##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

QUARTERLY REPORT ON FORM 10-Q

|    |  |                                                                                                                                           
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------
|[X] |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003

COMMISSION FILE NUMBER 0-21013

XYBERNAUT CORPORATION

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

|                                                        |  |                                                
|------------------------------------------------------- |  | -----------------------------------------------
|DELAWARE
(STATE OR OTHER JURISDICTION
OF INCORPORATION) |  | 54-1799851
(I.R.S. EMPLOYER
IDENTIFICATION NO.)

12701 FAIR LAKES CIRCLE, FAIRFAX, VA 22033
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES WITH ZIP CODE)

(703) 631-6925
(REGISTRANTS TELEPHONE NUMBER, INCLUDING AREA CODE)

Check whether the registrant: (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months
(or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days. Yes [X] No [  ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [  ] No [X]

The number of shares outstanding of the registrants Common Stock, $0.01
par value per share, as of November 10, 2003 was 167,946,564.





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##### 



XYBERNAUT CORPORATION

QUARTERLY REPORT ON FORM 10-Q

|                               |                                                                                                |                                                            |    |    |   | 
|------------------------------ | ---------------------------------------------------------------------------------------------- | ---------------------------------------------------------- | -- | -- | - | 
|                               |                                                                                                | PAGE                                                      
|COVER PAGE                     |                                                                                                |                                                            | 1  |   
|INDEX                          |                                                                                                |                                                            | 2  |   
|PART I  FINANCIAL INFORMATION |                                                                                                |                                                            |    |   
|                               | Item 1 - Financial Statements                                                                  |                                                            |    |    |  
|                               |                                                                                                | Condensed Consolidated Balance Sheets (unaudited)          |    |    | 3 | 
|                               |                                                                                                | Condensed Consolidated Statement of Operations (unaudited) |    |    | 4 | 
|                               |                                                                                                | Condensed Consolidated Statement of Cash Flows (unaudited) |    |    | 5 | 
|                               |                                                                                                | Notes to Condensed Consolidated Financial Statements       |    |    | 6 | 
|                               | Item 2 - Managements Discussion and Analysis of Results of Operations and Financial Condition |                                                            |    | 13 |  
|                               | Item 3 - Quantitative and Qualitative Disclosures about Market Risk                            |                                                            |    | 23 |  
|                               | Item 4 - Controls and Procedures                                                               |                                                            |    | 24 |  
|PART II  OTHER INFORMATION    |                                                                                                |                                                            |    |   
|                               | Item 2 - Changes in Securities and Use of Proceeds                                             |                                                            |    | 24 |  
|                               | Item 6 - Exhibits and Reports on Form 8-K                                                      |                                                            |    | 24 |  
|SIGNATURES                     |                                                                                                |                                                            | 25 |   

2



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##### 



XYBERNAUT CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |           |            |           | 
|------------------------------------------------ | ----------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------------------------------------------ | ------------------------- | --------- | ------------- | --------- | ------------ | --------- | ---------- | --------- | 
|                                                 |                                                                                                                         |                            |                                            |                           |           | September 30, |           | December 31,
|                                                 |                                                                                                                         |                            |                                            |                           |           | 2003          |           | 2002        
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |             
|ASSETS                                           |                                                                                                                         |                            |                                            |                           |           |               |           |             
|Current assets:                                  |                                                                                                                         |                            |                                            |                           |           |               |           |             
|                                                 | Cash and cash equivalents                                                                                               |                            | $                                          | 13,063,053                |           |               | $         | 1,967,710    |          
|                                                 | Restricted cash                                                                                                         |                            |                                            | 876,111                   |           |               |           | 500,000      |          
|                                                 | Accounts receivable, net of allowances of $205,340 and $202,911                                                         |                            |                                            | 2,199,246                 |           |               |           | 3,410,871    |          
|                                                 | Inventory, net of reserves of $2,662,658 and $0                                                                         |                            |                                            | 2,722,394                 |           |               |           | 2,393,465    |          
|                                                 | Prepaid and other current assets                                                                                        |                            |                                            | 684,398                   |           |               |           | 804,102      |          
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |          
|                                                 |                                                                                                                         |                            | Total current assets                       |                           |           | 19,545,202    |           |              |           | 9,076,148  |          
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |          
|Property, equipment and demonstration units, net |                                                                                                                         |                            | 394,270                                    |                           |           |               | 590,387   |             
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |          
|Other assets:                                    |                                                                                                                         |                            |                                            |                           |           |               |           |             
|                                                 | Patent costs, net of accumulated amortization of $1,851,398
and $1,516,758                                              |                            |                                            | 927,248                   |           |               |           | 1,052,518    |          
|                                                 | Tooling costs, net of accumulated amortization of
$807,917 and $141,122 and reserves of $325,000 and $250,000           |                            |                                            | 58,226                    |           |               |           | 776,699      |          
|                                                 | Other                                                                                                                   |                            |                                            | 666,383                   |           |               |           | 639,619      |          
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |          
|                                                 |                                                                                                                         |                            | Total other assets                         |                           |           | 1,651,857     |           |              |           | 2,468,836  |          
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |          
|                                                 |                                                                                                                         |                            | Total assets                               |                           | $         | 21,591,329    |           |              | $         | 12,135,371 |          
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |          
|LIABILITIES AND STOCKHOLDERS EQUITY             |                                                                                                                         |                            |                                            |                           |           |               |           |             
|Liabilities:                                     |                                                                                                                         |                            |                                            |                           |           |               |           |             
|                                                 | Current liabilities:                                                                                                    |                            |                                            |                           |           |               |           |              |          
|                                                 |                                                                                                                         | Accounts payable           |                                            | $                         | 2,277,685 |               |           | $            | 3,007,647 |           
|                                                 |                                                                                                                         | Accrued expenses and other |                                            |                           | 1,742,827 |               |           |              | 1,473,506 |           
|                                                 |                                                                                                                         | Deferred revenue           |                                            |                           | 356,905   |               |           |              | 88,460    |           
|                                                 |                                                                                                                         | Notes payable              |                                            |                           | 784       |               |           |              | 8,376     |           
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |          
|                                                 |                                                                                                                         |                            |                                            | Total current liabilities |           |               | 4,378,201 |              |           |            | 4,577,989 | 
|                                                 | Long-term restructuring liability                                                                                       |                            |                                            | 71,857                    |           |               |           | 119,295      |          
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |          
|                                                 |                                                                                                                         |                            | Total liabilities                          |                           | $         | 4,450,058     |           |              | $         | 4,697,284  |          
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |          
|Commitments and contingencies                    |                                                                                                                         |                            |                                            |                           |           |               |           |             
|Stockholders equity:                            |                                                                                                                         |                            |                                            |                           |           |               |           |             
|                                                 | Common stock, $0.01 par value, 200,000,000 shares
authorized, 167,880,064 and 113,615,722 shares
issued and outstanding |                            | $                                          | 1,678,801                 |           |               | $         | 1,136,157    |          
|                                                 | Additional paid-in capital                                                                                              |                            |                                            | 159,403,942               |           |               |           | 137,181,587  |          
|                                                 | Foreign currency translation                                                                                            |                            |                                            | 391,270                   |           |               |           | 143,502      |          
|                                                 | Accumulated deficit                                                                                                     |                            |                                            | (144,332,742              | )         |               |           | (131,023,159 | )        
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |          
|                                                 |                                                                                                                         |                            | Total stockholders equity                 |                           | $         | 17,141,271    |           |              | $         | 7,438,087  |          
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |          
|                                                 |                                                                                                                         |                            | Total liabilities and stockholders equity |                           | $         | 21,591,329    |           |              | $         | 12,135,371 |          
|                                                 |                                                                                                                         |                            |                                            |                           |           |               |           |              |          

