stock of (i) each of
the Company's directors and executive officers, (ii) directors and executive
officers as a group, and (iii) all persons known by the Company to be the
beneficial owners of more than five percent of the outstanding Common stock.





                                      -28-
<PAGE>   43
<TABLE>
<CAPTION>
                                                               AMOUNT OF SHARES          PERCENTAGE OWNED
                                                                 BENEFICIALLY
                                                                     OWNED

 NAME(1)
 -------                                                      -------------------       -------------------
 <S>                                                              <C>                                 <C>
 Edward G. Newman(2) . . . . . . . . . . . . . . . . . . .        4,529,200                           31.6%
 John F. Moynahan(3)   . . . . . . . . . . . . . . . . . .           90,000                               *
 John W. Williams  . . . . . . . . . . . . . . . . . . . .           10,000                               *
 Lt. Gen.  Harry E. Soyster (Ret.) . . . . . . . . . . . .           25,000                               *
 James J. Ralabate . . . . . . . . . . . . . . . . . . . .           50,000                               *
 Keith P. Hicks  . . . . . . . . . . . . . . . . . . . . .          368,000                            2.6%
 Steven A. Newman(4) . . . . . . . . . . . . . . . . . . .        1,617,940                           11.3%
 Phillip E. Pearce . . . . . . . . . . . . . . . . . . . .              ---                             ---
 Jacques Rebibo(5)   . . . . . . . . . . . . . . . . . . .          187,500                            1.3%
 Eugene J. Amobi . . . . . . . . . . . . . . . . . . . . .          300,000                            2.1%
 Frances C. Newman(6)  . . . . . . . . . . . . . . . . . .          776,950                            5.4%
 Officers and directors (10 persons) . . . . . . . . . . .        7,954,590                           55.5%
</TABLE>

------------
*        Less than 1%

(1)      The address for Messrs. Edward G. Newman and Moynahan and Mrs. Newman
         is 12701 Fair Lakes Circle, Suite 550, Fairfax, Virginia 22033; the
         address for Mr. Steven A. Newman is 303 Avenida Cerritos, Newport
         Beach, California 92660; the address for Mr. Hicks is 4121 Roberts
         Road, Fairfax, Virginia 22032; the address for Mr. Rebibo is 7216
         Dulany Drive, McLean, Virginia 22101; the address for Mr. Amobi is 100
         Jade Drive, Wilmington, Delaware 19810; the address for Mr. Ralabate
         is 5792 Main Street, Williamsville, New York 14221; the address for
         Mr. Pearce is 6624 Glenleaf Court, Charlotte, North Carolina 28270;
         and the address for Lt.  Gen.  Soyster (Ret.) is 1201 E. Abingdon
         Drive, Suite 425, Alexandria, Virginia 22314.

(2)      Includes 200,000 shares owned by a trust for Mr. Newman's children and
         580,000 shares owned by a trust established by Mr.  Newman.  See
         footnote 7 below.  Excludes 776,950 shares owned by Mr. Newman's wife,
         Frances C. Newman.  See footnote 6 below.

(3)      Includes 80,000 shares of Common stock subject to acquisition by Mr.
         Moynahan at $.01 per share pursuant to a stock option.

(4)      Includes 100,000 shares owned by a trust for Dr. Newman's children.

(5)      Includes 17,500 shares owned by Mortgage Investment Corp., an
         affiliate of Mr. Rebibo, and 10,000 shares owned by the profit sharing
         plan of Rebibo and Corazy.

(6)      Frances C. Newman is the wife of Edward G. Newman.

ITEM 12.         CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

         In connection with transactions described below, the Company did not
secure an independent determination of the fairness and reasonableness of such
transactions and arrangements with affiliates of the Company.  In each instance
described below, the disinterested directors (either at or following the time
of the transaction) reviewed and approved the fairness and reasonableness of
the terms of the transaction.  The Company believes that each transaction was
fair and reasonable to the Company and on terms at least as favorable as could
have been obtained





                                      -29-
<PAGE>   44
from non-affiliates.  Transactions between any corporation and its officers and
directors are subject to inherent conflicts of interest.  There is no assurance
that approval of such transactions by the Company's Board of Directors will
protect the best interests of the Company. The Company could be subject to
litigation or claims by stockholders or third-parties, or regulatory action, in
the event such transactions are found to be contrary to the best interests of
the Company.

