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                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                            ------------------------
 
                                  FORM 10-KSB
 
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<C>              <S>
      [X]        ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                 THE SECURITIES EXCHANGE ACT OF 1934
                 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998

      [  ]       TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                 SECURITIES EXCHANGE ACT OF 1934
                 FOR THE TRANSITION PERIOD FROM ____________ TO ____________.
</TABLE>
 
                         COMMISSION FILE NUMBER 0-21013
                            ------------------------
 
                             XYBERNAUT CORPORATION
                 (NAME OF SMALL BUSINESS ISSUER IN ITS CHARTER)
 
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<S>                                            <C>
                   DELAWARE                                      54-1799851
(State or other jurisdiction of incorporation       (I.R.S. Employer Identification No.)
               or organization)
</TABLE>
 
<TABLE>
<S>                                            <C>
           12701 FAIR LAKES CIRCLE,
                 FAIRFAX, VA                                       22033
   (Address of principal executive offices)                      (Zip Code)
</TABLE>
 
                                 (703) 631-6925
                (Issuer's telephone number, including area code)
 
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-KBS:  [X]
 
     State issuer's revenues for its most recent fiscal year: $875,560
 
     The aggregate market value at April 12, 1999 of the Common Stock of the
issuer, its only class of voting stock, was $89,613,668, of which $64,928,461
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 April
12, 1999 was 22,229,747.
 
                   DOCUMENTS INCORPORATED BY REFERENCE:  NONE
 
     Transitional Small Business Disclosure Format  Yes  [ ]  No  [X]
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                                     PART I
 
ITEM 1.  BUSINESS.
 
                                  INTRODUCTION
 
     Xybernaut Corporation, a Delaware corporation (the "Company"), is engaged
in the research, development and commercialization of mobile computer systems
and related software solutions designed to enhance personal productivity,
especially in commercial, industrial and military applications. The Company's
current mobile computing product is the Mobile Assistant(R) IV (MA IV) model,
which is a full-function, body-worn, voice-controlled computer with a
head-mounted video display.
 
     The MA IV is a MMX Pentium(R) PC which combines the speed, memory,
processing, multimedia and communication capabilities of a desktop personal
computer ("PC") in a lightweight unit with hands-free operation and simultaneous
user mobility. The Mobile Assistant(R) is a combination of hardware and software
designed to be worn on the body 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.
 
     The Mobile Assistant(R) Series can utilize technologically advanced
features such as real time two-way video and audio communications through radio
frequency transmissions, integrated cellular linkups, global positioning system
tracking capabilities and access to information through the Internet and World
Wide Web. The new head-mounted display unit ("HMD") includes a two-way audio
system and optional built-in video camera, weighs approximately l5 ounces and
presents a desk-top quality full VGA color image that is approximately
equivalent to that of a 15" VGA monitor at a distance of approximately two feet.
An optional light-weight, 6.4 inch, full VGA color, flat panel display ("FPD"),
with integrated digitizer, is offered for users who do not desire an HMD or do
not need to be 100% hands-free to perform their job. 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
two pounds and is designed to run software applications designed for
Microsoft(R) Windows(R) 3.11, Windows(R) 95 and 98, Windows(R) NT(TM), DOS, SCO
UNIX(R) and LINUX.
 
     The Company offers two software products, linkAssist(TM) and webAssist(TM)
which are designed to get user documentation up and running on the Mobile
Assistant quickly, and which can also be used on conventional desktop or laptop
computers. To date, sale of software products have not been material. In
addition, there can be no assurances that the Company will be able to develop
additional software and generate significant sales from software products.
 
     The Company was incorporated in Virginia as Contemporary Products &
Services, Inc. in October 1990 and changed its 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.
 
     The Company's executive and administrative offices are located at 12701
Fair Lakes Circle, Fairfax, Virginia 22033. Its telephone number is (703)
631-6925, and its e-mail address is investrel@xybernaut.com.
 
                           FORWARD-LOOKING STATEMENTS
 
     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
 
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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) 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 of this evolution to be body-worn, voice-activated
computers, which will provide hands-free portability. The Company believes 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 and corporate accounting information. With
personal computers came software to provide information to users in the form of
analysis, relationships, etc. The Company believes that providing specific
information to users on as-needed basis is the next step in the evolution of the
computer software and one that is well suited for use with body-worn computers.
 
                               BUSINESS STRATEGY
 
     The Company's objective is to be the leading provider of hands-free mobile
computing systems and related software 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:
 
     DEVELOP AND STRENGTHEN STRATEGIC ALLIANCES.  The Company has established
and intends to continue to establish strategic alliances with world-class
distribution partners, as well as selected systems integrators, independent
software vendors, VARs, OEMs and industrial and commercial equipment and service
providers. The benefits that the Company receives from these associations
include access to a larger potential customer
 
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base, complementary technologies, reduced capital investment through utilization
of outside resources, and access to manufacturing expertise and efficiencies of
world-class manufacturers.
 
     During 1998, the Company announced signed distribution and support
agreements with En Pointe Technologies for North America, and Hewlett Packard
for European, Middle East and Africa. All of these agreements have resulted in a
world class distribution network to support the launch of the MA IV Series.
Additionally, large systems integrators, such as DynCorp, were signed to both
provide implementation support for Xybernaut customers worldwide as well as to
place our products within their own client bases. The Company has been pursuing,
and will continue to pursue, additional strategic associations to enhance its
product offerings and expand its marketing activities.
 
     In addition to marketing and supporting strategic relationships, the
Company has signed agreements and is executing other relationships with
organizations such as the SBS in Europe (over 30 software companies serving as a
Xybernaut Center of Excellence for speech and wearable applications), and
companies in the USA and Asia for hardware development and field testing of
application-specific solutions for industry.
 
     PROVIDE CUSTOM SOFTWARE SOLUTIONS FOR DIVERSE CUSTOMER NEEDS.  The Company
intends to continue acquiring software that enables its customers to more
rapidly create customized software applications for use with the Mobile
Assistant(R)Series and on conventional PC's. This software will be designed to
provide prepackaged application expertise that incorporates the end user's
existing programs, procedures and technical documentation. This will permit the
cost-effective development of productivity-enhancing software applications by
customers. To date, revenue from the sales of software products have not been
material, however, the Company believes that revenue from software will become
an important contributor to operating margins in the future.
 
     PENETRATE TARGET MARKETS THROUGH LICENSEES, OEMS, VARS, DISTRIBUTORS, AND
DIRECT SALES.  The Company believes that its mobile computing technology is
especially well suited for the manufacture, repair and maintenance of
commercial, industrial and military equipment and facilities. The Company also
believes that forms-based applications, such as inventory and data collection,
are extremely well-suited for its products. As an example, the flat panel
display configuration is a one pound VGA color display/digitizer worn by the
user instead of their current much heavier pen tablets offering only limited
computing power. The Company intends to penetrate its target markets through
effective use of OEMs, VARs and distributors that demonstrate comprehensive
market knowledge in their markets. Through the use of already approved agents,
the Company intends to leverage internal marketing and sales resources, and
achieve rapid foreign and domestic market penetration resulting in a diversified
customer base. The Company also intends to continue marketing directly to key
national accounts in order to build multiple reference accounts for its
distributors to use to quickly expand their own sales world-wide. These
reference accounts will also provide the Company's RD&E organizations with
valuable unfiltered feedback from customers for future product development. The
Company expects that as large computer and equipment manufacturers attempt to
enter the wearable or user-supported computing marketplace that it will have
numerous opportunities to license its strong intellectual property. Such
licensing, the Company believes, will yield significant revenue as well as
accelerated market penetration of mobile computing hardware and software.
 
     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 hardware and software 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) Series has resulted in a set of core competencies which
provides 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. The Company also intends to rely heavily
on joint developments with its strategic partners worldwide, and cross-licensing
of its valuable intellectual property to build and market new technology. The
current MA IV Series, for example, was the result of the Company's successful
relationships with Fujitsu,
 
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Sony Digital Products, Hitachi, Shimadzu, Toshiba, JAE and NEC, all under the
auspices of the Company's Japanese staff.
 
     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 to use, 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 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, software applications and hardware
products. The Company's goal is to adhere to the model of an Intellectual
Property-Virtual Hardware-Communications-Software company, concentrating on RD&E
and marketing strategies. It intends to continue to allow its strategic partners
to execute the Company's manufacturing, service, sales and marketing functions,
under close coordination with Company management. The Company intends to remain
small, able to react quickly to market needs and world economic changes.
 
                        PRODUCTS AND PRODUCT DEVELOPMENT
 
     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 five key features:
 
     - Compact, lightweight and rugged hardware specifically designed for
       mobile, body-worn use
 
     - Easy to use human interface
 
     - Voice command control
 
     - Head-worn miniature display
 
     - Flat panel miniature display/digitizer
 
     COMPACT HARDWARE FOR MOBILE, BODY-WORN USE.  The MA IV CPU currently
utilizes standard industry hardware components in a patented body-worn computing
package weighing less than two pounds. Design features for the MA IV and its
related additional products currently include:
 
     - Intel Pentium(R) 200 or 233 MHZ processor w/512 KB L2 cache
 
     - Synchronus DRAM (SDRAM) (currently ranging from 32 Mb to 128 Mb)
 
     - Internal hard disk currently ranging from 2 -- 6 GB (8 GB scheduled for
       1999)
 
     - Protected internal dual PC Card readers using CardBus (industry-standard
       peripheral cards)
 
     - Enclosure to allow use in a wide range of environmental conditions
 
     - Advanced-technology, hot-swappable lithium-ion battery and charger
 
     - Head Mounted and/or Flat Panel Displays, USB, Power and Replicator ports
 
     - Mini-port replicator for mobile use and a full port replicator for
       desk-top use
 
     - Wrist-mounted miniature keyboard
 
     - Miniature integrated full color video camera
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     - Compatibility with DOS, Windows(R) 3.11(TM), Windows(R) 95 and 98,
       Windows(R) NT(TM), SCO UNIX(R) and LINUX operating systems
 
     - Integrated pointing device (mouse)
 
     - Built-in sound system for speech recognition and generation
 
     The Mobile Assistant(R) Series are full-featured "Wintel" PC's, which can
be readily used as a desktop PC, and allows for the incorporation of a wide
range of capabilities including portable CD-ROM readers, bar code readers,
battery-operated printers, still and motion video cameras, global positioning
technologies, cellular and radio frequency communications and interfaces for
medical and test equipment.
 
     VOICE COMMAND CONTROL.  The Mobile Assistant(R) 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 or a phonetic engine is utilized. The
system can also be programmed to "learn" the user, on the job, during real-time
field use. The speaker-independent approach works well for the menu and
button-driven programs used in the Mobile Assistant(R). System accuracy is
improved greatly since the words and phrases for each menu screen can be
predetermined and used to limit recognition ranges to the screen at hand. The
combination of voice recognition and head/flat panel worn displays provide the
user of the Mobile Assistant(R) 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. In addition to basic command-and-control speech
recognition, the MA IV also offers dictation features, and natural language
speech processing is planned for introduction in 1999. The Company's main speech
is provided through IBM's Via Voice(R).
 
     HEAD-WORN MINIATURE DISPLAY.  The MA IV uses a lightweight HMD with 640 X
480 pixels (VGA color). It is anticipated that this display will be offered in
color SVGA 800 X 600, and XGA 1280 X 1024 pixel resolutions, and eventually in
color resolutions comparable to those planned for High-Definition TV. All head
mounted 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. The display is 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. This high
quality, miniature display presents information in a heads-mounted display
format without completely occluding vision.
 
     FLAT PANEL DISPLAY.  The MA IV uses an optional light-weight, 6.4 inch,
full VGA color, flat panel display ("FPD"), with integrated digitizer, which is
offered for users who do not desire a HMD or do not need to be 100% hands-free.
The FPD can also be speech-activated and contain a built-in speaker.
 
     COMPUTER SOFTWARE FOR MOBILE, BODY-WORN AND DESK-TOP USE.  The Company
acquired two software products that are offered to the market, and two other
planned products which will be developed for the market. All products, while
designed to speed up the development of applications for the Company's line of
wearable computers, are equally applicable to lap-top and desk-top applications.
 
     Currently, the Company offers two software products, linkAssist(TM) and
webAssist(TM), which are designed to get user documentation up and running on
the Mobile Assistant(TM) quickly, and which can also be used on conventional
desktop or laptop computers. The Company's linkAssist(TM) software allows users
to develop applications that need information to be quickly and easily linked
together regardless of the format of the data or where it is stored, avoiding
the need to change, convert or re-enter the existing information in any manner,
nor to use the very technical and source-altering HTML tagging process. An
interesting and useful feature of this product is that the linked words or
phrases can then be activated by voice automatically, with no development work
by the author of the documentation or databases. The webAssist(TM) software
offered by the Company allows voice navigation of HTML document links such as
those found on web sites on the World Wide Web and intranets. This provides the
user with hands-free access to all of the information found on, for example,
manufacturer and supplier and company-owned, web sites.
 
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     In addition to webAssist(TM) and linkAssist(TM), the Company intends to
develop the mobile Inspector(TM). This will be a toolkit to assist developers in
the creation of inspection applications - whether the item under inspection is a
car, a furnace or a human body. This toolkit, already proven without speech
navigation and entry features, will be updated to incorporate the Company's
speech recognition software offerings.
 
                              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 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 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 manufacturing,
     transportation, aerospace, telecommunications, 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 be material. 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). 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) can provide needed knowledge to workers in virtually any
     location. Locations may include the top of a telephone pole, a remote relay
     station or in a conduit tunnel. Crew locations can be monitored and
     coordinated in the field with the Mobile Assistant(R) through optional
     global positioning system technology and telecommunication capability.
     Crews at remote locations can consult with experts using the Company's
     two-way audio and/or video communications products.
 
          HEALTH SERVICES.  According to the National Center for Health
     Statistics, in 1995 the United States spent approximately 13.6% of the U.S.
     Gross Domestic Product, or approximately $1 trillion 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) 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). 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.
 
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          PUBLIC SECTOR.  The Company has demonstrated the ability of its
     technology to aid in law enforcement, fire protection, emergency services
     and control of national borders. The North American distributor of
     Xybernaut's MA IV, En Pointe Technologies, has recently established
     purchasing schedules for its product offerings with most significant city,
     state and municipal agencies, thus making the technology readily available.
 
          EDUCATION.  The Company believes that its mobile computing systems are
     well suited for educational applications. The Mobile Assistant(R) 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. The downsizing of the United States military and
     related budget constraints has compounded these problems. 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.
 
     The United States military's increasingly sophisticated weapon systems
require volumes of operational and technical manuals and have dramatically
increased the importance of, and reliance on, 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 that
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
and commercial 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
Military. The Army and Marine Corps have 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.
 
     The Company has already sold systems into the US Army and Navy, and expects
that its sales partners will sell heavily into the armed services both in the
USA and overseas.
 
  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 distributors, systems
integrators, industrial and commercial equipment manufacturers, independent
software vendors and VARs with defined market niche expertise and presence, as
well as to end users. In conjunction with the introduction of the MA IV, the
Company has and is negotiating terms with specialized distributors for higher
volume distribution of the MA IV. The Company believes that by forming
relationships with these partners they can gain entry to various sub-markets and
types of end users, and serve customers or have in-place sales and distribution
channels that identify new customers and sales opportunities. The Company can
then reach end users more rapidly in a variety of industries.
 
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     To try to ensure outstanding partner performance, the Company has offered
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 these channels and end-users.
 
     The Company's marketing and sales employees are responsible for
implementing direct marketing plans and sales programs, and coordinating sales
activities with sales and marketing and service partners. All fulfillment will
be accomplished mainly through distribution partners, regardless of which entity
effects the actual sales.
 
  SALES AND BACKLOG
 
     As of December 31, 1998 the Company had sold and delivered approximately
$2.7 million of the Mobile Assistant(R) systems since its commercial
introduction, and had a purchase order backlog of approximately $750,000 which
the Company anticipates will be shipped prior to June 30, 1999, although there
can be no assurance of shipment by that date. The Company does not believe that
the backlog is currently a reliable indicator of future sales since most sales
tend to book and ship within the same quarter as order sizes have been
relatively small to date. The Company expects that in the future, backlog will
emerge as an indicator of future sales as order size increases. Customers who
have placed orders in the past include, among others, AT&T, Dyncorp, Sentel, BOC
Gas, NTT (Nippon Telegraph and Telephone), Eaton Corporation, Fujitsu,
Mitsubishi, Lockheed Martin, and the United States Army. Purchase orders are
generally cancelable by the customers without penalty and are not binding upon
the customer.
 