The accompanying notes are an integral part of these
condensed consolidated financial statements

3



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##### 



XYBERNAUT CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

|                                           |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |           |            |             |             |  
|------------------------------------------ | ----------------------------------- | ------------------------------------------ | ----------------------------------------------------------------- | ------------------------ | --------- | -------------------------------- | ---------- | ------------------------------- | --------- | ---------- | ---------- | --------- | --------- | ----------- | ----------- | --------- | ---------- | ----------- | ----------- | -
|                                           |                                     |                                            |                                                                   |                          |           | Three Months Ended September 30, |            | Nine Months Ended September 30,
|                                           |                                     |                                            |                                                                   |                          |           |                                  |            |                                
|                                           |                                     |                                            |                                                                   |                          |           | 2003                             |            | 2002                            |           | 2003       |            | 2002     
|                                           |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |          
|Revenue:                                   |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |          
|                                           | Hardware                            |                                            | $                                                                 | 1,621,532                |           |                                  | $          | 1,553,019                       |           |            | $          | 4,222,036 |           |             | $           | 4,471,634 |           
|                                           | Consulting, licensing and other     |                                            |                                                                   | 1,081,589                |           |                                  |            | 992,308                         |           |            |            | 3,056,643 |           |             |             | 2,897,077 |           
|                                           |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |          
|                                           | Total revenue                       |                                            |                                                                   | 2,703,121                |           |                                  |            | 2,545,327                       |           |            |            | 7,278,679 |           |             |             | 7,368,711 |           
|Cost of sales:                             |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |          
|                                           | Hardware                            |                                            |                                                                   | 1,302,490                |           |                                  |            | 1,368,415                       |           |            |            | 3,124,741 |           |             |             | 3,839,681 |           
|                                           | Consulting, licensing and other     |                                            |                                                                   | 690,998                  |           |                                  |            | 610,976                         |           |            |            | 1,920,859 |           |             |             | 1,839,500 |           
|                                           | Provision for inventory and tooling |                                            |                                                                   | 1,500,000                |           |                                  |            | 359,217                         |           |            |            | 3,249,354 |           |             |             | 413,175   |           
|                                           |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |          
|                                           |                                     |                                            | Gross income / (loss)                                             |                          |           | (790,367                         | )          |                                 |           | 206,719    |            |           |           | (1,016,275  | )           |           |            | 1,276,355   |            
|Operating expenses:                        |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |          
|                                           |                                     | Sales and marketing                        |                                                                   |                          | 2,058,762 |                                  |            |                                 | 3,749,623 |            |            |           | 6,199,691 |             |             |           | 12,641,816 |            
|                                           |                                     | General and administrative                 |                                                                   |                          | 1,042,434 |                                  |            |                                 | 1,373,240 |            |            |           | 3,022,809 |             |             |           | 4,649,702  |            
|                                           |                                     | Research and development                   |                                                                   |                          | 708,520   |                                  |            |                                 | 1,602,275 |            |            |           | 2,708,848 |             |             |           | 5,126,413  |            
|                                           |                                     | Provision for note receivable from officer |                                                                   |                          |          |                                  |            |                                 | 1,015,575 |            |            |           |          |             |             |           | 1,015,575  |            
|                                           |                                     | Restructuring charges                      |                                                                   |                          |          |                                  |            |                                 | 361,227   |            |            |           |          |             |             |           | 516,461    |            
|                                           |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |          
|                                           |                                     |                                            |                                                                   | Total operating expenses |           |                                  | 3,809,716  |                                 |           |            | 8,101,940  |           |           |             | 11,931,348  |           |            |             | 23,949,967  |  
|                                           |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |          
|                                           |                                     |                                            |                                                                   | Operating loss           |           |                                  | (4,600,083 | )                               |           |            | (7,895,221 | )         |           |             | (12,947,623 | )         |            |             | (22,673,612 | )
|Interest and other income / (expense), net |                                     |                                            | (74,007                                                           | )                        |           |                                  | 24,581     |                                 |           |            | (361,552   | )         |           |             | 135,786     |          
|                                           |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |          
|                                           |                                     |                                            | Loss before provision for income taxes                            |                          |           | (4,674,090                       | )          |                                 |           | (7,870,640 | )          |           |           | (13,309,175 | )           |           |            | (22,537,826 | )          
|Provision for income taxes                 |                                     |                                            | 149                                                               |                          |           |                                  | 2,775      |                                 |           |            | 408        |           |           |             | 7,380       |          
|                                           |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |          
|                                           |                                     |                                            | Net loss                                                          |                          | $         | (4,674,239                       | )          |                                 | $         | (7,873,415 | )          |           | $         | (13,309,583 | )           |           | $          | (22,545,206 | )          
|                                           |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |          
|                                           |                                     |                                            | Net loss per share (basic and diluted)                            |                          | $         | (0.03                            | )          |                                 | $         | (0.10      | )          |           | $         | (0.10       | )           |           | $          | (0.33       | )          
|                                           |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |          
|                                           |                                     |                                            | Weighted average number of shares
outstanding (basic and diluted) |                          |           | 158,635,685                      |            |                                 |           | 78,011,017 |            |           |           | 138,485,139 |             |           |            | 68,397,202  |            
|                                           |                                     |                                            |                                                                   |                          |           |                                  |            |                                 |           |            |            |           |           |             |             |          