TECH INTERNATIONAL AND TECH VIRGINIA

         Since December 1992, the Company has maintained various business
relationships with Tech International and since 1994, with Tech Virginia.  Tech
International operates a computer software and consulting business.  Until
December 30, 1994, Tech International's Virginia operations were conducted
through its Virginia business unit.  In December 30, 1994, Tech International
spun-off the Virginia business unit (the "Spin-Off") as Tech Virginia. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."  Edward G. Newman, a principal stockholder, director, the
Chairman, President and Chief Executive Officer of the Company and Steven A.
Newman and Eugene J. Amobi, directors of the Company, were the stockholders,
and continue as officers and directors of Tech Virginia.  Eugene J. Amobi is
the sole director and stockholder of Tech International.

         From December 1992, until November 1994 the Company utilized, on a fee
basis, a portion of the office facilities and certain personnel, office support
and equipment of Tech International's Virginia business unit.  In November 1994
the Company relocated its office to its current location and ceased using Tech
International's office facility, support and equipment.  The Company continued
to use certain Tech International personnel until the Spin- Off, after which
the Company began purchasing certain consulting services from Tech Virginia.

         As part of the Spin-Off, Tech Virginia acquired approximately $45,000
of net receivables owed by the Company to Tech International for office and
personnel support.  On December 31, 1994, Tech Virginia forgave those
receivables and agreed to provide six months of free consulting services to the
Company in exchange for serving as the Company's principal VAR and Small
Business contracting agent for federal government contracts accounts.  The
Company treated approximately $45,000 of net payables forgiven by Tech Virginia
as a contribution to capital as of December 31, 1994 for which no additional
shares were issued.

         Simultaneous with the closing of the IPO, the Company acquired 100% of
the issued and outstanding shares of Tech Virginia, which were owned by Messrs.
Amobi, Edward G. Newman and Steven A. Newman, for $50,000 pursuant to a
December 31, 1994 option agreement (the "Tech Virginia Option").  The Tech
Virginia Option was executed together with an agreement pursuant to which Tech
Virginia forgave the Company's net indebtedness of approximately $45,000 for
services rendered and the Company retained Tech Virginia as its VAR and
contracting agent for all sales to the United States government.  The
acquisition of Tech Virginia provides the Company with the intellectual
property, technical capability, data and key personnel for portions of the data
conversion, voice and presentation manager toolkits and the ability to
bid Company products in United states government contracts requiring security
clearances and to have Company products listed on approved United States
Government purchasing lists. The terms of the Tech Virginia Option were
negotiated between Mr. Amobi and the Company, and approved by the Company's
disinterested directors.

PATENT

         In 1993 each of Messrs. Edward G. Newman, the Company's President,
Chief Executive Officer and Chairman of the Board of Directors, Gil Christian,
a former employee of the Company, and Michael Jenkins, and employee of the
Company, assigned to the Company all of their right, title and interest in and
to the Patent.  In consideration of the assignment of their interests in the
Patent, Mr. Edward G. Newman, Mr. Christian and Mr. Jenkins each received
300,000 shares of Common stock (valued at $.01 per share or $9,000 in the
aggregate), and $22,500 in the aggregate.  Certain officers and employees of
the Company have related patent applications pending in the United States and
certain other countries.  Any patents obtained by employees of the Company will
be assigned to the Company under existing invention agreements.  See "Business
--Intellectual Property."