  LICENSE GRANTED TO THE COMPANY BY DATA DISK
 
     During 1997, the Company entered into a series of agreements with Data-Disk
Technology, Inc., a Virginia-based company, that produces a memory product known
as the Data Disk that consists of a non-volatile memory chip encapsulated in a
rugged polymer casing slightly smaller than a soldier's "dogtag" that is highly
resistant to temperature and environmental conditions. The Company's management
believes that the Data Disk provides an ideal storage medium for body-worn
computer applications, especially those that involve a large number of people,
inspection sites or equipment. These tags can be used to store information such
as medical history, repair history or other data unique to an individual or
piece of equipment and from which information can be read by inserting the tag
into a reader that fits in the existing PC card slots on all models of the
Mobile Assistant(R). The U.S. Department of Defense is evaluating the Data Disk
and competing technologies to replace the current system of stamped metal
dogtags for soldiers. Under the agreement with Data Disk, the Company received
an exclusive, perpetual worldwide license to use and sell present and future
Data Disk technology for user-supported (wearable) computing applications. In
exchange for a license to sell and use Data Disk technology, the Company made
payments of $100,000 in both 1998 and 1997.
 
                                 KEY SUPPLIERS
 
     The Company has entered into supplier relationships with Sony Digital
Products, Hokubu Tsushin and Shimadzu, among others, for the production of the
MA IV system. (See "Production").
 
     The Company has also entered into design, production, supply and support
agreements with many companies, in the USA and overseas, in order to complete
its wearable line of computers. They include Fujitsu, Sony Digital Products,
Hitachi, Shimadzu, JAE, Toshiba, NEC, Multicosm, IBM, the SBS, etc.
 
     Although the Company believes there are multiple sources for many parts and
components, the Company currently depends heavily on its current suppliers.
While management believes that the Company could adapt to any supply
interruptions, such occurrences could necessitate changes in product design or
assembly methods for the Mobile Assistant(R) Series and cause the Company to
experience temporary delays or interruptions in supply while such changes are
incorporated. Further, because the order time for certain components may range
up to approximately four months, the Company also could experience delays or
interruptions in supply in the event the Company is required to find a new
supplier for any of these components. Any disruptions in supply of necessary
parts and components from the Company's key suppliers
 
                                        9
<PAGE>   10
 
could have a material adverse effect on the Company's results of operations. Any
future shortage or limited allocation of components for the Mobile Assistant(R)
could have a material adverse effect on the Company.
 
                                   PRODUCTION
 
     The Company commenced full scale production of the MA IV in the quarter
ended December 31, 1998. The Company has manufacturing agreements with Sony
Digital Products, a subsidiary of Sony Corporation based in Nagano, Japan, and
Hokubu Tsushin for the manufacture of the MA IV. Shimadzu Corporation, a
supplier of head-mounted displays and other commercial technology products based
in Kyoto, Japan, has developed and manufactured a color HMD for use with the MA
IV. Most of the parts and components for the Mobile Assistant(R) are existing PC
components that are available in high quantity from multiple vendors.
 
                                   WARRANTIES
 
     The Company currently provides customers with a warranty of one year for
parts and six months for labor. Warranty services for the MA IV Series is an
integrated offering by several vendors. Our distribution partners are
responsible for levels one and two service. The Company intends to pass on
levels one and two maintenance and call-center support to a 3rd party service
firm.
 
                                  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 CDI, Teltronics, Inc. (a subsidiary of Interactive Solutions Inc.),
ViA Inc., Texas Microsystems, Telxon, Norand, Raytheon and others. Personal
digital assistants and laptop and notebook computers are also products that
could compete against the Mobile Assistant(R) Series. 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 in which the Mobile Assistant(R)
Series is directed. 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.
However, the Company considers entry by reputable, large computer manufacturers
to be healthy for the marketplace in that it would bring legitimacy to the
market in a more rapid fashion. The Company is also confident in its
intellectual property position.
 
                             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") and
the patent and trademark offices in several foreign countries.
 
     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. Employees of the Company previously assigned this patent
to the Company.
 
     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 some of
such competitors. The Company intends to take any and all appropriate measures,
including legal action, necessary to maintain and enforce its rights under the
Patent and other patents held by the Company and to recover any damages suffered
as a result of any alleged infringement.
                                       10
<PAGE>   11
 
     In December 1998, U.S. patent number 5,844,824 ("hands-free, portable
computer and system") for the Mobile Assistant(R) Series was granted to the
Company. This patent when viewed in the context of the Company's existing
intellectual property, strengthens the near term and strategic patent position
of the Company. It not only addresses the most likely technology embodiments and
applications for wearable computing now and in the foreseeable future, but also,
just as importantly, incorporates all known prior art applicable to the
Company's industry.
 
     Most of the Company's revenue for the year ended December 31, 1998 and 1997
was derived from products included within the scope of the patents.
 
     Since inception, the Company has filed twenty-one patent applications
covering various aspects of computers in general and wearable computers in
particular. Of these twenty-one applications, nine patents have been issued and
twelve patents are pending. Most of these applications have also been filed in
European countries, The People's Republic of China, Japan, Republic of Korea,
Republic of China (Taiwan), Canada and Australia. All patents obtained by
Company employees under pending and future applications have been and will be
assigned to the Company under existing invention assignments.
 
     Notwithstanding the foregoing, there can be no assurance that the Company's
pending patent applications will issue as patents, that any issued patent will
provide the Company with significant competitive advantages or that challenges
will not be instituted against the validity or enforceability of any patent held
by the Company. The cost of litigation to uphold the validity and prevent
infringement of patents can be substantial. There also can be no assurance that
others will not independently develop similar or more advanced products, design
patentable alternatives to the Company's products or duplicate the Company's
trade secrets. The Company may in some cases be required to obtain licenses from
third-parties or to redesign its products or processes to avoid infringement.
The Company also relies on trade secrets and proprietary technology and enters
into confidentiality agreements with its employees and consultants. The Company
has implemented a trade secret management program to further protect the
Company's trade secrets and proprietary information. There can be no assurance
that the obligation to maintain the confidentiality of such trade secrets or
proprietary information will not be breached by employees or consultants or that
the Company's trade secrets or proprietary technology will not otherwise become
known or be independently developed by competitors in such a manner that the
Company has no practical recourse.
 
                            RESEARCH AND DEVELOPMENT
 
     Research and development expenditures for the years ended December 31, 1998
and 1997 and were $2,870,808 and $2,350,237 respectively. These expenditures
consist primarily of personnel engaged in the research and design of new
hardware products, test components, consulting fees, equipment and purchase
software costs required to conduct the Company's development activities.
 
                           EMPLOYEES AND CONSULTANTS
 
     As of December 31, 1998, the Company had 41 full-time and 13 part-time
employees, and had consulting arrangements with eight individuals or firms for
advice and assistance on selected technical and business issues. Of the
Company's full-time employees, three are executive officers, fourteen (14) are
technical and administrative support employees, nine are engaged in research and
development, and fifteen (15) are engaged in sales and marketing. None of the
Company's employees are represented by a labor organization and management
believes that the Company's relations with its employees are good.
 
     The Company is a party to employment and consulting agreements with certain
of its executive officers and directors. See "Management -- Employment
Agreements; -- Consulting Agreements."
 
                                       11
<PAGE>   12
 
ITEM 2.  DESCRIPTION OF PROPERTY.
 
     The Company's office and development facility consists of 18,842 square
feet located at 12701 Fair Lakes Circle, Fairfax, Virginia. The Company's
current lease is for a five-year term expiring September 30, 2003 and requires
monthly rent of $26,640.
 
     To minimize lodging expenses for visiting employees and consultants, the
Company leases four apartments in Fairfax, Virginia with aggregate monthly
rental costs of $4,651.
 
     During 1998, the Company leased approximately 1,500 square feet of office
space at the Wakadayashi Building, 5-12-6 Kita-Shinagawa, Shinagawa-ku, Tokyo
141, Japan, for use as its Far East representative office. Terms of the lease
are month-month with a base rent of approximately $2,500 per month.
 
ITEM 3.  LEGAL PROCEEDINGS.
 
     On March 19, 1998, Matrix Corporation, with whom the Company had entered
into an agreement in June 1997 (the "June Agreement"), filed a summons against
the Company in the United States District Court, Eastern District of North
Carolina, alleging that: Matrix had been damaged by a purported breach of the
December 1997 Agreement (the "December Agreement") by the Company; that the
Company should return all goods shipped by Matrix under both the June Agreement
and the December Agreement and that the Company did not intend to comply with
the December Agreement and therefore the governing contract between the two
entities should revert to the June Agreement. In addition, this summons requests
that any damages incurred by Matrix as a result of this purported breach of
contract be trebled. On August 6, 1998, the court rendered an order dismissing
all of Matrix's claims, except for the breach of contract claim under the
December Agreement. On September 9, 1998, the Company filed an answer which
denies the material allegations of the complaint, and asserts a counterclaim
alleging that Matrix failed to perform to the requirements of the December
Agreement and that Xybernaut has been damaged by this failure to perform. While
there can be no assurance of the outcome of this legal proceeding, the Company's
management believes that the remaining claim by Matrix is groundless and intends
to rigorously defended against the claim. Management further believes that the
impact of this legal proceeding will not have a material adverse effect on the
Company's operations or financial position. The maximum amount payable by the
Company under the December Agreement if Matrix performs defined tasks is
approximately $250,000 and the maximum amount of inventory that could be assumed
by the Company under the December Agreement is approximately $600,000.
 
ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
 
     At the 1998 Annual Meeting of Xybernaut Stockholders held on September 24,
1998, the following items were submitted to a vote by the common stockholders
and were approved by a majority vote:
 
     1. The election of three (3) persons to serve as directors of the Company
        for a term of three years and until their successors are duly elected
        and qualified;
 
     2. An amendment to the Company's Certificate of Incorporation and the
        Bylaws to implement an advance notice procedure for the submission of
        director nominations and other business to be considered at annual
        meetings of stockholders;
 
     3. An amendment to the Company's Certificate of Incorporation and the
        Bylaws to permit only the President, the Vice Chairmen of the Board, the
        Secretary or the Board of Directors to call special meetings of
        stockholders and to limit the business permitted to be conducted at such
        meetings to be brought before the meetings by or at the direction of the
        Board of Directors;
 
     4. An amendment to the Company's Certificate of Incorporation and the
        Bylaws to provide that a member of the Board of Directors may only be
        removed by the stockholders of the Company for cause by an affirmative
        vote of holders of at least 66 2/3% of the voting power of the then
        outstanding shares of any class or series of capital stock of the
        Company entitled to vote generally in the election of directors voting
        together as a single class (the "Voting Stock");
 
                                       12
<PAGE>   13
 
     5. An amendment to the Company's Bylaws to (a) limit the size of the Board
        of Directors to a maximum of twelve directors, the authorized number of
        directors to ten, and the Board of Directors having the sole power and
        authority to increase or decrease the number of directors acting by an
        affirmative vote of at least a majority of the total number of
        authorized directors most recently fixed by the Board of Directors, and
        (b) provide that any vacancy on the Board of Directors may be filled for
        the unexpired term (or for a new term in the case of an increase in the
        size of the board) only by an affirmative vote of at least a majority of
        the remaining directors then in office even if less than a quorum, or by
        the sole remaining director;
 
     6. An amendment to the Company's Certificate of Incorporation and the
        Bylaws to eliminate stockholder action by written consent;
 
     7. An amendment to the Company's Certificate of Incorporation and the
        Bylaws to require the approval of holders of 80% of the then outstanding
        Voting Stock and/or the approval of 66 2/3% of the directors of the
        Company for certain corporate transactions;
 
     8. An amendment to the Company's Certificate of Incorporation and the
        Bylaws to require an affirmative vote of 66 2/3% of the Voting Stock in
        order to amend or repeal any adopted amendments to the Certificate of
        Incorporation and Bylaws proposed herein and;
 
     9. Ratification of the appointment of PricewaterhouseCoopers LLP as
        independent auditors for the 1998 fiscal year.
 
                                    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"). The Common Stock and Warrants trade on the NASDAQ SmallCap
Market.
 
     As of March 26, 1998, there are approximately 330 registered 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 years ended December 31,
1998 and 1997, the high and low market prices of the Company's Common Stock and
Warrants.
 
<TABLE>
<CAPTION>
                                                               COMMON STOCK           WARRANTS
                                                              --------------       --------------
                                                              HIGH       LOW       HIGH       LOW
                                                              ----       ---       ----       ---
<S>                                                           <C>        <C>       <C>        <C>
1st Quarter 1997............................................   4 11/16    1 29/32   1 11/32     13/32
2nd Quarter 1997............................................   3 1/2      1 5/16     7/16      3/16
3rd Quarter 1997............................................   5 9/16     2 3/8      23/32     3/16
4th Quarter 1997............................................   4          1 25/32    17/32     5/32
1st Quarter 1998............................................   2 1/2      1 3/8      13/32     5/32
2nd Quarter 1998............................................   8 7/16     1 13/32   1 3/4       1/8
3rd Quarter 1998............................................   5 15/16    4 3/32    2          1 1/16
4th Quarter 1998............................................   7 7/8      3 31/32   2 11/32    1 3/16
</TABLE>
 
                                       13
<PAGE>   14
 
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 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 initial public offering ("IPO") of its Common Stock
and Warrants, which are traded on the NASDAQ SmallCap Market.
 
     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) Series. The first product in this series was introduced in
1994 and used "486" based technology ("486 System") that was produced in a
limited quantity and is no longer manufactured. Product development has been
based on the expectation of the Company that continued improvements in software
for operating systems, applications and speech recognition software will require
continued improvements in the performance and capabilities of the Mobile
Assistant Series. Based on that expectation, the Company undertook a product
development program that resulted in the second product offering in the Mobile
Assistant(R) Series, which was introduced on a preproduction basis in January
1997 and which used "586" based technology ("Mobile Assistant(R) II System").
The Mobile Assistant(R) II was replaced by the third system in this product
development program, which was introduced during the third quarter of 1997 and
used a Pentium(R) processor running at 133 MHz ("133P System"). In the fourth
quarter of 1998, the Company commenced production of the fourth system in this
product development program, the Mobile Assistant(R) IV ("MA IV"), which uses a
Pentium chipset known as the "Tillamook" that runs at 233 MHz.
 
     Additional software products are being developed and are planned for
development for use on the Mobile Assistant and other personal computers. In the
third quarter of 1997, the Company announced the introduction of linkAssist(TM),
a software product which provides a "windows" style graphical user interface
with speech navigation that allows data stored in almost any format, such as
commonly-used word processing, spreadsheet, data base, graphics or media files,
to be linked to most any application without altering the original data. In the
second quarter of 1998, the Company announced the introduction of webAssist(TM),
a software product that allows voice navigation of HTML document links such as
those found on the World Wide Web and Intranets.
 
     Since inception, the Company has financed its operations primarily through
private and public sales of equity securities, and to a lesser extent, cash
generated from operations. In 1998 and 1997, the Company received cash of
$10,426,622 and $5,710,406, respectively, from public and private placements of
its equity securities.
 
     The Company has derived its revenues from sales of the Mobile Assistant(R)
Series, 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, 1998, the Company derived the majority of its revenues
from sales of the Mobile Assistant(R). For the year ended December 31, 1997, the
Company derived approximately 68% of its revenues from sales of the Mobile
Assistant(R), including fees related to licensing agreements, and 32% of its
revenues from consulting services. In the future, the Company expects to derive
additional revenues from the sale of software and additional optional components
of the Mobile Assistant(R) Series. Cost of sales include the cost of components
for the Mobile Assistant(R) Series, direct labor, direct materials, overhead
allocations, inventory obsolescence charges, amortization of tooling costs and
shipping costs.
 