The accompanying notes are an integral part of these
condensed consolidated financial statements

4



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##### 



XYBERNAUT CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
(UNAUDITED)

|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |          |             |          |  
|------------------------------------------------------------ | --------------------------------------------------------------------------- | ---------------------------------------------------------- | -------------------------------------------------------------------------------------- | -------------------------------- | -------- | ------------------------------- | ---------- | ----------- | -------- | ----------- | -------- | -
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          | Nine Months Ended September 30,
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          | 2003                            |            | 2002       
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|Cash flows from operating activities:                        |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                             | Net loss                                                                    |                                                            | $                                                                                      | (13,309,583                      | )        |                                 | $          | (22,545,206 | )       
|                                                             | Adjustments to reconcile net loss to net cash used in
operating activities: |                                                            |                                                                                        |                                  |          |                                 |            |             |         
|                                                             |                                                                             |                                                            | Depreciation and amortization                                                          |                                  |          | 1,520,926                       |            |             |          | 1,383,183   |         
|                                                             |                                                                             |                                                            | Provision for inventory and tooling                                                    |                                  |          | 3,249,354                       |            |             |          | 413,175     |         
|                                                             |                                                                             |                                                            | Provision for note receivable from officer                                             |                                  |          |                                |            |             |          | 1,015,575   |         
|                                                             |                                                                             |                                                            | Loss on disposal of assets                                                             |                                  |          | 38,341                          |            |             |          |            |         
|                                                             |                                                                             |                                                            | Non-cash restructuring charges                                                         |                                  |          |                                |            |             |          | 335,567     |         
|                                                             |                                                                             |                                                            | Non-cash charges for equity securities issued for services                             |                                  |          | 218,313                         |            |             |          | 1,665,704   |         
|                                                             |                                                                             |                                                            | Changes in assets and liabilities:                                                     |                                  |          |                                 |            |             |          |             |         
|                                                             |                                                                             |                                                            |                                                                                        | Inventory                        |          |                                 | (2,815,251 | )           |          |             | 849,296  |  
|                                                             |                                                                             |                                                            |                                                                                        | Accounts receivable              |          |                                 | 1,228,285  |             |          |             | 362,758  |  
|                                                             |                                                                             |                                                            |                                                                                        | Prepaid and other current assets |          |                                 | 111,739    |             |          |             | (188,146 | )
|                                                             |                                                                             |                                                            |                                                                                        | Other assets                     |          |                                 | (59,852    | )           |          |             | (57,450  | )
|                                                             |                                                                             |                                                            |                                                                                        | Accounts payable                 |          |                                 | (786,682   | )           |          |             | (649,490 | )
|                                                             |                                                                             |                                                            |                                                                                        | Accrued expenses and other       |          |                                 | (361,223   | )           |          |             | (127,730 | )
|                                                             |                                                                             |                                                            |                                                                                        | Restructuring liability          |          |                                 | (60,641    | )           |          |             | 222,270  |  
|                                                             |                                                                             |                                                            |                                                                                        | Deferred warranty costs          |          |                                 | (69,315    | )           |          |             |         |  
|                                                             |                                                                             |                                                            |                                                                                        | Deferred revenue                 |          |                                 | 268,445    |             |          |             | 39,567   |  
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                             |                                                                             |                                                            | Net cash used in operating activities                                                  |                                  | $        | (10,827,144                     | )          |             | $        | (17,280,927 | )       
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|Cash flows from investing activities:                        |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                             |                                                                             | Note receivable from officers, net                         |                                                                                        |                                  |         |                                 |            |             | (24,145  | )          
|                                                             |                                                                             | Acquisition of property, equipment and demonstration units |                                                                                        |                                  | (256,012 | )                               |            |             | (666,592 | )          
|                                                             |                                                                             | Acquisition of patents and trademarks                      |                                                                                        |                                  | (211,156 | )                               |            |             | (425,844 | )          
|                                                             |                                                                             | Restricted cash                                            |                                                                                        |                                  | (376,111 | )                               |            |             |         |            
|                                                             |                                                                             | Capitalization of tooling costs                            |                                                                                        |                                  | (20,000  | )                               |            |             |         |            