                                      -30-
<PAGE>   45
         In September 1995, the Company received a notification from the Patent
Office entitled "office action in re-examination," which indicated that
certain claims were subject to re-examination and were preliminarily rejected.
The re-examination of the Patent was initiated as a result of a request from
one of the Company's competitors.  A second request for re-examination was
received by the Company in April 1996.  In July 1996, the Company was formally
notified by the Patent Office that the Patent had been upheld with respect to
the issues raised by the September 1995 re-examination.  Mr. James J. Ralabate,
the Company's Secretary and a director has advised the Company with respect to
legal matters concerning the reexamination requests (and other intellectual
property matters) although he is not formally representing the Company before
the Patent Office on those matters.  During the transitional period ended
December 31, 1995, the Company paid Mr. Ralabate fees, in cash or in shares of
Common stock, of $135,904 for legal services rendered to the Company.  During
the year ended December 31, 1996, the Company paid Mr. Ralabate fees in cash of
$93,250 for legal services rendered to the Company.

MANAGEMENT PERSONNEL EMPLOYMENT AGREEMENTS WITH TECH VIRGINIA

         Messrs. Edward G. Newman, Steven A. Newman and Eugene Amobi each had
employment agreements with Tech Virginia under which each of them was entitled
to a salary and each was eligible to receive certain bonuses.  The agreements
with Messrs. Edward G.  Newman and Steven A. Newman require each of them to
devote only reasonable time and attention to Tech Virginia, provided their
activities for Tech Virginia do not interfere with their obligations to the
Company.  Upon the acquisition of Tech Virginia by the Company, such employment
agreements were terminated by agreement with Messrs. Newman, Newman, and Amobi.
Messrs. Newman, Newman and Amobi have continued to provide services to Tech
Virginia since the acquisition without contract but under similar terms and
conditions as their terminated agreements.

ADVANCES AGAINST COMMISSIONS

         During 1996, the Company paid $35,000 as advances against future
commissions and services to Ed Nixon Davis for sales of the Company's products
and securing alliances with licensees, software developers and manufacturing
partners in Europe, Middle East and Asia.  Mr.  Davis is an uncle of Frances
C. Newman, the wife of Edward G. Newman, who serves as assistant secretary and
manager of facilities and community relations for the Company.





                                      -31-
<PAGE>   46
ITEM 13.         EXHIBITS, LISTS AND REPORTS ON FORM 8-K.


     Exhibit     Description

       1.1       Form of Underwriting Agreement.*

       1.2       Form of Financial Consulting Agreement between the Company
                 and the Representative.*

       1.3       Form of Selected Dealers Agreement.*

       3.1       Certificate of Incorporation of the Company.*

       3.2       Bylaws of the Company.*

       4.1       Warrant Exercise Fee Agreement.*

       4.2       Form of Forfeiture Escrow.**

       4.3       Form of Unit Purchase Option between the Company and the
                 Representative.*

       4.4       Form of specimen certificate for Units.**

       4.5       Form of specimen certificate for common stock.**

       4.6       Form of specimen certificate for Warrants.**

       4.7       Form of Warrant Agreement among the Company, the
                 Representative, and the Warrant Agent.*

       4.8       Form of Debenture.*

       5.1       Opinion of Baker & Hostetler re legality.**

       10.1      December 31, 1994 Acquisition Agreement between the
                 Company and Tech Virginia.*

       10.2      Form of Indemnification Agreement to be entered into
                 between the Company and each officer and director of the
                 Company.**

       10.3      Form of Employment Agreement between the Company and
                 Edward G. Newman.**

       10.4      Form of Employment Agreement between the Company and John
                 F. Moynahan.**

       10.5      November 30, 1994 Lease Agreement between Hyatt Plaza
                 Limited Partnership and the Company.*

       10.6      March 22, 1996 Month-to-Month Tenancy Agreement between
                 the Company and The Original Tollhouse Historical
                 Preservation Company.*

       10.7      October 27, 1994 Residential Deed of Lease between the
                 Company and Frank E. and Heather H. Moxley.*