     The Company has incurred operating losses throughout 1998 and expects such
losses to continue in the near term as it expands its product development and
marketing capabilities. At December 31, 1998, the Company had an accumulated
deficit of $31,364,331. The achievement of profitability is primarily dependent
upon the continued development and commercial acceptance of the Company's
products, the successful management of the business and management's ability to
strategically focus the Company. There can be no assurance as to whether or when
profitable operations will occur. In addition, the Company is experiencing
 
                                       14
<PAGE>   15
 
negative cash flow from operations and it is expected that it will continue to
experience negative cash flows through 1999 and potentially thereafter.
 
     The Company's independent accountant's report on its financial statements
as of and for the years ended December 31, 1998 and 1997 contains an explanatory
paragraph that the Company's historical operating losses and limited capital
resources raise substantial doubt about its ability to continue as a going
concern. The Company may require substantial additional funds in the future, and
there can be no assurance that any independent accountant's report on the
Company's future financial statements will not include a similar explanatory
paragraph if the Company is unable to raise sufficient funds or generate
sufficient cash from operations to cover the costs of its operations.
 
     The Company intends to continue expenditures on research and development of
additional hardware and software products. Research and development activities
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 (SFAS 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 started limited shipments of its
linkAssist(TM) software late in the year ended December 31, 1997, but the costs
eligible for capitalization under SFAS 86 were immaterial during this period and
were not capitalized. Such costs were immaterial in 1998 and are expected to be
immaterial in 1999. Research and development expenses for the years ended
December 31, 1998 and 1997 were $2,870,808 and $2,350,237, respectively, none of
which were 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 and completed payments under this option
during the year ended December 31, 1997. 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 10 to Consolidated Financial Statements). At December 31,
1998, the Company had approximately $27,692,000 of net operating loss carry
forwards for federal income tax purposes that begin to expire in 2010. The use
of these carry forwards may be limited in any one year under Internal Revenue
Code Section 382 if significant ownership changes occur.
 
     The Year 2000 Issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of the Company's
computer programs that have date-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. This could result in a system
failure or miscalculations causing disruptions of operations, including, among
other things, a temporary inability to process transactions, send invoices, or
engage in similar normal business activities.
 
     Based on a recent assessment, the Company has determined that it will be
required to modify or replace portions of our software so that its computer
systems will properly utilize dates beyond December 31, 1999. The Company
believes that it can mitigate the Year 2000 Issue with modifications to existing
software and conversions to new software. However, if the Company fails to make
such modifications and conversions, or if it does not make them on a timely
basis, the Year 2000 Issue could have a material impact on its operations.
 
     The Company has contacted all of its significant suppliers and large
customers to determine the possible effect on its operations of their inability
or failure to remediate its own Year 2000 Issue. Its estimate of the costs to
remediate the Year 2000 issue is based on presently available information.
However, the Company cannot guarantee that the systems of other companies on
which it systems relies will be timely converted, or
 
                                       15
<PAGE>   16
 
that a failure to convert by another company, or a conversion that is
incompatible with our systems, would not have material adverse effect on its
operations. The Company has no exposure to contingencies related to the Year
2000 Issue for the products we have sold.
 
     The Company utilizes both internal and external resources to reprogram, or
replace, and test the software for Year 2000 modifications. The Company plans to
complete the Year 2000 project within three months and it estimates the total
remaining cost of the Year 2000 project at $6,000. Approximately $1,700 of the
total project cost is attributable to the purchase of new software, which will
be capitalized. The remaining $4,300, which will be expensed as incurred over
the next six months, is not expected to have a material effect on its results of
operations. To date, the Company has incurred and expensed approximately $1,000
related to its Year 2000 project.
 
     The Company's estimates of the date of completion and cost of our Year 2000
project are based on its best estimates, which it derived utilizing numerous
assumptions of future events including the continued availability of certain
resources, third party modification plans and other factors. The costs and
completion date of its Year 2000 project could differ materially from our
estimates due to the lack of availability and cost of personnel trained in this
area, our ability to locate and correct all relevant computer codes, and similar
uncertainties.
 
RESULTS OF OPERATIONS
 
     The following table sets forth certain consolidated financial data as a
percentage of revenues for the years ended December 31, 1998 and 1997.
 
<TABLE>
<CAPTION>
                                                               YEAR ENDED     YEAR ENDED
                                                              DECEMBER 31,   DECEMBER 31,
                                                                  1998           1997
                                                              ------------   ------------
<S>                                                           <C>            <C>
Revenues....................................................       100.0%         100.0%
Cost of Sales...............................................       259.8          150.8
                                                                --------       --------
     Gross margin...........................................      (159.8)         (50.8)
                                                                --------       --------
Operating expenses:
     Sales and marketing....................................       512.6          403.7
     General and administrative.............................       501.0          433.1
     Research and development...............................       327.9          289.3
                                                                --------       --------
Total operating expenses....................................     1,341.5        1,126.1
                                                                --------       --------
Interest income, net........................................         3.8           10.2
                                                                --------       --------
Net loss....................................................    (1,497.5)      (1,166.7)
                                                                --------       --------
Provisions for preferred stock..............................       110.4           70.4
                                                                --------       --------
Net loss applicable to holders of common stock..............    (1,607.9)%     (1,237.1)%
                                                                ========       ========
</TABLE>
 
              YEARS ENDED DECEMBER 31, 1998 AND DECEMBER 31, 1997
 
     REVENUES.  Revenues for the year ended December 31, 1998 were $875,560, an
increase of $63,038, or 8%, compared to $812,522 for the year ended December 31,
1997. Product revenues for the year ended December 31, 1998 were $873,586 an
increase of $318,064 or 57%, compared to $555,522 for the corresponding period
in 1997. The increase in product revenues for the year was related to the
introduction of the MA IV and the higher number of 133P Systems that were sold
during that period, compared to the lower number of 133P and Mobile Assistant(R)
II Systems that were sold in the corresponding period in 1997. Consulting and
license revenues for the year ended December 31, 1998 were $1,974, a decrease of
$255,026, or 99%, compared to $257,000 for the corresponding period in 1997. In
1997 the Company recognized licensing revenue of $250,000, which represented the
remaining balance of deferred licensing revenue with
 
                                       16
<PAGE>   17
 
Rockwell International, who elected to discontinue operating under a license
agreement with the Company due to a restructuring of their business operations.
 
     COST OF SALES.  The cost of sales for the year ended December 31, 1998 was
$2,274,455, an increase of $1,048,883 or 86%, compared to $1,225,572 for the
year ended December 31, 1997. The cost of goods sold increased commensurately
with the increase in product sales. Additionally in 1998, the Company recognized
charges of approximately $455,000 related to the write-off of certain
capitalized tooling costs related to the 133P Systems. In 1998 and 1997, the
Company recognized charges to decrease the carrying value of inventory by
$770,557 and $724,978, respectively, to reflect the loss of value of older
products and technologies.
 
     SALES AND MARKETING EXPENSES.  Sales and marketing expenses for the year
ended December 31, 1998 were $4,488,496, an increase of $1,208,140, or 37%,
compared to $3,280,356 for the year ended December 31, 1997. The increase
resulted mainly from increases in consulting expenses related to additional
marketing programs to support the launch of the MA IV, personnel and
infrastructure costs to support sales, marketing and customer service, and
expenses related to the Company's representative office in Japan which became
fully operational in 1998. Offsetting the 1997 increase was approximately
$253,000 related to receivables which were written off and an expense of
approximately $125,000 related to the issuance of warrants to a consultant.
 
     GENERAL AND ADMINISTRATIVE EXPENSES.  General and administrative expenses
for the year ended December 31, 1998 were $4,386,899 an increase of $868,031 or
25%, compared to $3,518,868 for the year ended December 31, 1997. This increase
resulted primarily from a charge of approximately $230,000 related to the
write-off of software that had no further remaining value to the Company, legal
and accounting fees of approximately $225,000 related to a cancelled offering of
equity securities and increased expenses related to the recruitment of key
personnel.
 
     RESEARCH AND DEVELOPMENT EXPENSES.  Research and development expenses for
the year ended December 31, 1998 were $2,870,808, an increase of $520,571, or
22%, compared to $2,350,237 for the year ended December 31, 1997. This increase
reflects the Company's ongoing research and development efforts, including
payments to Sony Digital Products for the design and production of the MA IV,
and the addition of new personnel.
 
     OTHER INCOME, NET.  Other income for the year ended December 31, 1998 was
$33,610, a decrease of $48,935, or 59%, compared to $82,545 for the year ended
December 31, 1996. This decrease is primarily the result of lower average
monthly cash balances in fiscal 1998 versus those during fiscal 1997, which
reflected the interest income on proceeds from the Company's initial public
offering that was completed in July 1996.
 
     DIVIDEND ON PREFERRED STOCK, DEEMED DIVIDEND ACCRETION ON PREFERRED
STOCK.  The Company's Series A Preferred Stock was issued in June 1997 and
accrues dividends at 5% per annum on the outstanding principal amount. The
Company's Series B Preferred Stock was issued in November 1997 and February 1998
and accrues dividends at 4% per annum on the outstanding principal amount. The
Company's Series C Preferred Stock was issued in May 1998 and accrues dividends
at 5% per annum on the outstanding principal amount. For the year ended December
31, 1998, the amount of dividends was $59,303, a decrease of $23,602 or 28%,
compared to $82,905 in 1997. In accordance with the Emerging Issues Task Force
report from the Securities and Exchange Commission titled "Accounting for the
Issuance of Convertible Preferred Stock and Debt Securities with a Nondetachable
Conversion Feature", the value of the beneficial conversion feature was
recognized for the Series A and Series B Preferred Stock, which have been fully
accreted. The amount of this accretion for the year ended December 31, 1998 was
$907,489, an increase of $418,796 or 86%, compared to $488,693 in 1997.
Additional paid in capital is reduced by the amount of accretion and preferred
stock is increased by the amount of accretion, resulting in no impact on the
overall amount of stockholders' equity. All of the Company's Series A and B
Preferred Stock has been converted as of December 31, 1998.
 
     NET LOSS ATTRIBUTABLE TO HOLDERS OF COMMON STOCK.  As a result of the
factors described above, the net loss attributable to holders of Common Stock
for the year ended December 31, 1998 was $14,078,280, an increase of $4,026,716
or 40% compared to $10,051,564 for the year ended December 31, 1997. Although
the
 
                                       17
<PAGE>   18
 
Company was subject to taxation during the years ended December 31, 1998 and
1997, the Company incurred net losses during these periods, and therefore no
provision for taxes was made.
 
                        LIQUIDITY AND CAPITAL RESOURCES
 
     From its inception until the completion of the IPO, the Company has
financed its operations from the private sale of its securities, from vendor
credit, short-term loans received from management, stockholders and others.
 
     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 ("the Unit"). Gross
proceeds from the sale of the Units were $13,282,500 and net proceeds after
expenses were $10,842,487.
 
     On June 30, 1997, the Company completed a private placement of an aggregate
of 3,000 shares of the Company's Series A Preferred Stock, par value $0.01 per
share ("Series A Preferred Stock"), and realized gross proceeds of $3,000,000
and net proceeds of approximately $2,762,000 after related expenses. The holders
of the Series A Preferred Stock converted all such shares resulting in the
issuance of 1,958,984 shares of Common Stock.
 
     On November 12, 1997, the Company completed a private placement of an
aggregate of 3,180 shares of the Company's Series B Preferred Stock, par value
$0.01 per share ("Series B Preferred Stock"), and realized gross proceeds of
$3,180,000 and net proceeds of approximately $2,949,000 after related expenses.
On February 23, 1998, the Company completed a follow-on placement of its Series
B Preferred and realized gross proceeds of $1,000,000 and net proceeds of
approximately $875,000 after related expenses. The holders of the Series B
Preferred Stock converted all such shares resulting in the issuance of 3,172,239
shares of Common Stock.
 
     In April 1998, the Company entered into an equity line of credit agreement
and received an initial gross amount of $1,000,000 in exchange for Common Stock.
Under this line of equity, the Company had the right, but not the obligation, to
obtain up to an additional $10,000,000 in a series of equity drawdowns based on
terms and conditions specified in the line of credit. In connection with this
line of equity, the Company issued five-year warrants to purchase up to 40,000
shares of stock at $1.76 per share and 20,000 shares of stock at $2.81 per share
at any time starting six months after closing. The placement agent for this
transaction received a cash fee of 5% and 50,000 shares of unregistered stock.
 
     In May 1998, the Company completed a $750,000 private placement of 375
shares of Series C Preferred Stock, par value $0.01 per share ("Series C
Preferred Stock") and 110,294 shares of Common Stock. The Series C Preferred
Stock has a stated value of $1,000 per share. A holder of the Series C Preferred
Stock is entitled to receive, if and when declared, a dividend equal to 5% of
the stated value per share per annum, payable in shares of Common Stock or in
cash, payable upon conversion of the Series C Preferred Stock. The Certificate
of Designation of the Series C Preferred Stock provides the Company with several
redemption options and allows for the conversion of unredeemed Series C
Preferred Stock in 25% increments on August 15, 1998, November 15, 1998,
February 15, 1999, and May 15, 1999. The holders of the Series C Preferred Stock
have converted 187.5 of such shares resulting in the issuance of 47,781 shares
of Common Stock. Any Series C Preferred Stock outstanding on May 15, 2000 must
be converted into Common Stock at that date.
 
     In June 1998, the Company completed a $1,000,000 private placement of
Common Stock in which 153,846 restricted shares, as defined in Rule 144
promulgated under the Securities Act, were issued at a price of $6.50 per share.
 
     In June 1998, the Company amended and exercised a put option in the
aggregate principal amount of $3,000,000 under the April 1998 private equity
line of credit agreement mentioned above. In connection with such action, the
Company issued 545,454 shares of Common Stock. Such shares are subject to
restrictions on resale for a period of nine months and to repricing upon
occurrences of certain conditions. In addition, the
 
                                       18
<PAGE>   19
 
Company issued five-year warrants to purchase up to 300,000 shares of Common
Stock at a price of $5.25 per share. Subsequently the Company has issued an
additional 94,004 shares upon the occurrence of certain repricing events.
 
     In October 1998, the Company entered into a financing agreement with an
investor pursuant to which the Company sold $2,600,000 of Common Stock to the
investor during the period from October 8, 1998 to November 12, 1998. The
Company issued 593,201 shares of Common Stock at prices ranging from $4.04 to
$5.72 under this financing agreement. In addition, the Company issued three
warrants to purchase up to 12,500 shares of Common Stock each, at prices of
$9.58, $9.09 and $13.05 per share, respectively. These warrants are exercisable
at any time starting six months after the closing and ending five years after
closing. The placement agent for this transaction received a cash fee of 6%.
 
     In November 1998, the Company entered into a financing agreement with an
investor pursuant to which the Company sold $1,595,000 of Common Stock to the
investor. The Company issued 290,000 shares of Common Stock at $5.50 per share
under this financing agreement. Such shares were subject to repricing under
certain circumstances. Subsequently the Company issued an additional 150,000
shares upon the occurrence of certain repricing events.
 
     On December 17, 1998, the Company borrowed $1,250,000 from two financial
institutions. The maturity date of the debt was January 29, 1999 and interest
was at 12% per annum. On January 29, 1999, the Company repaid the debt.
 
     In January 1999, the Company exercised separate put options in the
aggregate amount of $3,360,000 under the April 1998 private equity line of
credit agreement mentioned above. In connection with such put options, the
Company issued 841,356 shares of Common Stock at prices ranging from $4.08 to
$4.46. In addition, the Company issued a warrant to purchase 100,000 shares of
Common Stock at an exercise price of $6.00 per share and a warrant to purchase
100,000 shares of Common Stock at an exercise price of $5.50 per share.
 
     On March 10, 1999, the Company completed the first tranche of $5.0 million
of a $10.0 million private placement of an aggregate of 5,000 shares of the
Company's Series D Preferred Stock, par value $.01 per share (the "Series D
Preferred Stock"), and realized gross proceeds of $5.0 million and net proceeds
of approximately $4,990,000 after related expenses. In addition, the Company
issued warrants to purchase an aggregate of 100,000 shares of the Company's
Common Stock. The warrants have an exercise price equal to 125% of the closing
bid price of the Common Stock on the first trading day immediately preceding the
closing date of the first tranche. The warrants have an exercise period which
ends on the three year anniversary of the issuance date of the warrants.
 