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                             |                                                                             |                                                            | Net cash used in investing activities                                                  |                                  | $        | (863,279                        | )          |             | $        | (1,116,581  | )       
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|Cash flows from financing activities:                        |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                             | Proceeds from:                                                              |                                                            |                                                                                        |                                  |          |                                 |            |             |         
|                                                             |                                                                             |                                                            | Common stock offerings, net                                                            |                                  |          | 14,636,009                      |            |             |          | 14,192,440  |         
|                                                             |                                                                             |                                                            | Exercise of warrants                                                                   |                                  |          | 6,295,343                       |            |             |          | 1,698,773   |         
|                                                             |                                                                             |                                                            | Exercise of stock options                                                              |                                  |          | 26,878                          |            |             |          | 3,047       |         
|                                                             |                                                                             |                                                            | Notes and loans                                                                        |                                  |          | 1,750,000                       |            |             |          | 250,000     |         
|                                                             | Payments for:                                                               |                                                            |                                                                                        |                                  |          |                                 |            |             |         
|                                                             |                                                                             |                                                            | Capitalization of loan costs                                                           |                                  |          | (18,376                         | )          |             |          | (10,375     | )       
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                             |                                                                             |                                                            | Net cash provided by financing activities                                              |                                  | $        | 22,689,854                      |            |             | $        | 16,133,885  |         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|Effect of exchange rate changes on cash and cash equivalents |                                                                             |                                                            | 95,912                                                                                 |                                  |          |                                 | (281,847   | )          
|Net increase in cash and cash equivalents                    |                                                                             |                                                            | 11,095,343                                                                             |                                  |          |                                 | (2,545,470 | )          
|Cash and cash equivalents, beginning of period               |                                                                             |                                                            | 1,967,710                                                                              |                                  |          |                                 | 3,172,609  |            
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|Cash and cash equivalents, end of period                     |                                                                             | $                                                          | 13,063,053                                                                             |                                  |          | $                               | 627,139    |            
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|Supplemental disclosure of cash flow information:            |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                             |                                                                             |                                                            | Cash paid for interest                                                                 |                                  | $        | 579                             |            |             | $        | 1,966       |         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                             |                                                                             |                                                            | Cash paid for taxes                                                                    |                                  | $        | 585                             |            |             | $        | 22,011      |         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|Supplemental disclosure of non-cash financing activities:    |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                             |                                                                             |                                                            | Equity securities issued for future services, recorded
as prepaid expenses when issued |                                  | $        |                                |            |             | $        | 1,919,498   |         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                             |                                                                             |                                                            | Equity securities issued for services rendered, expensed
in periods issued             |                                  | $        | 202,980                         |            |             | $        | 159,587     |         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                             |                                                                             |                                                            | Equity securities issued for settlement of accounts payable
and accrued expenses       |                                  | $        |                                |            |             | $        | 287,431     |         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                             |                                                                             |                                                            | Equity securities issued for settlement of notes payable                               |                                  | $        | 1,750,000                       |            |             | $        | 250,000     |         
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            

The accompanying notes are an integral part of these
condensed consolidated financial statements

5



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XYBERNAUT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.     BASIS OF PRESENTATION

The accompanying unaudited, condensed and consolidated financial
statements of Xybernaut Corporation, a Delaware Corporation (the Company),
have been prepared in accordance with accounting principles generally accepted
in the United States of America (U.S. GAAP) for interim financial information
and instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly,
these statements do not include all of the information and footnotes required
by U.S. GAAP for complete financial statements. In the opinion of the Companys
management, these unaudited, condensed and consolidated financial statements
reflect all adjustments of a normal, recurring nature necessary to present
fairly the financial position of the Company and its subsidiaries at September
30, 2003 and December 31, 2002, and the results of their operations and cash
flows for the three and nine months ended September 30, 2003 and 2002. Results
of operations for the three and nine months ended September 30, 2003 are not
necessarily indicative of results of operations expected for the full fiscal
year ending December 31, 2003. Please refer to the Companys Annual Report on
Form 10-K/A for the complete financial statements.

2.     THE COMPANY AND FINANCING REQUIREMENTS

The Company is engaged in the research, development, manufacture,
marketing and sale of mobile, wearable computing and communication systems as
well as software and service solutions designed to enhance productivity and
improve product management, asset management, and the accuracy, timeliness and
utilization of captured data. The Company offers solutions with a software and
services focus through its wholly-owned subsidiary Xybernaut Solutions, Inc.
(U.S.). The Company offers solutions with a hardware focus through its U.S.
operations and through its wholly-owned subsidiaries Xybernaut K.K. (Japan) and
Xybernaut GmbH (Germany). Introduced in 1995, the Mobile Assistant® (MA®)
series is the Companys primary line of wearable computer hardware products,
the current versions of which are the MA V and MA TC. Introduced in 2002, the
Atigo product line is a family of mobile wireless web panels that can be used
either as stand-alone handheld personal computers (PCs) or as displays for an
MA system, a laptop or a conventional PC. Since their commercial introductions,
the Company has recognized revenue of approximately $24,000,000 on sales of
approximately 6,500 MA and Atigo systems.