       10.8      June 10, 1994 Rockwell International Corporation
                 contract.*

       10.9      January 5, 1995 Kopin Corporation contract.*

       10.10     June 19, 1995 License Agreement for Mobile Inspector
                 software.*

       10.11     1996 Omnibus Stock Incentive Plan.*

       10.12     May 5, 1995 Consulting Agreement with Andrew Heller.*



                                      -32-
<PAGE>   47
       10.13     November 20, 1995 Consulting Agreement with CMC Services.*

       10.14     Form of Consulting Agreement with Victor J. Lombardi.**

       10.15     March 29, 1996 License Agreement with Rockwell
                 International Corporation.*

       10.16     January 13, 1997 Manufacturing Agreement between Hi-Tech
                 Manufacturing and the Company.***

       10.17     December 30, 1996 Purchase Agreement between Adaptive
                 Systems, Inc. and the Company.***

       10.18     September 9, 1996 Employee Agreement between Will
                 Stackhouse and the Company.***

       10.19     December 10, 1996 Lease Agreement between Autumnwood
                 Apartments and the Company.***

       10.20     September 10, 1996 Lease Agreement between the Company and
                 South Beach Warehouse, LLC.***

       10.21     February 26, 1997 Purchase Order between Greenway
                 Engineering and the Company.***
        23.1     Consent of Baker & Hostetler (included in Exhibit 5.1).**

        23.2     Consent of Coopers & Lybrand L.L.P.*

        24.1     Power of Attorney (included in signature page hereto).*

        27.1     Financial Data Schedule***

---------------
*        Incorporated by reference in the initial filing of the Company's
         Registration Statement on Form SB-2, No. 333-4156.

**       Incorporated by reference in an amendment to the Company's
         Registration Statement on Form SB-2, No. 333-4156.

***      Filed herewith.


Reports on Form 8-K

         The Company did not file any Report on Form 8-K during the year
ended December 31, 1996.




                                      -33-
<PAGE>   48
                                   SIGNATURES


         In accordance with Section 13 or 15(d) of the Securities Exchange Act
of 1934, the Company has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.


                                      XYBERNAUT CORPORATION


                                      By:/s/ EDWARD G. NEWMAN
                                         ---------------------------------------
                                         Edward G. Newman
                                         Present, Chief Executive Officer and
                                         Chairman of the Board of Directors

                                      Date:   March 31, 1997

         In accordance with the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Company and the
capacities and on the dates indicated.


<TABLE>
<CAPTION>
 Signature                                   Title                                 Date
 ---------                                   -----                                 ----
 <S>                                         <C>                                   <C>



                                             President, Chief Executive Officer    March 31, 1997
      /s/ EDWARD G. NEWMAN                   and Chairman of the Board of
 --------------------------------------      Directors
          Edward G. Newman

                                             Vice President, Chief Financial       March 31, 1997
     /s/  JOHN F. MOYNAHAN                   Officer, Treasurer and Director
 --------------------------------------
          John F. Moynahan

                                             Vice President and Chief Operating    March 31, 1997
    /s/   JOHN W. WILLIAMS                   Officer
 --------------------------------------
          John W. Williams

  /s/ LT. GEN. HENRY E. SOYSTER              Director                              March 31, 1997
 --------------------------------------
      Lt. Gen. Henry E. Soyster

      /s/ JAMES J. RALABATE                  Secretary and Director                March 31, 1997
 --------------------------------------
          James J. Ralabate

       /s/ KEITH P. HICKS                    Director                              March 31, 1997
 --------------------------------------
           Keith P. Hicks

      /s/ STEVEN A. NEWMAN                   Director                              March 31, 1997
 --------------------------------------
          Steven A. Newman
</TABLE>


                                      -34-
<PAGE>   49

<TABLE>
 <S>                                         <C>                                   <C>
       /s/ PHILLIP E. PEARCE                 Director                              March 31, 1997
 --------------------------------------
           Phillip E. Pearce

        /s/ JACQUES REBIBO                   Director                              March 31, 1997
 --------------------------------------
            Jacques Rebibo

        /s/ EUGENE J. AMOBI                  Director                              March 31, 1997
 --------------------------------------
            Eugene J. Amobi
</TABLE>





                                      -35-