     For the year ended December 31, 1998, the Company's operating activities
used cash of $10,699,000. This was primarily the result of a $13,111,488 net
loss and a net increase in inventories of $835,795. These were offset by a net
increase in accounts payable and accrued expenses of $1,242,766, a non-cash
obsolescence inventory charge of $770,557, depreciation and amortization of
$503,143 and a non-cash charge for tooling costs of $455,449. Cash used in
investing activities for the year ended December 31, 1998 was $985,899, which
included $448,744 in capitalized tooling costs, $313,109 related to obtaining
and maintaining patents and $256,358 for the acquisition of property and
equipment. Proceeds from the Company's financing activities for the year ended
December 31, 1998 were $11,657,182 which primarily consisted of $9,186,659 from
the issuance of Common Stock, $1,240,053 from the issuance of the Company's
Series B and Series C Preferred Stock, net of related fees, and $1,250,000 of
proceeds from notes and loans. As a result of the above, cash and cash
equivalents on hand as of December 31, 1998 was $924,649, a decrease of $27,717
from the $952,366 of cash on hand as of December 31, 1997.
 
     For the year ended December 31, 1997, the Company's operating activities
used cash of $10,062,427. This was primarily the result of a $9,479,966 net loss
and cash used by inventory of $1,930,378, offset by a net increase in accounts
payable and accrued expenses of $515,466 and depreciation and amortization of
$277,299. Cash used in investing activities for the year ended December 31, 1997
was $866,228, which included $364,678 for the acquisition of property and
equipment, $231,298 related to obtaining and
 
                                       19
<PAGE>   20
 
maintaining patents and $270,252 in capitalized tooling costs. Proceeds from the
Company's financing activities for the year ended December 31, 1997 were
$5,606,054 which primarily consisted of $5,710,406 from the issuance of the
Company's Series A and Series B Preferred Stock, net of related fees, and
$56,500 of proceeds from notes and loans, offset by payments on notes and loans
totaling $72,232, and $16,667 for the remaining payment on the acquisition of
Tech Virginia and repayment of loans. As a result of the above, cash and cash
equivalents on hand as of December 31, 1997 was $952,366, a decrease of
$5,322,601 from the $6,274,967 of cash on hand as of December 31, 1996.
 
     At December 31, 1998, the Company had no material capital commitments.
 
     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), and expands its full sales, service and marketing functions, and
develops the support structure for these activities. The timing of increases in
personnel and other expenses, the amount of working capital consumed by
operations, marketing and rollout expenses for the MA IV, and competitive
pressures on gross margins will impact the magnitude and timing of the Company's
cash requirements. Management is currently exploring financing alternatives to
supplement the Company's cash position. Potential sources of additional
financing include private equity financings, mergers, strategic investments,
strategic partnerships or various forms of debt financings. If additional funds
are raised by the Company through the issuance of equity securities, the
percentage of ownership of the then current stockholders of the Company will be
reduced. 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 2000. However, there
can be no assurance that the Company can or will obtain sufficient funds from
operations or from closing additional financings on terms acceptable to the
Company.
 
     The Company's independent accountant's report on its financial statements
as of and for the years ended December 31, 1998 and 1997 contains an explanatory
paragraph that the Company's historical operating losses and limited capital
resources raise substantial doubt about its ability to continue as a going
concern. The Company may require substantial additional funds in the future, and
there can be no assurance that any independent accountant's report on the
Company's future financial statements will not include a similar explanatory
paragraph if the Company is unable to raise sufficient funds or generate
sufficient cash from operations to cover the costs of its operations.
 
                        POSSIBLE NON-CASH FUTURE CHARGE
 
     As a condition to the Company's initial public offering (the "IPO"), Royce
Investment Group, the Representative of the several underwriters (the
"Representative"), required certain of the Company's stockholders to deposit a
total of 1,800,000 shares of Common Stock (the "Escrowed Shares"), in escrow
pursuant to an escrow agreement with Continental Stock Transfer & Trust Company,
the escrow agent and the Representative. The Escrowed Shares are subject to the
following terms and conditions:
 
      - The Escrowed Shares will be released incrementally 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 certain gross revenue and earnings (loss)
        per share targets.
 
      - If such per share targets are not met in any of the relevant 12-month
        periods and the price of the common stock does not meet or exceed agreed
        upon price levels, certain amounts of the Escrowed Shares will be
        returned to the Company for each period and canceled.
 
      - All the Escrowed Shares will be released to the stockholders if the
        closing price of the common stock as reported on The Nasdaq SmallCap
        Market 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.
 
     The difference between the initial offering price and the market value (at
the time of release) of any Escrowed Shares released will be deemed to be an
additional compensation expense. Such expense, depending
 
                                       20
<PAGE>   21
 
on the price per share, may 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 Company did not meet the targets for escrow release for September 30,
1997 and September 30, 1998. As a result, 300,000 and 750,000 shares,
respectively, were canceled from the escrow pool resulting in a reduction of
2.1% and 3.6% of our outstanding shares of common stock.
 
     Give the start of full-scale production and distribution of the MA IV in
early 1999, the Company's management believes that it is likely that the
Company's gross revenues and allowable losses will not meet the Performance
Targets of the 12-month period ending September 30, 1999. 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, 1999. If conditions are not met
for release from escrow, then 750,000 shares of stock will be returned to the
Company on September 30, 1999 and canceled, resulting in no earnings impact and
a commensurately lower number of outstanding shares.
 
     Since the Company has reported losses, the loss per share for the Company
is calculated using outstanding shares less shares held in escrow to avoid
antidilution. Therefore, the cancellation of shares from escrow does not affect
the reported loss per share.
 
                                       21
<PAGE>   22
 
ITEM 7.  FINANCIAL STATEMENTS.
 
                         INDEX TO FINANCIAL STATEMENTS
 
<TABLE>
<S>                                                           <C>
Report of Independent Accountants...........................  F-1
Consolidated Balance Sheets -- December 31, 1998 and
  1997......................................................  F-2
Consolidated Statements of Operations -- Years ended
  December 31, 1998 and 1997................................  F-3
Consolidated Statements of Stockholders' Equity -- Years
  ended December 31, 1998 and 1997..........................  F-4
Consolidated Statements of Cash Flows -- Years ended
  December 31, 1998 and 1997................................  F-5
Notes to Consolidated Financial Statements..................  F-6
</TABLE>
 
                                       22
<PAGE>   23
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
 
To the Board of Directors and
Stockholders of Xybernaut Corporation
 
     In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, of changes in stockholders'
equity and of cash flows present fairly, in all material respects, the financial
position of Xybernaut Corporation and its subsidiary at December 31, 1998 and
1997, and the results of their operations and their cash flows for each of the
two years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles. 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 of these statements in accordance with generally accepted auditing
standards which 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, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion expressed above.
 
     The accompanying financial statements have been prepared assuming the
Company will continue as a going concern. As discussed in Note 1 to the
financial statements, the Company has incurred recurring losses from operations
and will require additional capital to fund its operations. These matters raise
substantial doubt about the Company's ability to continue as a going concern.
Management's plans in regard to these matters are also described in Note 1. The
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.
 
/s/ PricewaterhouseCoopers, LLP
 
McLean, VA
April 14, 1999
 
                                       F-1
<PAGE>   24

                             XYBERNAUT CORPORATION
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                                     DECEMBER 31,
                                                              ---------------------------
                                                                  1998           1997
                                                              ------------   ------------
<S>                                                           <C>            <C>
                                         ASSETS
Current assets:
      Cash and cash equivalents.............................  $    924,649   $    952,366
      Accounts receivable, net of allowances of $91,131 and
       $53,211..............................................       229,120        216,767
      Inventory, net of reserves of $770,557 and $724,978...     1,347,668      1,607,781
      Prepaid and other current assets......................       374,243        334,245
                                                              ------------   ------------
          Total current assets..............................     2,875,680      3,111,159
                                                              ------------   ------------
Property and equipment, net.................................       462,384        505,695
                                                              ------------   ------------
Other assets:
      Patent costs, net of accumulated amortization of
       $313,982 and $177,076................................       560,625        384,422
      Tooling costs, net of accumulated amortization of
       $326,752 and $47,194.................................       370,285        376,990
      Other.................................................       142,614        153,351
                                                              ------------   ------------
          Total other assets................................     1,073,524        914,763
                                                              ------------   ------------
          Total assets......................................  $  4,411,588   $  4,531,617
                                                              ============   ============
 
                          LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
      Notes and loans payable...............................  $  1,250,000   $     19,530
      Accounts payable......................................     1,626,897        429,780
      Accrued expenses......................................       786,980        908,372
                                                              ------------   ------------
          Total current liabilities.........................     3,663,877      1,357,682
                                                              ------------   ------------
Commitments and contingencies (Note 11) Stockholders'
  equity:
      Preferred Stock, $.01 par value, 6,000,000 shares
       authorized, 188 and 5,430 shares of convertible
       preferred stock issued and outstanding (Note 6)......       182,378      4,193,355
      Common Stock, $.01 par value, 40,000,000 shares
       authorized, 21,359,751 and 14,360,515 shares issued
       and outstanding......................................       213,597        143,605
      Additional paid-in capital............................    31,716,067     17,181,329
      Deferred compensation.................................            --        (91,511)
      Accumulated deficit...................................   (31,364,331)   (18,252,843)
                                                              ------------   ------------
          Total stockholders' equity........................       747,711      3,173,935
                                                              ------------   ------------
          Total liabilities and stockholders' equity........  $  4,411,588   $  4,531,617
                                                              ============   ============
</TABLE>
 
              The accompanying notes are an integral part of these
                       consolidated financial statements.
                                       F-2
<PAGE>   25
 
                             XYBERNAUT CORPORATION
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                                              ----------------------------
                                                                  1998            1997
                                                              ------------    ------------
<S>                                                           <C>             <C>
Revenue:
      Product sales.........................................  $    873,586    $    555,522
      Consulting and license................................         1,974         257,000
                                                              ------------    ------------
          Total revenue.....................................       875,560         812,522
Cost of sales...............................................     2,274,455       1,225,572
                                                              ------------    ------------
          Gross loss........................................    (1,398,895)       (413,050)
Operating expenses:
      Sales and marketing...................................     4,488,496       3,280,356
      General and administrative............................     4,386,899       3,518,868
      Research and development..............................     2,870,808       2,350,237
                                                              ------------    ------------
          Total operating expenses..........................    11,746,203       9,149,461
                                                              ------------    ------------
          Operating loss....................................   (13,145,098)     (9,562,511)
Interest income, net........................................        33,610          82,545
                                                              ------------    ------------
      Net loss..............................................   (13,111,488)     (9,479,966)
                                                              ------------    ------------
Provision for preferred stock dividends.....................        59,303          82,905
Provision for accretion on preferred stock beneficial
  conversion feature........................................       907,489         488,693
                                                              ------------    ------------
      Net loss applicable to holders of common stock........  $(14,078,280)   $(10,051,564)
                                                              ============    ============
      Net loss per common share applicable to holders of
        common stock (basic and diluted)....................  $      (0.80)   $      (0.78)
                                                              ============    ============
Weighted average number of common shares Outstanding (basic
  and diluted)..............................................    17,670,318      12,844,974
                                                              ============    ============
</TABLE>
 
              The accompanying notes are an integral part of these
                       consolidated financial statements.
                                       F-3
<PAGE>   26
 
                             XYBERNAUT CORPORATION
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
                                         NUMBER OF SHARES          VALUE OF SHARES       ADDITIONAL
                                      ----------------------   -----------------------     PAID-IN     ACCUMULATED      DEFERRED
                                      PREFERRED     COMMON      PREFERRED     COMMON       CAPITAL       DEFICIT      COMPENSATION
                                      ---------   ----------   -----------   ---------   -----------   ------------   ------------
<S>                                   <C>         <C>          <C>           <C>         <C>           <C>            <C>
BALANCE, DECEMBER 31, 1996..........       --     14,259,112            --   $142,591    $15,520,245   $ (8,772,877)          --
Issuance of Series A Preferred
  Stock.............................    3,000             --   $ 2,761,669         --             --             --           --
Partial Conversion of Preferred
  Stock into common stock...........     (750)       250,000      (690,417)     2,500        687,917             --           --
Cancellation of escrow shares of
  common stock......................       --       (300,000)           --     (3,000)         3,000             --           --
Cancellation of accrued shares of
  common stock......................       --         (1,747)           --        (17)            17             --           --
Issuance of Series B Preferred
  Stock.............................    3,180             --     2,948,737         --             --             --           --
Exercises of stock options..........       --        150,000            --      1,500             --             --           --
Value of beneficial conversion
  feature on Preferred Stock........       --             --    (1,219,712)        --      1,219,712             --           --
Accretion of deemed dividend of
  Preferred Stock...................       --             --       488,693         --       (488,693)            --           --
Preferred Stock dividend
  requirements......................       --             --            --         --        (82,905)            --           --
Issuance of warrants on common
  stock.............................       --             --            --         --        217,000             --    $(217,000)
Compensation related to common stock
  warrants..........................       --             --            --         --             --             --      125,489
Warrants issued in connection with
  Series B Preferred stock
  offerings.........................       --             --       (95,615)        --         95,615             --           --
Dividends on preferred stock paid
  with common stock.................       --          3,150            --         31          9,421             --           --
Net loss............................       --             --            --         --             --     (9,479,966)          --
                                       ------     ----------   -----------   --------    -----------   ------------    ---------
BALANCE, DECEMBER 31, 1997..........    5,430     14,360,515     4,193,355    143,605     17,181,329    (18,252,843)     (91,511)
Sale of common stock................       --      2,776,923            --     27,770      9,158,889             --           --
Issuance of Series B Preferred
  Stock.............................    1,000             --       875,299         --             --             --           --
Issuance of common stock in
  connection with Sale of Series B
  Preferred Stock...................       --         50,000            --        500         97,938             --           --
Partial conversion of Preferred
  Stock into common stock...........   (6,617)     4,827,570    (5,982,049)    48,275      5,933,774             --           --
Value of beneficial conversion
  feature on Preferred Stock........       --             --      (176,470)        --        176,470             --           --
Accretion of deemed dividend of
  Preferred Stock...................       --             --       907,489         --       (907,489)            --           --
Preferred Stock dividend
  requirements......................       --             --            --         --        (59,303)            --           --
Amortization of deferred
  compensation......................       --             --            --         --             --             --       91,511
Issuance of Series C Preferred
  Stock.............................      375             --       364,754         --             --             --           --
Cancellation of escrow shares of
  common stock......................       --       (750,000)           --     (7,500)         7,500             --           --
Dividends on Preferred Stock paid
  with common stock.................       --         94,743            --        947        126,959             --           --
Net loss............................       --             --            --         --             --    (13,111,488)          --
                                       ------     ----------   -----------   --------    -----------   ------------    ---------
BALANCE, DECEMBER 31, 1998..........      188     21,359,751   $   182,378   $213,597    $31,716,067   $(31,364,331)   $      --
                                       ======     ==========   ===========   ========    ===========   ============    =========
 
<CAPTION>
                                          TOTAL
                                      STOCKHOLDERS'
                                         EQUITY
                                      -------------
<S>                                   <C>
BALANCE, DECEMBER 31, 1996..........  $  6,889,959
Issuance of Series A Preferred
  Stock.............................     2,761,669
Partial Conversion of Preferred
  Stock into common stock...........            --
Cancellation of escrow shares of
  common stock......................            --
Cancellation of accrued shares of
  common stock......................            --
Issuance of Series B Preferred
  Stock.............................     2,948,737
Exercises of stock options..........         1,500
Value of beneficial conversion
  feature on Preferred Stock........            --
Accretion of deemed dividend of
  Preferred Stock...................            --
Preferred Stock dividend
  requirements......................       (82,905)
Issuance of warrants on common
  stock.............................            --
Compensation related to common stock
  warrants..........................       125,489
Warrants issued in connection with
  Series B Preferred stock
  offerings.........................            --
Dividends on preferred stock paid
  with common stock.................         9,452
Net loss............................    (9,479,966)
                                      ------------
BALANCE, DECEMBER 31, 1997..........     3,173,935
Sale of common stock................     9,186,659
Issuance of Series B Preferred
  Stock.............................       875,299
Issuance of common stock in
  connection with Sale of Series B
  Preferred Stock...................        98,438
Partial conversion of Preferred
  Stock into common stock...........            --
Value of beneficial conversion
  feature on Preferred Stock........            --
Accretion of deemed dividend of
  Preferred Stock...................            --
Preferred Stock dividend
  requirements......................       (59,303)
Amortization of deferred
  compensation......................        91,511
Issuance of Series C Preferred
  Stock.............................       364,754
Cancellation of escrow shares of
  common stock......................            --
Dividends on Preferred Stock paid
  with common stock.................       127,906
Net loss............................   (13,111,488)
                                      ------------
BALANCE, DECEMBER 31, 1998..........  $    747,711
                                      ============
</TABLE>
 