The Company was originally incorporated in 1990 and completed its initial
public offering in July 1996. In April 2000, Xybernaut acquired Selfware, Inc,
which subsequently changed its name to Xybernaut Solutions, Inc. (XSI). The
merger was accounted for as a pooling of interests.

The Company has recorded significant net losses since its inception and
will require additional capital to fund its business plan and meet its ongoing
obligations. Management believes the Company will be successful in its efforts
to obtain such capital, having raised approximately $23,000,000 during the nine
months ended September 30, 2003, and based on debt and equity financings
currently available to the Company. In addition, the Company has reduced its
operating expenses by significant amounts through a restructuring program and
had approximately $13,000,000 in cash on hand as of September 30, 2003.
However, there can be no assurance that the Company will not incur additional
losses or will not require significant amounts of additional capital. If the
Company is unable to obtain sufficient additional financing, it will be
required to reduce spending further in order to maintain its operations at a
reduced level. Management believes that it will be able to reduce spending if
required but there can be no assurances that it can successfully do so.

3.     Summary of Significant Accounting Policies

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with U.S. GAAP
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, Cash Equivalents and Restricted Cash

The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents. At September
30, 2003 and December 31, 2002, the Company had $876,111 and $500,000,
respectively, in restricted cash. The balance at December 31, 2002 consisted of
a $500,000 cash deposit that secures a long-term services contract. The balance
at September 30, 2003 consisted of this same balance in addition to a $376,111
cash deposit and interest that secures a letter of credit held by a vendor.
The restrictions on the $500,000 deposit are scheduled to lapse in late 2004,
which date coincides with the completion of services pursuant to a follow-on
contract awarded to the Company by the customer in the third quarter of 2003.
The restrictions on the

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$376,111 deposit are scheduled to lapse in the first quarter of 2004.

Inventory

At September 30, 2003, inventory consisted primarily of wearable computer
component parts held for resale and allocated tooling costs, and is comprised
primarily of finished goods. Inventory is stated at the lower of cost or
market, with cost being determined on a first-in, first-out basis. Management
periodically assesses the need to provide for obsolescence of inventory and
adjusts the carrying value of inventory to its net realizable value when
required. The Company anticipates that it will be required to sell certain of
the MA V and other wearable computer systems and components at prices that are
less than their production costs in order to sell the quantities of inventory
on hand as well as the inventory to be delivered according to its current
manufacturing contracts.

During the nine months ended September 30, 2003, charges of $3,174,354
were recorded to reflect managements estimate of losses to be incurred on the
systems in inventory and on the total remaining production run of the MA V
product line. A portion of this inventory charge was applied as an inventory
reserve against the systems on hand. The remaining inventory charge related to
systems and components that had not been received by the Company as of March
31, 2003, which was the period in which the underlying contracts were entered
into. Since this inventory had not been received and was therefore not
recorded as an asset, the Company recorded the expected losses on these future
shipments as an accrued liability which is being reclassified to an inventory
reserve or write-off as MA V systems and components are received during 2003.
At September 30, 2003, these inventory charges were allocated as an inventory
reserve totaling $2,662,658, an accrued liability totaling $497,016 and to
demonstration units totaling $14,680. At December 31, 2002, no such balances
were recorded.

During the three months ended September 30, 2003, MA V systems and
microchip components were received into inventory resulting in a
reclassification of $378,282 and $240,543, respectively, from the existing
accrued inventory reserve to inventory reserve. MA V systems capitalized as
demonstration units reduced the accrued inventory reserve balance by $12,986.
During the nine months ended September 30, 2003, MA V systems and microchips
were received into inventory resulting in a reclassification of $677,520 and
$326,960, respectively, from accrued inventory reserve to inventory reserve. MA
V systems capitalized as demonstration units reduced the accrued inventory
reserve balance by $14,680.

The Companys management believes that it can sell its wearable and mobile
computer inventory at amounts that approximate current net carrying values,
which have been or will be reduced as a result of the above charges. To
determine the size of the charges to record, management reviewed the carrying
value of its inventory in light of the introduction of new product lines, its
ability to sell the quantities of inventory on hand as well as the quantities
expected to be received in the future and the sales prices it ultimately
expects to achieve. This analysis took into account estimated price concessions
which management believes are likely to be necessary in disposing of this
inventory. As a result of this review, it was determined that certain of the
Companys inventory is slow-moving, risked becoming obsolete or will likely be
sold at below its historical cost. Based upon a specific review of the carrying
costs for the inventory items, management estimated the quantity of each
inventory item that the Company was expected to be able to sell and also
quantified inventory amounts that may not be recoverable. Management does not
expect to record significant profits or losses upon the ultimate sale of the
inventory that has been written down or reserved.

As of September 30, 2003, net of the effect of write-offs and reserves,
the Companys inventory consisted of $2,195,503 in MA V systems, $388,190 in MA
TC systems and $138,701 in Atigo systems.

Tooling Costs

Capitalized tooling costs consist of payments made to third-party vendors
for their products and services that are used in the manufacture of the
Companys proprietary hardware products. Tooling costs are systematically
allocated to inventory or property and equipment and are amortized as a
component of cost of sales or depreciation based upon the number of units sold
or used as demonstration units in a given period compared to the total number
of units management expects to make in a products production run.

Managements expectation of the number of units to be made during a given
products production run is based on a number of assumptions and estimates,
including but not limited to those related to the introduction of new product
lines, the Companys ability to procure and sell the quantities of inventory,
the introduction of competing products, customer demand and general economic
conditions.

Management periodically assesses the need to provide for obsolescence of
tooling costs and adjusts the carrying values to their net realizable value
when required through a process similar to that discussed in the Inventory
section above. During the three months ended September 30, 2003, the Company
recognized a $75,000 charge related to its capitalized tooling assets. As of
September 30, 2003 and December 31, 2002, the Companys tooling reserve totaled
$325,000 and $250,000, respectively. These reserves were established to provide
for an estimated decline in value of the inventory associated primarily with
the MA V product line. In the event that the anticipated production run size or
sales of a product do not materialize, additional adjustment may be necessary
to reserve or write down the carrying value of the Companys tooling costs.

As of September 30, 2003, net of the effects of accumulated amortization,
reserves and write-offs, the Companys tooling costs

7



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asset consisted of $23,251 for MA V systems and $34,975 for MA TC systems.
Capitalized tooling costs during the nine months ended September 30, 2003 and
2002 were $23,321 and $36,308, respectively. Amortization to cost of goods sold
or depreciation, depending on classification of tooling costs as inventory or
property and equipment, was $309,749 and $10,250, for the three months ended
and $666,795 and $40,035, for the nine months ended September 30, 2003 and
2002, respectively.

Revenue Recognition

During 2003, the Company entered into the high-volume electronic component
parts distribution business. Revenue from this distribution business is
accounted for based on the facts and circumstances of each individual
transaction in accordance with Emerging Issues Task Force (EITF) Issue No.
99-19, Reporting Revenue Gross as a Principal versus Net as an Agent. Based
upon the facts and circumstances of the transactions entered into during the
three and nine months ended September 30, 2003, the Company recorded
consulting, licensing and other revenue of $43,557 and $57,157, respectively,
such amounts representing the net fees the Company earned for services
performed during these periods. On a gross basis, the transactions totaled
$1,499,008 and $1,822,608, respectively, during the three and nine months ended
September 30, 2003. There have been no changes to the Companys other revenue
recognition policies as disclosed in the Companys previously filed Form
10-K/A.

Net Loss Per Share

The Company computes net loss per share in accordance with Statement of
Financial Accounting Standards (SFAS) No. 128, Earnings Per Share, and SEC
Staff Accounting Bulletin (SAB) No. 98. Under the provisions of SFAS No. 128
and SAB No. 98, basic net loss per share is computed by dividing the net loss
available to common stockholders for the period by the weighted average number
of common shares outstanding during the period. Diluted net loss per share is
computed by dividing the net loss available to common stockholders for the
period by the weighted average number of common and dilutive common equivalent
shares outstanding during the period. Diluted net loss per share adjusts the
weighted average number of outstanding shares for the potential dilution that
could occur if stock options, warrants or other convertible securities were
exercised or converted into common stock. If the Company posted a net income
instead of a net loss, the impact of the Companys outstanding stock options,
warrants or other convertible securities would have a negative effect on
diluted net income per share. As the Company had a net loss in each of the
periods presented, basic and diluted net loss per share is the same.

Stock-Based Compensation

In December 2002 the Financial Accounting Standards Board issued SFAS No.
148, Accounting for Stock Based Compensation-Transition and Disclosure, an
amendment to SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No.
148 amends the disclosure provisions to require prominent disclosure about the
effects on reported net income of an entitys accounting policy decisions with
respect to stock-based compensation. Stock options are accounted for using the
intrinsic method in accordance with Accounting Principles Board (APB) No. 25,
Accounting for Stock Issued to Employees, as interpreted, whereby if options
are priced at fair market value or above at the date of grant, no compensation
expense is recognized. The pro forma information is as follows:

|                      |                                                                                                     |   |                                  |          |                                 |   |            |            |      |   |             |            |   |   |             |            |  
|--------------------- | --------------------------------------------------------------------------------------------------- | - | -------------------------------- | -------- | ------------------------------- | - | ---------- | ---------- | ---- | - | ----------- | ---------- | - | - | ----------- | ---------- | -
|                      |                                                                                                     |   |                                  |          |                                
|                      |                                                                                                     |   | Three Months Ended September 30, |          | Nine Months Ended September 30,
|                      |                                                                                                     |   | 2003                             |          | 2002                            |   | 2003       |            | 2002
|                      |                                                                                                     |   |                                  |          |                                 |   |            |            |     
|Net loss, as reported |                                                                                                     | $ | (4,674,239                       | )        |                                 | $ | (7,873,415 | )          |      | $ | (13,309,583 | )          |   | $ | (22,545,206 | )         
|                      | Add: Stock-based
employee
compensation
expense included in
net loss, as
reported                    |   |                                  |         |                                 |   |            | 62,262     |      |   |             | 150,325    |   |   |             | 112,262    |  
|                      | Deduct: Stock-based
employee
compensation
expense determined
under fair value
method of SFAS No
123 |   |                                  | (473,961 | )                               |   |            | (1,069,361 | )    |   |             | (1,367,389 | ) |   |             | (3,189,611 | )
|                      |                                                                                                     |   |                                  |          |                                 |   |            |            |      |   |             |            |   |   |             |           
|Pro forma net loss    |                                                                                                     | $ | (5,148,200                       | )        |                                 | $ | (8,880,514 | )          |      | $ | (14,526,647 | )          |   | $ | (25,622,555 | )         
|                      |                                                                                                     |   |                                  |          |                                 |   |            |            |      |   |             |            |   |   |             |           
|Earnings per share:   |                                                                                                     |   |                                  |          |                                 |   |            |            |      |   |             |            |   |   |             |           
|                      | Basic and diluted
net loss per share
- as reported                                                  |   | $                                | (0.03    | )                               |   | $          | (0.10      | )    |   | $           | (0.10      | ) |   | $           | (0.33      | )
|                      |                                                                                                     |   |                                  |          |                                 |   |            |            |      |   |             |            |   |   |             |           
|                      | Basic and diluted
net loss per share
- pro forma                                                    |   | $                                | (0.03    | )                               |   | $          | (0.11      | )    |   | $           | (0.10      | ) |   | $           | (0.37      | )
|                      |                                                                                                     |   |                                  |          |                                 |   |            |            |      |   |             |            |   |   |             |           