              The accompanying notes are an integral part of these
                       consolidated financial statements
                                       F-4
<PAGE>   27
 
                             XYBERNAUT CORPORATION
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                                              ---------------------------
                                                                  1998           1997
                                                              ------------   ------------
<S>                                                           <C>            <C>
Cash flows from operating activities:
  Net loss..................................................  $(13,111,488)  $ (9,479,966)
  Adjustments to reconcile net loss to net cash used in
     operating activities:
     Depreciation and amortization..........................       503,143        277,299
     Gain on disposal of assets.............................        (6,626)            --
     Provision for write-down of inventory..................       770,557        724,978
     Provision for bad debts................................        37,920        253,211
     Non-cash charges for stock and warrants issued for
       services.............................................        91,511        125,489
     Reduction of equipment carrying value..................       233,097             --
     Reduction of tooling costs carrying value..............       455,449             --
     Changes in assets and liabilities:
       Inventory............................................      (835,795)    (1,930,378)
       Accounts receivable..................................       (50,273)       (42,188)
       Prepaid and other current assets.....................       (39,998)      (136,534)
       Other assets.........................................        10,737       (119,804)
       Accounts payable and accrued expenses................     1,242,766        515,466
       Deferred licensing revenue...........................            --       (250,000)
                                                              ------------   ------------
     Net cash used in operating activities..................   (10,699,000)   (10,062,427)
                                                              ------------   ------------
Cash flows from investing activities:
  Proceeds from sale of property and equipment..............        32,312             --
  Acquisition of property and equipment.....................      (256,358)      (364,678)
  Acquisition of patents and related costs..................      (313,109)      (231,298)
  Capitalization of tooling costs...........................      (448,744)      (270,252)
                                                              ------------   ------------
     Net cash used in investing activities..................      (985,899)      (866,228)
                                                              ------------   ------------
Cash flows from financing activities:
  Proceeds from:
     Common stock offering, net.............................     9,186,659             --
     Notes and loans........................................     1,250,000         56,500
     Preferred stock offerings, net.........................     1,240,053      5,710,406
  Payments for:
     Notes and loans........................................       (19,530)       (72,232)
     Acquisition of Tech Virginia...........................            --        (16,667)
     Other..................................................            --        (71,953)
                                                              ------------   ------------
     Net cash provided by financing activities..............    11,657,182      5,606,054
                                                              ------------   ------------
Net decrease in cash and cash equivalents...................       (27,717)    (5,322,601)
Cash and cash equivalents, beginning of period..............       952,366      6,274,967
                                                              ------------   ------------
Cash and cash equivalents, end of period....................  $    924,649   $    952,366
                                                              ============   ============
Supplemental disclosure of cash flow information:
     Cash paid during the period for interest...............  $      5,032   $      7,124
                                                              ============   ============
Supplemental disclosure of non-cash financing activities:
     Common stock issued for settlement of accrued
       liabilities..........................................  $    226,344   $         --
                                                              ============   ============
     Deferred compensation in connection with stock warrants
       granted..............................................  $         --   $    217,000
                                                              ============   ============
     Issuance of warrants in connection with preferred stock
       offering.............................................  $         --   $     96,615
                                                              ============   ============
</TABLE>
 
              The accompanying notes are an integral part of these
                       consolidated financial statements.
                                       F-5
<PAGE>   28
 
                             XYBERNAUT CORPORATION
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1. BUSINESS AND FINANCING:
 
  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.
 
  FINANCING:
 
     The Company has incurred significant recurring losses from operations since
inception and had a working capital deficit of $788,197 as of December 31, 1998.
The Company will require additional capital to fund its operations and meet its
ongoing obligations for 1999 and beyond. Management believes they will be
successful in their efforts to obtain such financing and subsequent to year end
has raised approximately $8,350,000 (see Note 13). The Company also recently
introduced its Mobile Assistant IV(R) product and has plans to continue
acquiring additional software applications for the Mobile Assistant IV(R). There
can be no assurance that the Company will not incur additional losses until its
recently introduced product generates significant revenue. The accompanying
consolidated financial statements have been prepared assuming the Company will
continue as a going concern. If the Company is unable to obtain additional
financing, it will be required to reduce discretionary spending in order to
maintain its operations at a reduced level. Management believes that it will be
able to reduce discretionary spending if required. The accompanying financial
statements do not include any adjustments that might result from the outcome of
these uncertainties.
 
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
 
  PRINCIPLES OF CONSOLIDATION:
 
     The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiary. All significant intercompany accounts and
transactions have been eliminated. Net gains and losses resulting from foreign
exchange transactions have not been material.
 
  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.
 
  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.
 
  INVENTORY:
 
     Inventory is stated at the lower of cost or market, cost being determined
on a first-in, first-out basis. As of December 31, 1998 and 1997, the allowance
to reduce inventory balances to net realizable value was $770,557
 
                                       F-6
<PAGE>   29
                             XYBERNAUT CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:

and $724,978, respectively. Most of the reserves and writedowns in inventory
values result from the introduction of new products or technologies resulting in
a reduction or loss of value of older products or technologies.
 
     Inventory consists principally of component parts held for resale.
 
  PROPERTY AND EQUIPMENT:
 
     Property and equipment 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..........................................    1 year
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.
 
  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
products. Capitalized tooling costs are depreciated on a straight-line basis
over an estimated useful life of 12 months. In 1998, the Company recognized
charges of approximately $455,000 related to the write-off of certain
capitalized tooling costs related to the 133P Systems.
 
  SOFTWARE DEVELOPMENT COSTS:
 
     Software development costs are included in research and development and are
expensed as incurred. Statement of Financial Accounting Standards No. 86
requires the capitalization of certain software development costs once
technological feasibility is established, which the Company defines as the
completion of a working model. The capitalized cost is then amortized on a
straight-line basis over the estimated product life, or on the ratio of current
revenues to total projected product revenues, whichever is greater. To date, the
period between achieving technological feasibility and the general availability
of such software has been short and software development costs qualifying for
capitalization have been insignificant. Accordingly, the Company has not
capitalized any software development costs. Since the Company is currently in
the planning and development phase for software toolkits, no costs have been
capitalized to date.
 
  PATENT COSTS:
 
     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. Amortization expense related to the
patents was $136,906 and $94,487 during 1998 and 1997, respectively.
 
  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
 
                                       F-7
<PAGE>   30
                             XYBERNAUT CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:

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:
 
     The Company recognizes revenue on the sale of its product when a valid
purchase order is received, collection is probable, shipment occurs and no
significant obligations remain. The Company provides services to its customers
under fixed-price and time-and-materials type contracts and recognize revenue
over the related contract term. The Company generally provides a one year
warranty on parts. A provision for estimated future warranty costs is recorded
at the time of shipment. However, the Company's suppliers for the computing
unit, FPD, HMD and batteries provide the Company with similar warranties and as
a result warranty reserves are immaterial.
 
  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 SHARE:
 
     Basic earnings (or loss) per share is based on the weighted average number
of outstanding shares of common stock. Diluted earnings per share adjusts the
weighted average for the potential dilution that could occur if stock options,
warrants or other convertible securities were exercised or converted into common
stock. For all periods presented herein, diluted earnings per share is the same
as basic earnings per share for the Company because the effects of such items
were anti-dilutive given the losses incurred in such periods.
 
  ESCROWED SHARES:
 
     Escrowed shares are considered issued and outstanding and reported as such
on the combined balance sheets. For purposes of computing basic and diluted
earnings per 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, 1998 and 1997, because of the relatively short maturity of these
instruments. The carrying value of the notes and loans payable approximated fair
value as of December 31, 1998 and 1997, based upon market prices for the same or
similar debt issues.
 
                                       F-8
<PAGE>   31
                             XYBERNAUT CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:

  RECENT ACCOUNTING PRONOUNCEMENTS:
 
     During 1998, the Company adopted SFAS No. 130 Reporting Comprehensive
Income. SFAS 130 established standards for reporting comprehensive income in a
full set of general purpose financial statements either in the statement of
operations or in a separate statement. The Company's comprehensive income is the
same as its net income for all periods presented.
 
     In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities. SFAS 133 is
effective for fiscal years beginning after June 15, 1999. SFAS 133 requires that
all derivative instruments be recorded on the balance sheet at their fair value.
Changes in the fair value of derivatives are recorded each period in current
earnings or other comprehensive income, depending on whether a derivative is
designated as part of a hedge transaction and, if it is, the type of hedge
transaction. Currently the Company does not utilize derivative instruments,
therefore the adoption of SFAS 133 is not expected to have a significant effect
on the Company's results of operations or its financial position. The Company
will adopt SFAS 133 for the year ending December 31, 2000.
 
3. PROPERTY AND EQUIPMENT:
 
     Property and equipment consists of the following:
 
<TABLE>
<CAPTION>
                                                                    DECEMBER 31,
                                                             --------------------------
                                                                1998            1997
                                                             ----------       ---------
<S>                                                          <C>              <C>
Equipment..................................................  $  516,669       $ 537,635
Furniture and fixtures.....................................      74,872          74,207
Demonstrator units.........................................     327,872          53,144
Leasehold improvements.....................................     153,159         149,659
                                                             ----------       ---------
                                                              1,072,572         814,645
Less accumulated depreciation and amortization.............    (610,188)       (308,950)
                                                             ----------       ---------
                                                             $  462,384       $ 505,695
                                                             ==========       =========
</TABLE>
 
     Depreciation expense for the years ended December 31, 1998 and 1997 was
$364,472 and $186,761, respectively.
 
4. ACCRUED EXPENSES
 
     Accrued expenses consists of the following:
 
<TABLE>
<CAPTION>
                                                                   DECEMBER 31,
                                                              -----------------------
                                                                1998           1997
                                                              --------       --------
<S>                                                           <C>            <C>
Accrued salaries............................................  $403,391       $396,604
Professional fees...........................................    70,418        120,000
Other.......................................................   313,171        391,768
                                                              --------       --------
                                                              $786,980       $908,372
                                                              ========       ========
</TABLE>
 
     Other consists of accruals related to expenses incurred in the normal
course of business, such as employee travel costs and sales commissions.
 
                                       F-9
<PAGE>   32
                             XYBERNAUT CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
5. NOTES PAYABLE
 
     On December 17, 1998, the Company borrowed $1,250,000 from two financial
institutions. The maturity date of the debt was January 29, 1999 and interest
was at 12% per annum. On January 29, 1999, the Company repaid the debt.
 
6. STOCKHOLDERS' EQUITY:
 
  INITIAL PUBLIC OFFERING AND SALES OF COMMON STOCK:
 
     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 ("the Unit"). Gross
proceeds from the sale of the Units were $13,282,500 and net proceeds after
expenses were $10,842,487.
 
     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.
 
     On April 13, 1998, the Company entered into an Equity Line of Credit
Agreement (the Agreement) with a private investor. Under the terms of the
Agreement, the Company issued 840,124 shares of common stock at a price per
share of $1.27 per share and obtained the right to require the investors to
purchase an additional $10,000,000 worth of common stock at 90% of the Company's
common stock market price (Put Rights). Pursuant to the Agreement, the Company
also agreed to pay the following issuance costs i) issued warrants to purchase a
total of 60,000 shares of the Company's common stock at a price per share
ranging from $1.76 to $2.81 ii) issued 50,000 shares of common stock which
cannot be traded prior to April 13, 1999 and iii) paid $60,000 in cash. Upon
exercise of a Put Right, the Company must pay issuance costs of approximately
5.5% of the gross proceeds in cash and issue common stock equal to 5% of the
number of shares issued in the transaction. On July 1, 1998, the Company amended
the Agreement to allow for the sale of 545,454 shares of common stock for $5.50
per share. The amendment contained certain repricing features which, as a result
of market fluctuations in the Company's common stock, required the Company to
issue an additional 94,004 shares of common stock without receiving additional
compensation. The Company has no further obligation to issue additional shares
related to these repricing features.
 
     On May 22, 1998, in conjunction with the sale of Series C Convertible
Preferred Stock, the Company issued 110,294 shares of common stock for $3.40 per
share.
 
     In November 1998, the Company sold 290,000 shares of common stock for $5.50
per share to a private investor. The terms of the purchase agreement allowed for
an adjustment to the purchase price per share based on of market fluctuations in
the Company common stock. Based on events in December 1998, the Company was
required to issue an additional 150,000 shares of common stock to this investor
without additional compensation. The Company has no further obligation to issue
additional shares related to these repricing features.
 
     In 1998, the Company entered several investment agreements whereby the
Company issued 747,047 shares of common stock at prices ranging from $4.04 to
$5.72. These agreements restricted the transfer of the shares for periods
ranging from six to twelve months.
 
  ESCROWED SHARES:
 
     In connection with the Company's IPO, 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
 
                                      F-10
<PAGE>   33
                             XYBERNAUT CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
6. STOCKHOLDERS' EQUITY, CONTINUED:
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. The parameters for the September
30, 1997 and 1998 releases were not met and 300,000 and 750,000 shares of Common
Stock, respectively, were canceled from the Escrowed Shares.
 
  COMMON STOCK WARRANTS:
 
     During the year ended December 31, 1996, the Company issued 100,000
warrants of Common Stock in exchange for services provided by an independent
contractor, for which compensation expense of $125,489 was recorded for the year
ended December 31, 1997.
 
     In 1998 and 1997, the Company granted to the underwriters of the Series A
and Series B Preferred Stock warrants to purchase a total of 11,430 and 100,000
shares, respectively, of common stock at prices that range from $2.13 to $4.50
per share. The warrants are exercisable for either a two or three year period
commencing six months from the date of grant. For the year ended December 31,
1997, the Company recorded approximately $95,000 as a reduction of proceeds from
these Preferred Stock offerings.
 
     At December 31, 1998 a total of 3,846,427 warrants to purchase common stock
were issued and outstanding related to the Company's IPO and the conversion of
debentures during 1996 and 1997. These warrants originally entitled 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. These warrants contain anti-dilution
provisions that, upon the issuance of the Series A Preferred Stock and the
Series B Preferred Stock, have adjusted the number of shares that can be
purchased with one warrant to 1.50, resulting in an effective exercise price of
$6.01, and 5,762,060 shares of common stock that would be issued upon full
conversion of the warrants.
 
     In connection with the Equity Line of Credit, the Company issued warrants
to purchase 360,000 shares of common stock at an exercise price ranging from
$1.76 to $5.25. The warrants are exercisable for five years and contain
anti-dilutive provisions.
 
     In 1998, the Company issued three warrants to purchase 37,500 shares of
common stock at prices ranging from $9.58 to $13.05, in connection with the sale
of common stock. The warrants are exercisable for a five year period.
 
  PREFERRED STOCK:
 
     As of December 31, 1998, the Company had 6,000,000 shares of authorized
Preferred Stock of which 3,000, 4,180, and 375 had been designated as
Convertible Preferred Stock Series A, B and C, respectively (Series A, B or C
Preferred Stock). 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.
 
     In 1997, the Company issued 3,000 and 3,180 shares of Series A and Series B
Convertible Preferred Stock, respectively, for proceeds of $5,710,406, net of
offering costs of $468,000. In 1998, the Company issued an additional 1,000
shares of Series B Preferred Stock for proceeds of $875,299, net of offering
cost of $124,701. The Series A and B Preferred Stock accrued dividends at a rate
of 5% and 4% per annum, respectively, which were payable in cash or common
stock. As of December 31, 1998, all Series A and
 
                                      F-11
<PAGE>   34
                             XYBERNAUT CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
6. STOCKHOLDERS' EQUITY, CONTINUED:
Series B Preferred Stock had been converted into common stock and all accrued
dividends were paid through the issuance of common stock.
 