Issuance of Equity Securities for Services

The Company periodically issues equity securities to certain employees,
consultants and companies for services provided to, or

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goods received by, the Company. These securities include shares of common stock
and warrants and options to purchase shares of common stock. These transactions
were individually valued based upon the fair value of the securities issued or
the services or goods provided, whichever was more reliably measured. In the
three months ended September 30, 2003 and 2002, the Company recorded prepaid
assets for future services or goods to be provided of $0 and $53,202,
respectively, which were expensed in 2002 and 2003. In the nine months ended
September 30, 2003 and 2002, the Company recorded prepaid assets for future
services or goods to be provided of $0 and $1,919,498, respectively, which were
expensed in 2002 and 2003. Included in prepaid and other assets at September
30, 2003 and December 31, 2002 are equity securities issued for payment of
future services of $0 and $19,167, respectively.

Restructuring

The Company recorded restructuring charges in accordance with EITF Issue
No. 94-3, Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring), and SAB No. 100, Restructuring and Impairment Charges.
During the second, third and fourth quarters of 2002, management adopted
various restructuring plans which established the plans of termination, the
benefits available to terminated employees and communicated these benefits to
the terminated employees. The employee severance costs and outplacement
services according to these plans were recorded as restructuring charges and
totaled $434,308. As part of the restructuring plans, office space was reduced
by moving XSI employees to the Companys headquarters and preparing the vacated
space for sublease. The present value of the future cash flows of the office
rent for the life of the contract less an estimate that the space can be
subleased at 50% of total rent totaled $223,305. Further consolidation and
subleasing of office space at headquarters resulted in an additional
restructuring charge of $10,199. In the fourth quarter, the Company closed its
branch operations in Japan, resulting in a $213,041 restructuring charge (the
Companys wholly-owned subsidiary operating in Japan, Xybernaut KK, was not
closed). Also, in the fourth quarter, management performed a cost-benefit
analysis of its patent portfolio and recorded a $157,307 charge related to the
write-off of certain patent costs. Of these 2002 restructuring charges,
$245,546 was paid in cash and $188,762 was paid by the issuance of equity
securities during the last three quarters of 2002. At September 30, 2003, of
the remaining unpaid balance of $137,098, $63,729 is included in accrued
expenses and is expected to be paid within one year of the balance sheet. The
remaining balance of $71,857 is classified as a long-term liability on the
balance sheet and is expected to be paid in 2004 and 2005. The original charge
for outplacement services extended to severed employees was reduced by $4,536
in 2002 as outplacement services expired resulting in no expense to the
Company. Management may establish and implement future additional restructuring
plans depending on business conditions.

The components of the restructuring charge in 2002 are as follows:

|                                    |  |   |           | 
|----------------------------------- |  | - | --------- | 
|Severance and outplacement services |  | $ | 434,308   | 
|Lease obligations                   |  |   | 233,504   | 
|Closing of branch operations        |  |   | 213,041   | 
|Write-down of certain patent costs  |  |   | 157,307   | 
|                                    |  |   |           | 
|                                    |  | $ | 1,038,160 | 
|                                    |  |   |           | 

Reclassifications

Certain 2002 balances and disclosures have been reclassified to conform to
the 2003 presentation.

3.     Liquidity and Operations

The Company has recorded net losses since its inception, including during
the periods presented in this Form 10-Q. These losses are primarily
attributable to the operating expenses incurred by the Company to design,
develop, market and sell its mobile and wearable computer products and to
provide general and administrative support for these operating activities.
During these periods, the Companys revenues and gross margins have not been
sufficient to fund these operating activities. As a result, the Company has
consistently recorded negative cash flows from operating activities and net
losses and had an accumulated deficit of $144,332,742 at September 30, 2003.
The combination of the Companys operating losses and its working capital
requirements has severely impacted the Companys financial position and
liquidity. During 2003 and 2002, the Company has funded its operating and
investing activities through its financing activities, which consist primarily
of private placements of common stock, warrant and stock option exercises and
borrowings.

The Companys management has taken steps that it believes are necessary to
improve the Companys operations and raise additional capital, both of which
are needed to enhance its ability to meet its cash flow needs through December
31, 2003 and thereafter. Beginning in April 2002, management has performed
reviews of the Companys operations and implemented various cost cutting
programs to significantly reduce the Companys operating expenses.

Assuming there are no significant changes to the Companys business plan,
management expects to maintain savings of over 50% from annualized fourth
quarter 2001 levels. Beginning in the fourth quarter of 2002 and continuing
through the first three quarters of 2003, management met its current target to
reach a quarterly operating expense level of between approximately $4,000,000
and $4,500,000.