     On May 22, 1998, the Company issued 375 shares of Series C Preferred Stock
for gross proceeds of $375,000. The Series C Preferred Stock have a 5%
cumulative dividend which is payable when and if declared by the Board of
Directors or at the time of conversion into common stock, whichever date is
earliest. At the Company's discretion, dividends can be paid in cash or through
the issuance of common stock. In the event of liquidation, dissolution, or
winding up of the Company, the holders of Series C Preferred Stock have a
liquidation preference of $1,000 per share, plus accrued dividends, over the
Company's common stockholders. In the event the holders of the Series C
Preferred Stock attempt to convert their shares into common stock when the
Company's common stock market price is below $3.40, the Company may redeem at
its option all outstanding shares of Series C Preferred Stock by issuing to the
holders of the Series C Preferred Stock a number of shares of common stock equal
to $1,000 divided by $3.40 for each share of Series C Preferred Stock redeemed.
Holders of the Series C Preferred Stock can convert their shares into shares of
the Company's common stock in four equal increments commencing August 15, 1998,
and on the fifteenth day of each third month thereafter until May 15, 1999. Any
remaining outstanding shares of Series C Preferred Stock convert into common
stock on May 15, 2000. The Series C Preferred Stock converts into shares of
common stock by dividing the lesser of $4.00 per share or 100% of the average
market price for the 5 trading days immediately preceding conversion. In 1998,
holders of the Series C converted 187 shares into 46,876 shares of common stock.
 
     The preferred stock activity is summarized as follows:
 
<TABLE>
<CAPTION>
                                                    SERIES A               SERIES B              SERIES C
                                              --------------------   --------------------   ------------------
                                              SHARES     AMOUNT      SHARES     AMOUNT      SHARES    AMOUNT
                                              ------   -----------   ------   -----------   ------   ---------
<S>                                           <C>      <C>           <C>      <C>           <C>      <C>
Balance, December 31, 1996..................      --   $        --       --   $        --      --    $      --
Issuance of shares, net.....................   3,000     2,761,669    3,180     2,853,122      --           --
Value of beneficial conversion feature......      --      (658,537)      --      (561,175)     --           --
Accretion of deemed dividend................      --       329,268       --       159,425      --           --
Conversion into common stock................    (750)     (690,417)      --            --      --           --
                                              ------   -----------   ------   -----------    ----    ---------
Balance, December 31, 1997..................   2,250     1,741,983    3,180     2,451,372      --           --
                                              ------   -----------   ------   -----------    ----    ---------
Issuance of shares, net.....................      --            --    1,000       875,299     375      364,754
Value of beneficial conversion feature......      --            --       --      (176,470)     --           --
Accretion of deemed dividend................      --       329,269       --       578,220      --           --
Conversion into common stock................  (2,250)   (2,071,252)  (4,180)   (3,728,421)   (187)    (182,376)
                                              ------   -----------   ------   -----------    ----    ---------
Balance, December 31, 1998..................      --   $        --       --   $        --     188    $ 182,378
                                              ======   ===========   ======   ===========    ====    =========
</TABLE>
 
     The Preferred Stock included a nondetachable conversion feature that was
"in the money" at the date of issue (a "beneficial conversion feature"). The
beneficial conversion feature was recognized as a return to the preferred
stockholders over the minimum period in which the preferred stockholders could
realize the maximum beneficial conversion. As a result of the accumulated
deficit, the value of the Preferred Stock was not allocated between par value
and additional paid-in capital and the accretion of the value allocated to the
beneficial conversion on the Preferred Stock and the related dividends is
recorded against additional paid-in capital.
 
7. 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
 
                                      F-12
<PAGE>   35
                             XYBERNAUT CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
7. STOCK OPTIONS, CONTINUED:
appreciation rights ("SARs"). The Plan is administered by the Compensation
Committee of the Board of Directors. At the annual meeting of stockholders on
August 28, 1997, Company stockholders approved the 1997 Stock Incentive Plan,
which provides for up to 1,650,000 shares of the Company's stock. Under these
plans, Options generally 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>
                                                FISCAL 1998                 FISCAL 1997
                                         -------------------------   -------------------------
                                                       WEIGHTED                    WEIGHTED
                                          NUMBER     AVERAGE PRICE    NUMBER     AVERAGE PRICE
                                         OF SHARES     PER SHARE     OF SHARES     PER SHARE
                                         ---------   -------------   ---------   -------------
<S>                                      <C>         <C>             <C>         <C>
Beginning balance......................  1,738,430       $3.04       1,246,030       $2.97
Granted................................    802,550       $4.61         892,200       $3.04
Exercised..............................     --          --            (150,000)      $0.01
Cancelled..............................   (745,980)      $3.29        (249,800)      $4.85
                                         ---------       -----       ---------       -----
Ending balance.........................  1,795,000       $3.59       1,738,430       $3.04
                                         =========       =====       =========       =====
</TABLE>
 
     The following table summarizes information about fixed stock options
outstanding at December 31, 1998:
 
<TABLE>
<CAPTION>
                       OPTIONS OUTSTANDING                       OPTIONS EXERCISABLE
                 -------------------------------               -----------------------
                                                   WEIGHTED-                 WEIGHTED-
   RANGE OF                     WEIGHTED-AVERAGE    AVERAGE                   AVERAGE
   EXERCISE        NUMBER          REMAINING       EXERCISE      NUMBER      EXERCISE
    PRICES       OUTSTANDING    CONTRACTUAL LIFE     PRICE     EXERCISABLE     PRICE
  -----------    -----------    ----------------   ---------   -----------   ---------
  <S>            <C>            <C>                <C>         <C>           <C>
  $1.37-$2.50       242,200         10 years         $1.98       217,600       $2.01
  $2.51-$3.00       868,000         10 years         $2.90       704,540       $2.92
  $3.01-$7.31       684,800         10 years         $5.02        52,800       $5.37
                  ---------         --------         -----       -------       -----
  $1.37-$7.31     1,795,000         10 years         $3.59       974,940       $2.85
                  =========         ========         =====       =======       =====
</TABLE>
 
     The Company complies with the disclosure-only provisions of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock Based
Compensation". 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.
 
     Had compensation expense for the Company's plan been determined based on
the fair value at the grant date for plan awards 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 DECEMBER 31,
                                                          ------------------------------
                                                              1998              1997
                                                          ------------      ------------
<S>                                                       <C>               <C>
Net loss -- as reported.................................  $(13,111,488)     $ (9,479,966)
Net loss -- pro forma...................................  $(13,647,074)     $(10,170,223)
Net loss per share -- as reported.......................  $      (0.74)     $      (0.74)
Net loss per share -- pro forma.........................  $      (0.77)     $      (0.79)
</TABLE>
 
                                      F-13
<PAGE>   36
                             XYBERNAUT CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
7. STOCK OPTIONS, CONTINUED:
     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 1998 and 1997: dividend yield of 0%; expected
volatility of 60%; risk-free interest rate of 5.20% in 1998 and 6.41% in 1997;
and expected lives of 3 years.
 
8. CONCENTRATION OF CREDIT RISK:
 
     In 1998, two customers, who individually comprised over 10%, combined to
comprise 23% of revenue and four customers, who individually comprised over 10%,
combined to comprise 62% of accounts receivable. In 1997, two customers, who
individually comprised over 10%, combined to comprise 44% of revenue and four
customers, who individually comprised over 10%, combined to comprise 72% of
accounts receivable. The Company has not experienced any difficulties with
collections of accounts receivables from these customers.
 
     At times, cash balance held at financial institutions were in excess of
federally insured limits.
 
9. 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 1996 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. During the year
ended December 31, 1997, the Company's licensee informed the Company that as a
result of the restructuring of its business operations, the licensee had elected
to not continue with its business activities under the license. A portion of the
consideration received by the Company in March 1996 for granting this license
was a $300,000 cash payment, which the Company recorded as deferred license
revenue and was amortizing this amount over a five year period. Given the
licensee's stated intent to not to continue conducting business operations under
the license, the remaining deferred licensing revenue of $250,000 as of December
31, 1996, was recorded as revenue in the year ended December 31, 1997.
 
10. INCOME TAXES:
 
     For the years ended December 31, 1998 and 1997 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, 1998, the Company has approximately $27,809,000 of net
operating loss carryforwards for federal income tax purposes. These losses begin
to expire in 2010. 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.
 
                                      F-14
<PAGE>   37
                             XYBERNAUT CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
10. INCOME TAXES, CONTINUED:
     Net deferred tax assets are comprised of the following:
 
<TABLE>
<CAPTION>
                                                             YEAR ENDED DECEMBER 31,
                                                            --------------------------
                                                                1998          1997
                                                            ------------   -----------
<S>                                                         <C>            <C>
Excess of book over tax depreciation......................  $     65,000   $    23,000
Net operating loss carryforwards..........................    10,557,000     6,084,000
Adjustment to accrual basis of accounting.................       244,000       283,000
Accrued expenses and reserves.............................       517,000            --
Tax credit carryforwards..................................        63,000        63,000
Less valuation allowance..................................   (11,446,000)   (6,453,000)
                                                            ------------   -----------
Net deferred tax asset....................................            --            --
                                                            ============   ===========
</TABLE>
 
11. COMMITMENTS AND CONTINGENCIES:
 
  LEASE COMMITMENTS:
 
     The Company leases 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, 1998 are:
 
<TABLE>
<CAPTION>
                  YEAR ENDING DECEMBER 31,
                  ------------------------
<S>                                                           <C>
1999........................................................  $  322,413
2000........................................................     333,436
2001........................................................     344,844
2002........................................................     356,651
2003 and thereafter.........................................     274,303
                                                              ----------
                                                              $1,631,647
                                                              ==========
</TABLE>
 
     Total rental expense charged to operations for the year ended December 31,
1998 and 1997 was $292,957 and $258,071, respectively.
 
  LEGAL PROCEEDINGS:
 
     On March 19, 1998, Matrix Corporation (see "Key Suppliers") filed a summons
against the Company in the United States District Court, Eastern District of
North Carolina, alleging that: Matrix has been damaged by a purported breach of
the December Agreement by the Company; that the Company should return all goods
shipped by Matrix under both the June Agreement and the December Agreement; that
the Company did not intend to comply with the December Agreement and therefore
the governing contract between the two entities should revert to the June
Agreement. In addition, this summons requests that any damages incurred by
Matrix as a result of this purported breach of contract be trebled. The Company
and its legal counsel have initiated a thorough review of these allegations and
intend to file a counterclaim against Matrix stating that Matrix failed to
perform to the requirements of both the June Agreement and the December
Agreement and that Xybernaut has been damaged by this failure to perform. While
there can be no assurance of the outcome of this legal proceeding, the Company
believes that the ultimate resolution of this litigation will not have a
material adverse effect on the Company's results of operations or financial
position. The maximum amount payable by the Company under the December Agreement
if Matrix performs defined tasks is approximately $250,000 and the maximum
amount of inventory that could be assumed by the Company under the December
Agreement is approximately $600,000.
 
                                      F-15
<PAGE>   38
                             XYBERNAUT CORPORATION
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
12. RELATED PARTY TRANSACTIONS:
 
     The Company uses a Director of the Company as its patent counsel and paid
cash to this Director for fees and reimbursement of expenses of approximately
$313,187 and $276,000 in 1998 and 1997, respectively. The Company paid $189,647
and $136,001 in 1998 and 1997, respectively, to a law firm of which one of the
partners is Director of the Company. An individual who was a Director of the
Company through August 1997 was paid $20,750 during 1997 for consulting services
pursuant to a contract between that Director and the Company. The Company
accrued $97,800 in 1998 and 1997 for salaries and automobile allowances payable
to a Director of the Company for services provided to Tech Virginia, and paid
$65,000 in 1998.
 
     A Director of the Company, who is the brother of the President and Chief
Executive Officer, serves as a consultant to the Company and during 1997 was
paid $305,000 for consulting fees and $110,000 as reimbursement for expenses.
During 1998, the Company paid $162,869 in consulting payments and $23,789 as
reimbursement for expenses incurred during the year to the same Director. In
addition the Company reserved for approximately $45,000 of advances that were
paid to this consultant during 1998. The Company paid $172,000 in 1997 as
advances on commissions and expenses to an individual consultant who is an uncle
by marriage to the President and Chief Executive Officer of the Company. In
addition, this consultant is the President of Davis Group to whom the Company
sold products during 1998 for approximately $23,000. The wife of the Chief
Executive Officer is employed by the Company and was paid a salary of $50,000 in
1998 and 1997.
 
     During 1998 and 1997, the Company paid approximately $219,433 and $81,000,
respectively, for sales and marketing consulting fees and expenses to two
members of the SBS Software Center in Germany. The Company sold approximately
$135,000 of products to the SBS Software Center in 1997. During 1998 the Company
sold approximately $35,000 of products to Call In, the President of whom is the
son of one of the Company's Directors.
 
13. SUBSEQUENT EVENTS:
 
     In January 1999, the Company exercised a Put Right under its Equity Line of
Credit (See Note 6) and issued 841,356 shares of common stock for proceeds of
$3,360,000.
 
     On March 10, 1999, the Company issued 5,000 shares of Series D Convertible
Preferred Stock for proceeds of $4,990,000 net of offering costs of $10,000. In
addition, the Company has available an additional $5,000,000 under this
agreement pursuant to which an additional 5,000 shares of Series D Preferred
Stock would be issued within 3 business days of the effective registration
statement being filed with the SEC, which registers the underlying common shares
for these securities.
 
                                      F-16
<PAGE>   39
 
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>
<CAPTION>
                      NAME                        AGE   CLASS               POSITION
                      ----                        ---   -----               --------
<S>                                               <C>   <C>     <C>
Edward G. Newman................................  55     III    President, Chief Executive
                                                                Officer and Chairman of the Board
                                                                of Directors
Maarten R. Heybroek.............................  56      --    Senior Executive Vice President,
                                                                Chief Operating Officer and Chief
                                                                Financial Officer
Kaz Toyosato....................................  54       I    Executive Vice President and
                                                                Director
George Allen, Esq. .............................  46     III    Director
Eugene J. Amobi.................................  53      II    Director
Keith P. Hicks, Esq.(2).........................  76       I    Director
Steven A. Newman, M.D.(1)(2)(3).................  53     III    Director and Vice Chairman of the
                                                                Board of the Board of Directors
Phillip E. Pearce(2)(3).........................  70      II    Director
James J. Ralabate, Esq. ........................  71     III    Director
Lt. Gen. Harry E. Soyster (Ret.)(1)(3)..........  63      II    Director
Martin Eric Weisberg, Esq.(1)(3)................  48       I    Secretary and Director
Dr. Edwin Vogt(4)...............................  65      II    Director
</TABLE>
 
---------------
 
(1) Member of the Compensation Committee.
 
(2) Member of the Audit Committee.
 
(3) Member of the Nominating Committee.
 
(4) Appointed to the Board of Directors on September 28, 1998.
 
     Officers are appointed by and serve at the discretion of the Board of
Directors. The Company's Board of Directors is divided into three different
classes. At each annual meeting of stockholders, one class of directors will be
elected for a term of three years to succeed those directors in the class whose
terms then expire. All directors hold office until the third annual meeting of
shareholders following their election or until their successors are elected and
qualified.
 
     The following is a brief summary of the background of each of our directors
and executive officers.
 
CLASS I DIRECTORS
 
     KEITH P. HICKS, ESQ. has been a director since July 1994 and is currently 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).
 
     KAZ TOYOSATO joined the Company in October 1996 as Executive Vice President
of Asian Operations. Mr. Toyosato is responsible for overseeing the Company's
operations in Asia, including Japan. Prior to joining the Company, Mr. Toyosato
spent 27 years with Sony Corporation in Japan where his last position was the
 
                                       23
<PAGE>   40
 
Vice President of Sony USA. He previously helped manage the Sony Walkman product
line, and managed Sony's 8mm video camcorder and its battery line of products.
 
     MARTIN ERIC WEISBERG, ESQ. who currently serves as Secretary of the
Company, is a partner of the law firm, Parker Chapin Flattau & Klimpl, LLP,
which serves general counsel to the Company. Mr. Weisberg specializes in the
areas of securities, mergers and acquisitions, financing and international
transactions and has been in the private practice of law for 23 years. Mr.
Weisberg is a summa cum laude graduate of Union College (B.A. 1972) and received
his law degree from The Northwestern University School of Law (1975), where he
graduated summa cum laude, was Articles Editor of the Law Review and was elected
to the Order of the Coif. Mr. Weisberg also attended The London School of
Economics and Political Science.
 
CLASS II DIRECTORS
 
     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, Inc. ("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 International of Virginia Inc. ("Tech Virginia"), our wholly-owned
subsidiary, 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 (B.S. 1969),
Princeton University (M.S. 1970) and Syracuse University (M.B.A. 1973).
 
     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., an operator of medical diagnostic facilities and clinical laboratories,
InfoPower International, Inc., a software development company and StarBase
Corporation, a software development company, and United Digital Networks, Inc.,
a provider of voice and data long distance services. Mr. Pearce is a graduate of
the University of South Carolina (B.A. 1953) and attended the Wharton School of
Investment Banking at the University of Pennsylvania.
 
     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).
 
     DR. EDWIN VOGT was appointed a director of the Company on September 28,
1998 and has been a consultant since 1996. Mr. Vogt joined IBM in 1961 as
Development Programmer and worked in the fields of hardware development, holding
28 patents, as well as software development. As manager he was responsible for
hardware projects (IBM /360, /370, 433x) as well as various software projects
(a.o. voice recognition products) before being appointed Director as manager of
several Hardware and Software Product Development Laboratories. As IBM Software
Group Executive he held the worldwide responsibility for the development and
marketing of IBM Workflow products and Reengineering tools until retiring from
IBM end of 1995. In early 1996 he was appointed Director for the SBS association
(Softwarezentrum Boeblingen/ Sindelfingen e.V.) and, since then, has grown this
center to 39 member companies with over 200 experts, predominantly working in
high-growth areas such as Internet, Workflow, Process Automation, Multimedia.
 
                                       24
<PAGE>   41
 
Dr. Vogt is a graduate of the University of Stuttgart with a M.S. in Electrical
Engineering and Mathematics in Theoretical Electrical Engineering.
 
CURRENT CLASS III DIRECTORS
 
     GEORGE ALLEN, ESQ. is a partner of the law firm of McGuire Woods Battle &
Boothe, LLP. Mr. Allen was Virginia's 67th governor from 1994-1998, during which
period state taxes were cut by $1 billion, $14 billion in new investments were
made in the state resulting in 300,000 net new private sector jobs. Mr. Allen's
term in office also was noted for comprehensive reforms in primary and secondary
education, the abolition of parole, reform of the juvenile justice systems and
the replacement of the welfare system with reforms which promote work ethic and
personal responsibility. Prior to serving as Governor of Virginia, Mr. Allen was
a member of the U.S. House of Representatives in 1991 and a member of the
Virginia House of Delegates from 1983-1991. Mr. Allen is a member of the Board
of Directors of Commonwealth Biotechnology, Inc. Mr. Allen is a graduate of the
University of Virginia at Charlottesville (B.A. 1974), with distinction, and
received his law degree from the University of Virginia at Charlottesville (J.D.
1977).
 
     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 our Treasurer 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.
 
     STEVEN A. NEWMAN, M.D. has been a director of the Company since January
1995, a consultant since January 1996 and Vice Chairman of the Board of
Directors since August 1997. See "Business -- Employees and Consultants." Dr.
Newman was the Executive Vice President and Secretary from December 1994 through
October 1995. Dr. Newman also provides business, management and administrative
consulting services to various medical and business groups. Dr. Newman was
President and Chief Executive Officer of Fed American, Inc., a mortgage banking
firm, from 1988 to 1991. Dr. Newman has been a director 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, our President, Chief Executive Officer and Chairman
of the Board of Directors.
 
     JAMES J. RALABATE, ESQ. has been a director of the Company since January
1995 and served as our Secretary until August 1997. 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
our intellectual property counsel and is a graduate of Canisius College (B.S.
1950) and The American University (J.D. 1959).
 
ADVISORY BOARD
 
     The Company also has an Advisory Board which was established to provide
council and support to the Board of Directors. The members of the Advisory Board
are appointed by the Board of Directors. Its members currently include:
 
     LAWRENCE BERK is currently Senior Managing Director of Brill Securities. He
has been a money manager and has structured and advised companies on financings
and strategic planning, having held executive positions with various investment
banking firms, including Oppenheimer & Co. where he was a partner. Mr. Berk has
also held many leadership roles in the entertainment business. He served as a
member of the Board of the Actors Studio for 15 years where he produced plays;
he was a founding Chairman of the Veterans Ensemble Theatre, a group of writers,
actors and directors from the Vietnam war; he was on the Board of the
 
                                       25
<PAGE>   42
 
Association of American Dance Companies; and he was a trustee of the Manhattan
Theatre Club. Mr. Berk is a member of the Financial Investment Analyst
Association and the Regional Investment Bankers Association.
 
     WAYNE COLESON is at present and since 1994 has been the President and a
Director of Avalon Capital, Inc., a Director of Settondown Capital
International, Ltd. and a Director of Manchester Asset Management, Ltd., each of
which is an investment company which invests in and structures private placement
transactions. Mr. Coleson is a founder of all three companies. During the last
three years Mr. Coleson completed over 75 transactions resulting in $500 million
of investments. Prior to these activities Mr. Coleson was affiliated with
Shoreline Pacific Institutional Finance, Laffer-Warren Investment Brokers and
Lehman Brothers, during which period Mr. Coleson had extensive roles in
structuring, evaluating, negotiating and raising capital for small to micro-cap
companies in the United States and Europe. Mr. Coleson graduated from the
University of Georgia in 1985 with a B.A. in Political Science.
 
     DR. ANDREW HELLER has been an advisor to the Board of Directors since 1995.
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.
We have a three-year consulting agreement with Dr. Heller whereby he provides us
with strategic planning, business management, strategic product development and
market and financial introduction services.
 
     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.
 
     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.
 
COMMITTEES OF THE BOARD OF DIRECTORS
 
     We have three committees, Compensation, Auditing and Nominating. The
functions of the Audit Committee include:
 
          - the nomination of independent auditors for appointment by the Board;
 
          - meeting with the independent auditors to review and approve the
            scope of their audit engagement;
 
                                       26
<PAGE>   43
 
          - meeting with our financial management and the independent auditors
            to review matters relating to internal accounting controls, the
            Company's accounting practices and procedures and other matters
            relating to our financial condition; and
 
          - reporting to the Board periodically with respect to such matters.
 
     The Audit Committee currently consists of Keith P. Hicks, Dr. Steven A.
Newman and Phillip E. Pearce.
 
     The function of the Compensation Committee is to review and recommend to
the Board of Directors the appropriate compensation of executive officers and to
administer the 1996 Omnibus Stock Incentive Plan and the 1997 Stock Incentive
Plan. The Compensation Committee currently consists of Dr. Steven A. Newman, Lt.
Gen. Harry E. Soyster (Ret.) and Martin Eric Weisberg, Esq.
 
     The function of the Nominating Committee is to select and recommend to the
Board of Directors appropriate candidates for election to the Board of
Directors. The Nominating Committee currently consists of Dr. Steven A. Newman,
Lt. Gen. Harry E. Soyster (Ret.) and Martin Eric Weisberg, Esq.
 
                            SECTION 16(a) REPORTING
 
     Section 16(a) of the Securities Exchange Act of 1934, as amended, requires
the Company's directors and executive officers, and persons who own more than
10% of the Company's Common Stock, to file with the Securities and Exchange
Commission (the "SEC") initial reports of ownership and reports of changes in
ownership of Common Stock and other equity securities of the Company. Officers,
directors and greater than 10% shareholders are required by SEC regulation to
furnish the Company with copies of all Section 16(a) reports they file. To the
Company's knowledge, based solely on review of the copies of such reports
furnished to the Company during the one-year period ended December 31, 1998, all
Section 16(a) filing requirements applicable to its officers, directors and
greater than ten-percent beneficial owners were complied with.
 
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 Company for the
fiscal years ended December 31, 1998, 1997 and 1996 paid to (i) Edward G.
Newman, the Company's President, Chief Executive Officer and Chairman of the
Board of Directors, (ii) Kaz Toyosato, an Executive Vice President of the
Company, and (iii) John F. Moynahan, the Company's former Vice President, Chief
Financial Officer, Treasurer and a director. Mr. Moynahan resigned from his
various positions with the Company effective June 3, 1998. No other officer of
the Company received annual salary and bonus exceeding $100,000 during the
relevant periods.
 
                                       27
<PAGE>   44
 
                           SUMMARY COMPENSATION TABLE
 
<TABLE>
<CAPTION>
                                                                  LONG TERM
                                                                 COMPENSATION
                                                                    AWARDS
                                          ANNUAL COMPENSATION    ------------
            NAME AND                      --------------------     OPTIONS       ALL OTHER
       PRINCIPAL POSITION          YEAR    SALARY        BONUS     (SHARES)     COMPENSATION
       ------------------          ----   --------       -----   ------------   ------------
<S>                                <C>    <C>            <C>     <C>            <C>
Edward G. Newman.................  1998   $216,171(1)     $0          0           $39,600(2)
  President and Chief Executive    1997   $211,211(1)     $0                      $43,600(2)
  Officer and Chairman of the      1996   $149,635(1)     $0          0           $ 7,034(2)
  Board of Directors
Kaz Toyosato.....................  1998   $172,086        $0          0           $     0
  Executive Vice President         1997   $ 77,188(3)     $0          0           $     0
                                   1996   $      0        $0          0           $     0
John F. Moynahan.................  1998   $ 93,507(4)     $0          0           $ 7,500(2)
  Senior Vice President, Chief     1997   $142,083        $0          0           $15,465(2)
  Financial Officer and Treasurer  1996   $139,688        $0          0           $ 5,517(2)
</TABLE>
 
---------------
(1) Compensation does not include (i) $50,000, $50,000 and $50,084 paid to
    Frances C. Newman, wife of Edward G. Newman in 1998, 1997 and 1996,
    respectively, and (ii) $21,276, $23,111 and $87,314 paid by Tech of Virginia
    in 1998, 1997 and 1996, as payment of accrued salaries and expenses.
 
(2) Includes payment of non-accountable expense allowances and car allowances,
    but not reimbursement of expenses.
 
(3) Represents compensation for a eight month period. Mr. Toyosato joined the
    Company in 1997.
 
(4) Mr. Moynahan resigned from his positions with the Company effective June 3,
    1998.
 
     OPTION GRANTS TABLE.  The following table sets forth information on grants
of stock options during fiscal 1998 to executive officers and directors of the
Company. All such options are exercisable to purchase shares of Common Stock.
 
<TABLE>
<CAPTION>
                                               PERCENT OF TOTAL
                                               OPTIONS GRANTED    EXERCISE OR
                             OPTIONS GRANTED     TO EMPLOYEES     BASE PRICE
           NAME                 (SHARES)           IN YEAR         ($/SHARE)     EXPIRATION DATE
           ----              ---------------   ----------------   -----------   ------------------
<S>                          <C>               <C>                <C>           <C>
Maarten R. Heybroek........      200,000            26.6%           $4.8750     June 1, 2008
George Allen...............       50,000             6.6%           $5.4688     September 24, 2008
Eugene J. Amobi............       10,000             1.3%           $4.3125     August 28, 2008
Keith Hicks, Esq. .........       10,000             1.3%           $4.3125     August 28, 2008
Dr. Steven A. Newman.......       10,000             1.3%           $4.3125     August 28, 2008
Phillip E. Pearce..........       10,000             1.3%           $4.3125     August 28, 2008
James J. Ralabate, Esq. ...       10,000             1.3%           $4.3125     August 28, 2008
Lt. Gen. Harry E.
  Soyster..................       10,000             1.3%           $4.3125     August 28, 2008
Kaz Toyosato...............       10,000             1.3%           $4.3125     August 28, 2008
Martin Eric Weisberg,
  Esq. ....................       10,000             1.3%           $4.3125     August 28, 2008
Dr. Edwin Vogt.............       50,000             6.6%           $5.4688     September 24, 2008
</TABLE>
 
                                       28
<PAGE>   45
 
FISCAL YEAR-END OPTIONS/OPTION VALUES TABLE.
 
<TABLE>
<CAPTION>
                                            NUMBER OF SECURITIES          VALUE OF UNEXERCISED
                                           UNDERLYING UNEXERCISED             IN-THE-MONEY
                                                   OPTIONS                       OPTIONS
                                             AT FISCAL YEAR-END         AT FISCAL YEAR-END($)(1)
                                         ---------------------------   ---------------------------
                 NAME                    EXERCISABLE   UNEXERCISABLE   EXERCISABLE   UNEXERCISABLE
                 ----                    -----------   -------------   -----------   -------------
<S>                                      <C>           <C>             <C>           <C>
Maarten R. Heybroek....................       0           200,000           0                0
George Allen...........................       0            50,000           0                0
Eugene J. Amobi........................       0            10,000           0            1,875
Keith Hicks, Esq. .....................       0            10,000           0            1,875
Dr. Steven A. Newman...................       0            10,000           0            1,875
Phillip E. Pearce......................       0            10,000           0            1,875
James J. Ralabate, Esq. ...............       0            10,000           0            1,875
Lt. Gen. Harry E. Soyster..............       0            10,000           0            1,875
Kaz Toyosato...........................       0            10,000           0            1,875
Martin Eric Weisberg, Esq. ............       0            10,000           0            1,875
Dr. Edwin Vogt.........................       0            50,000           0                0
</TABLE>
 
     None of the foregoing options were exercisable within 60 days of December
31, 1998.
 
     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.
 
  EMPLOYMENT AGREEMENTS
 
     The Company entered into employment agreements with Edward G. Newman and
John F. Moynahan. Mr. Moynahan resigned from his positions with the Company
effective June 3, 1998. 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 $198,000 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
1997 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 payment of $1,000 per month with a $650 automobile allowance per month.
The employment agreement with Mr. Newman also entitles him to participate in all
benefits which the Company may offer to its executive officers and employees, as
a group. The Company anticipates that such benefits will include an automobile,
health insurance and expense reimbursement. The employment agreement
automatically renews for an additional three-year term unless terminated in
writing by either party on or before October 31, 1998. The employment agreement
also provides for termination at the option of Mr. Newman 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 Mr. Newman is
entitled to at least two years of annual compensation under his employment
agreement.
 
     Mr. Toyosato is employed pursuant to a three-year Employment Agreement with
a term expiring on March 3, 2000. The Employment Agreement provides for an
annual salary of $153,575.23.
 
                                       29
<PAGE>   46
 
  CONSULTING AGREEMENTS
 
     The Company and Dr. Steven A. Newman entered into a Consulting Agreement
dated as of January 1, 1996, as amended January 1, 1997. Pursuant to the
Consulting Agreement, Dr. Newman will provide consulting services which
includes, among other things, the review and assistance in the preparation of
the Company's business strategies, assisting with the recruitment and hiring of
key executives and provide advice regarding financing, contracting, management,
overseas operations, strategic alliances and ventures. The annual consulting fee
is $150,000 payable on a monthly basis. The Consulting Agreement also provides
for additional compensation, as determined by the Company's Compensation
Committee, for services by Dr. Newman in connection with the successful
completion of financings, mergers, acquisitions, dispositions, joint ventures
and other material transactions. The term of the Consulting Agreement is four
years terminating on December 31, 2000 unless renewed by the parties.
 
     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 $5.00 per share for financial reporting purposes.
 
  OMNIBUS STOCK INCENTIVE PLAN
 
     The 1996 Omnibus Stock Incentive Plan (the "1996 Incentive Plan") was
adopted by the Company's Board of Directors effective January 1, 1996. The 1996
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 1996 Incentive
Plan subsequent to December 31, 2006. To date, options have been granted to
purchase all of the 650,000 shares of Common Stock reserved for issuance under
the 1996 Incentive Plan.
 
     The 1996 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 1996 Incentive Plan, including the exercise
price, number of shares subject to the option and the exercisability thereof.
Dr. Steven A. Newman, Lt. Gen. Harry E. Soyster (Ret.) and Martin Eric Weisberg,
Esq. currently are the members of the Compensation Committee.
 
     The exercise price of all Incentive Stock Options granted under the 1996
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 1996 Incentive Plan shall be determined by the Compensation Committee.
The term of any Incentive Stock Option granted under 1996 the Incentive Plan may
not exceed ten years, or, for Incentive Stock Options granted to Substantial
Stockholders, five years. The 1996 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.
 
                                       30
<PAGE>   47
 
     The 1996 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
Compensation Committee has granted extensions of the period before which options
may be exercised for certain terminated employees.
 
     The 1996 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 1996 Incentive Plan defines a change of
control as the consummation of a tender 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 1996 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 1996 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 1996 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.
 
  1997 STOCK INCENTIVE PLAN
 
     The 1997 Stock Incentive Plan (the "1997 Incentive Plan") was adopted by
the Company's Board of Directors on April 10, 1997. The 1997 Incentive Plan
provides for the granting of Incentive Stock Options within the meaning of
Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"),
nonqualified stock options, SARs and grants of shares of Common stock subject to
certain restrictions (collectively, "Awards") up to a maximum of 1,650,000
shares to officers, directors, key employees and others. Incentive Stock Options
can be awarded only to employees of the Company at the time of the grant. No ISO
may be granted under the 1997 Incentive Plan after April 9, 2007.
 
     The 1997 Incentive Plan is administered by the Board of Directors or a
Committee of the Board of Directors, which determines the terms and conditions
of the Awards granted under the 1997 Incentive Plan, including the exercise
price, number of shares subject to the option and the exercisability thereof.
Dr. Steven A. Newman, Lt. Gen. Harry E. Soyster (Ret.) and Martin Eric Weisberg,
Esq. currently are the members of the Committee.
 
     The exercise price of all Incentive Stock Options granted under the 1997
Incentive Plan must equal at least the fair market value of the Common Stock on
the date of grant. In the case of 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 1997 Incentive Plan shall be determined by the
Compensation Committee. The term of any Incentive Stock Option granted under the
1997 Incentive Plan may not exceed ten years, or, for Incentive Stock Options
granted to Substantial Stockholders, five years. The 1997 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.
 
                                       31
<PAGE>   48
 
     The 1997 Incentive Plan provides the 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, options may be exercised only to the extent exercisable on the
date of such termination (within three months), but not thereafter, unless
termination is due to death or disability, in which case the options are
exercisable within one year of termination.
 
     The 1997 Incentive Plan provides the Committee discretion to grant SARs to
key employees, consultants and directors. Promptly after exercise of a SAR the
holder shall be entitled to receive in chase, by check or in shares of Common
Stock, an amount equal to the excess of the fair market value on the exercise
date of the shares of Common Stock as to which the SAR is exercised over the
base price of such shares, which shall be determined by the Committee
 
     The 1997 Incentive Plan also provides the Committee discretion to grant to
key persons shares of restricted stock subject to certain contingencies and
restrictions as the Committee may determine.
 
     As of December 31, 1998 a total of 1,795,000 options were outstanding. 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. As of December 31, 1998,
there were no SARs outstanding and there has been one grant of Restricted Stock
of 10,000 shares of Common Stock to a former officer of the Company.
 
                                       32
<PAGE>   49
 
ITEM 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS.
 
  PRINCIPAL STOCKHOLDERS
 
     The following table sets forth, as of March 31, 1999, certain information
regarding the ownership of voting securities of the Company by each stockholder
known to the management of the Company to be (i) the beneficial owner of more
than 5% of the Company's outstanding Common Stock, (ii) the directors of the
Company during the last fiscal year, (iii) the executive officers named in the
Summary Compensation Table herein under "Executive Compensation" and (iv) all
executive officers and directors as a group. The Company believes that the
beneficial owners of the Common Stock listed below, based on information
furnished by such owners, have sole investment and voting power with respect to
such shares.
 
<TABLE>
<CAPTION>
                                                           AMOUNT OF SHARES
                                                             BENEFICIALLY         PERCENTAGE
                          NAME                                  OWNED               OWNED
                          ----                             ----------------       ----------
<S>                                                        <C>                    <C>
Edward G. Newman.........................................     3,176,972(1)         14.30%
  12701 Fair Lakes Circle, Suite 550
  Fairfax, Virginia 22033
Maarten R. Heybroek......................................         6,500(2)              *
  12701 Fair Lakes Circle, Suite 550
  Fairfax, Virginia 22033
Kaz Toyosato.............................................        50,000(3)              *
  Kita-Shinagawa 5-12-6,
  Wakabayashi Bldg. 2F,
  Shinagawa-Ku, Tokyo Japan 141-0001
George Allen, Esq........................................           300                 *
  901 East Cary Street
  Richmond, Virginia 23219
Eugene J. Amobi..........................................       360,000(4)          1.62%
  100 Jade Drive
  Wilmington, Delaware 19810
Keith P. Hicks, Esq......................................       379,597(4)          1.70%
  4121 Roberts Road
  Fairfax, Virginia 22032
Steven A. Newman, M.D....................................     1,704,790(5)          8.13%
  303 Avenida Cerritos
  Newport Beach, California 92660
Phillip E. Pearce........................................        60,000(4)              *
  6624 Glenleaf Court
  Charlotte, North Carolina 28270
James J. Ralabate, Esq...................................       113,424(4)              *
  5792 Main Street
  Williamsville, New York 14221
Lt. Gen. Harry E. Soyster (Ret.).........................        81,712(4)              *
  1201 E. Abingdon Drive, Suite 425
  Alexandria, Virginia 22314
Martin Eric Weisberg, Esq................................        60,000                 *
  1211 Avenue of the Americas
  New York, New York 10036
</TABLE>
 
                                       33
<PAGE>   50
 
<TABLE>
<CAPTION>
                                                           AMOUNT OF SHARES
                                                             BENEFICIALLY         PERCENTAGE
                          NAME                                  OWNED               OWNED
                          ----                             ----------------       ----------
<S>                                                        <C>                    <C>
Dr. Edwin Vogt...........................................         6,000(6)              *
  12701 Fair Lakes Circle, Suite 550
  Fairfax, Virginia 22033
John P. Moynahan.........................................         4,167                 *
  12303 Blair Ridge Road
  Fairfax, Virginia 22033
Officers and directors as a group
  (13 persons)...........................................     6,123,462(7)         26.92%
</TABLE>
 
---------------
 *  Less than 1%
 
(1) Includes 200,000 shares of Common Stock beneficially owned by an irrevocable
    trust established by Mr. Newman for the benefit of his children and 500,000
    shares registered under the name of Bear Stearns pursuant to a pledge
    agreement between Mr. Newman and Bear Stearns. Does not include (a) 776,950
    shares of Common Stock beneficially owned by beneficially owned by Mr.
    Newman's wife, Francis C. Newman; (b) 28,900 shares of Common Stock
    beneficially owned by an irrevocable trust established by Mr. Newman for the
    benefit of his sister; and (c) (b) 28,900 shares of Common Stock
    beneficially owned by an irrevocable trust established by Mr. Newman for the
    benefit of his mother. Mr. Newman disclaims beneficial ownership of all such
    shares.
 
(2) Includes 1,500 shares of Common Stock beneficially owned by Mr. Heybroek's
    children and 5,000 shares of Common Stock issuable upon exercise of
    currently exercisable options.
 
(3) Includes 50,000 shares of Common Stock issuable upon exercise of currently
    exercisable options.
 
(4) Includes 60,000 shares of Common Stock issuable upon exercise of currently
    exercisable options.
 
(5) Includes 100,000 shares of Common Stock beneficially owned by an irrevocable
    trust established by Mr. Newman for the benefit of his children, for which
    share Mr. Newman disclaims beneficial ownership; and 500,000 shares
    registered under the name of Bear Stearns pursuant to a pledge agreement
    between Mr. Newman and Bear Stearns.
 
(6) Includes 6,000 shares of Common Stock beneficially owned by Dr. Vogt's wife.
    Dr. Vogt disclaims beneficial ownership for all of such securities.
 
(7) Includes 531,500 shares of Common Stock issuable to the group upon exercise
    of currently exercisable options.
 
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 from non-affiliates. Transactions between any corporation and its
officers and directors are subject to inherent conflicts of interest.
 
  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. Edward G.
Newman, a principal stockholder, director and the Chairman,
 
                                       34
<PAGE>   51
 
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.
 
  MANAGEMENT PERSONNEL 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 required each of them to
devote only reasonable time and attention to Tech Virginia, provided their
activities for Tech Virginia did 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.
 
  CONSULTING AGREEMENT
 
     Steven A. Newman has entered into a consulting agreement with the Company.
See "Executive Compensation -- Consulting Agreements."
 
  LEGAL SERVICES
 
     James J. Ralabate, Esq. was paid $313,187 in fees and disbursements for
legal services rendered to the Company for the year ended December 31, 1998.
 
     Parker Chapin Flattau & Klimpl, LLP, the law firm where Martin Eric
Weisberg, Esq. is a partner, was paid $189,647 in fees and disbursements for
legal services rendered to the Company for the year ended December 31, 1998.
 
                                       35
<PAGE>   52
 
ITEM 13.  EXHIBITS, LISTS AND REPORTS ON FORM 8-K.
 
<TABLE>
<CAPTION>
EXHIBIT                                DESCRIPTION
-------                                -----------
<C>       <C>  <S>                                                           <C>
  1.1     --   Form of Financial Consulting Agreement between the Company     (1)
               and the Representative.
  3.1     --   Certificate of Incorporation of the Company, as Amended.        *
  3.2     --   Bylaws of the Company (as Amended on September 24, 1998).       *
  4.1     --   Warrant Exercise Fee Agreement.                                (1)
  4.2     --   Form of Forfeiture Escrow.                                     (1)
  4.3     --   Form of specimen certificate for Units.                        (1)
  4.4     --   Form of specimen certificate for Common Stock.                 (1)
  4.6     --   Form of Warrant.                                               (2)
 10.1     --   December 31, 1994 Acquisition Agreement between the Company    (1)
               and Tech Virginia.
 10.2     --   Form of Indemnification Agreement to be entered into between   (1)
               the Company and each officer and director of the Company.
 10.3     --   Form of Employment Agreement between the Company and Edward    (1)
               G. Newman.
 10.4     --   Form of Consulting Agreement between the Company and Steven    (1)
               A. Newman.
 10.5     --   November 30, 1994 Lease Agreement between Hyatt Plaza          (1)
               Limited Partnership and the Company.
 10.6     --   March 22, 1996 Month-to-Month Tenancy Agreement between the    (1)
               Company and The Original Tollhouse Historical Preservation
               Company.
 10.7     --   October 27, 1994 Residential Deed of Lease between the         (1)
               Company and Frank E and Heather H. Moxley.
 10.8     --   June 10, 1994 Rockwell International Corporation contract.     (1)
 10.9     --   January 5, 1996 Kopin Corporation contract.                    (1)
 10.10    --   June 19, 1996 License Agreement for Mobile Inspector           (1)
               software.
 10.11    --   1996 Omnibus Stock Incentive Plan.                             (1)
 10.12    --   1997 Omnibus Stock Incentive Plan.                             (2)
 10.13    --   November 20, 1995 Consulting Agreement with CMC Services.      (1)
 10.14    --   Form of Consulting Agreement with Victor J. Lombardi.          (1)
 10.15    --   March 29, 1996 License Agreement with Rockwell International   (1)
               Corporation.
 10.16    --   Interim 90-Day Agreement with Kopin Corporation.               (1)
 10.17    --   Multicosm Ltd. Software Licensing Agreement.                   (1)
 10.18    --   April 4, 1996 Electronic Surveillance Technologies             (1)
               Corporation VAR Agreement.
 10.19    --   January 22, 1996 FC Imaging, Inc. VAR Agreement.               (1)
 10.20    --   June 18, 1996 NeuroSystems Europe Limited VAR Agreement.       (1)
 10.21    --   Business Loan Agreement, Promissory Note and Commercial        (1)
               Security Agreement By and Between Fairfax Bank & Trust
               Company and the Company.
 10.22    --   December 10, 1996 Lease Agreement between Autumnwood           (3)
               Apartments and the Company.
 10.23    --   September 10, 1996 Lease Agreement between the Company and     (3)
               South Beach Warehouse, LLC.
 10.24    --   First Amendment to Office Lease Agreement between Hyatt        (4)
               Plaza Limited Ptr. and the Company.
 10.25    --   Form of Agreement between Ed Nixon Davis and the Company.      (4)
 10.26    --   Form of Exclusive Licensing Agreement between Data Disk        (4)
               Technology, Inc. and the Company.
 10.27    --   Form of Exclusive Licensing Agreement between SBS Vertrieb     (4)
               GmbH and the Company.
 10.28    --   Form of Software Distribution Agreement between Multicosm      (4)
               LTD and the Company.                                          
 10.29    --   First Amendment to Office Lease Agreement between Hyatt        (4)
               Plaza Limited Partnership and Tech International of
               Virginia, L.L.C.
</TABLE>
 
                                       36
<PAGE>   53
 
<TABLE>
<CAPTION>
EXHIBIT                                DESCRIPTION
-------                                -----------
<C>       <C>  <S>                                                           <C>
 10.30    --   Second Amendment to Storage Space Lease Agreement between       *
               Hyatt Plaza Limited Ptr. and the Company.
 10.31    --   Second Amendment to Office Lease Agreement between Hyatt        *
               Plaza Limited Ptr. and the Company.
 10.32    --   Third Amendment to Office Lease Agreement between Hyatt         *
               Plaza Limited Ptr. and the Company.
 27.1     --   Financial Data Schedule.                                        *
</TABLE>
 
---------------
 
(1) Incorporated by reference in the initial filing of the Company's
    Registration Statement on Form SB-2, No. 333-4156.
 
(2) Incorporated by reference in an amendment to the Company's Registration
    Statement on Form SB-2, No. 333-65123.
 
(3) Incorporated by reference in the filing of the Company's 1996 Annual Report
    on Form 10KSB, No. 0-15086.
 
(4) Incorporated by reference in the filing of the Company's 1997 Annual Report
    on Form 10KSB, No. 0-15086.
 
 *  Filed herewith.
 
  REPORTS ON FORM 8-K
 
     The Company filed one Report on Form 8-K during the year ended December 31,
1998 in connection with the resignation of John Moynahan from his positions with
the Company effective June 3, 1998.
 
                                       37
<PAGE>   54
 
                                   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
                                             President, Chief Executive Officer
                                                 and Chairman of the Board of
                                                          Directors
 
Date: April 14, 1999
 
     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
                      ---------                                      -----                    ----
<C>                                                      <S>                             <C>
 
                /s/ EDWARD G. NEWMAN                     President, Chief Executive      April 14, 1999
-----------------------------------------------------      Officer and Chairman of the
                  Edward G. Newman                         Board of Directors
 
               /s/ MAARTEN R. HEYBROEK                   Chief Operating Officer and     April 14, 1999
-----------------------------------------------------      Chief Financial Officer
                 Maarten R. Heybroek
 
                  /s/ KAZ TOYOSATO                       Executive Vice President        April 14, 1999
-----------------------------------------------------
                    Kaz Toyosato
 
               /s/ GEORGE ALLEN, ESQ.                    Director                        April 14, 1999
-----------------------------------------------------
                    George Allen
 
                 /s/ EUGENE J. AMOBI                     Director                        April 14, 1999
-----------------------------------------------------
                   Eugene J. Amobi
 
                 /s/ KEITH P. HICKS                      Director                        April 14, 1999
-----------------------------------------------------
                   Keith P. Hicks
 
                /s/ STEVEN A. NEWMAN                     Director and Vice Chairman of   April 14, 1999
-----------------------------------------------------      the Board of Directors
                  Steven A. Newman
 
                /s/ PHILLIP E. PEARCE                    Director                        April 14, 1999
-----------------------------------------------------
                  Phillip E. Pearce
 
                /s/ JAMES J. RALABATE                    Director                        April 14, 1999
-----------------------------------------------------
                  James J. Ralabate
 
            /s/ LT. GEN. HARRY E. SOYSTER                Director                        April 14, 1999
-----------------------------------------------------
              Lt. Gen. Harry E. Soyster
</TABLE>
 
                                       38
<PAGE>   55
 
<TABLE>
<CAPTION>
                      SIGNATURE                                      TITLE                    DATE
                      ---------                                      -----                    ----
<C>                                                      <S>                             <C>
              /s/ MARTIN ERIC WEISBERG                   Secretary and Director          April 14, 1999
-----------------------------------------------------
                Martin Eric Weisberg
 
                   /s/ EDWIN VOGT                        Director                        April 14, 1999
-----------------------------------------------------
                     Edwin Vogt
</TABLE>
 
                                       39