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Management believes that the Companys current staffing and resources will
be sufficient to carry out its business plan for the foreseeable future. In
addition to the cost cutting initiatives already undertaken, management
continues to review all aspects of the Companys operations and may take
additional actions to reduce operating expenses further. Future significant
fluctuations may still occur as a result of non-recurring charges associated
with cost-saving initiatives as well as the Companys research and development
activities, which will vary depending on the Companys wearable and mobile
computer product development cycle during any given period.

Based on historical results and the forecasted levels discussed above,
management expects that the Company will incur operating expenses of between
approximately $16,000,000 and $16,500,000 during 2003. However, there can be no
assurances that actual operating expenses during later periods will not be
significantly higher. The Company will also be required to fund inventory
procurement and other expenditures. Management expects to fund these activities
through cash on hand, gross profits and outside financings. Potential sources
of additional financing include private equity offerings, warrant exercises,
strategic investments and various forms of debt financing. In certain
instances, concurrently with the exercise of warrants, the exercise prices have
been reduced. Such reduction has resulted in the issuance of substantially more
shares of common stock than would have occurred had the exercise price of the
warrants not been reduced. The Company may reduce the exercise price of
additional warrants in the future. If additional funds are raised through the
issuance of equity securities, the percentage of ownership of current
stockholders of the Company will be reduced and if additional funds are raised
at current and historical prices for the Companys stock, such dilution could
be significant. If additional funds are raised through borrowings, the Company
will be subject to interest charges and principal repayments, will likely be
required to comply with financial covenants or other restrictions, and will
likely have to collateralize such borrowings with its assets, which could be
taken by the lender in the event of default.

During the nine months ended September 30, 2003, the Company raised
approximately $23,000,000 through sales of its common stock to institutional
investors, through warrant and stock option exercises and through borrowings.
The Companys management believes that the combination of cash on hand, cash
flows from operations and outside funding will provide sufficient liquidity to
meet the Companys ongoing cash requirements. This is based both on the
Companys historical ability to raise capital and on debt and equity financings
currently available to the Company. However, there can be no assurance that the
Company can or will obtain sufficient funds from operations or from additional
financings on terms acceptable to the Company.

4.     BORROWINGS

On March 26, 2003, the Company borrowed $1,750,000 from a lender pursuant
to a one-year promissory note that bore interest at 3.5% per annum. In
connection with this borrowing, the Company issued to the lender warrants to
purchase 1,750,000 shares of common stock at an exercise price of $1.25 per
share and warrants to purchase 2,000,000 shares of common stock at an exercise
price of $0.43 per share. Based on the relative fair values of the securities
issued, these warrants were assigned a value of $393,594, which amount was
recorded as a note discount to be amortized into interest expense over the life
of the note. On May 30, 2003, the Company repaid $860,000 in principal when the
lender elected to exercise the 2,000,000 warrants at $0.43 per share.
Subsequent to this partial repayment, the lender provided the Company with a
10% discount on the remaining unpaid principal to induce the Company to repay
the remaining principal prior to its original maturity date. The remaining
principal and interest was repaid on May 30, 2003 through the: i) $89,000
discount, which was applied against the Companys Additional Paid-In Capital,
ii) application of the $560,000 aggregate exercise price related to the
exercise of the warrants to purchase 1,750,000 shares of common stock at $0.32
per share, a reduction from the original $1.25 per share exercise price, iii)
issuance of 651,351 shares of common stock valued at $241,000, or $0.37 per
share, and iv) issuance of 30,350 shares of common stock valued at $11,229, or
$0.37 per share, as repayment of accrued interest. During the nine months ended
September 30, 2003, the Company fully amortized the $393,594 note discount into
interest expense. The Company had no outstanding principal or interest related
to this note at either September 30, 2003 or December 31, 2002.

5.     STOCKHOLDERS EQUITY

During March 2002, the Company received gross proceeds of $9,000,000
through a private placement of 5,625,000 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 1,406,250 shares of common stock at an
exercise price of $3.00 per share. In connection with this placement, the
Company paid $270,000 in cash to financial advisors.

During June 2002, the Company received gross proceeds of $4,000,000
through a private placement of 6,666,666 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 1,666,666 shares of common stock at an
exercise price of $1.50 per share. In connection with this placement, the
Company issued 740,740 shares of its common stock to financial and business
development advisors.

During August 2002, the Company received gross proceeds of $2,000,000
through a private placement of 5,714,286 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 5,714,286 shares of common stock at an
exercise price of $0.70 per share and callable warrants to purchase 5,714,286
shares of common stock at an exercise price of $1.50 per share. A portion of
the proceeds from this private placement was used to repay a $250,000 note payable.

10



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During February 2003, the Company received gross proceeds of $2,000,000
through a private placement of 6,666,667 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor callable warrants to purchase 3,333,333 shares of common stock at an
exercise price of $1.25 per share.

During May 2003, the Company received gross proceeds of $3,000,000 through
a private placement of 9,375,000 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to
the investors three-year callable warrants to purchase 3,281,250 shares of
common stock. These warrants have an exercise price of $0.45 if exercised in
the first year, $0.90 if exercised in the second year and $1.35 if exercised in
the third and final year.

During June 2003, the Company
  received gross proceeds of $2,000,000 through a private placement of 5,405,405
  shares of its common stock to an investor. In connection with this private placement,
  the Company issued to the investor three-year callable warrants to purchase
  4,054,054 shares of common stock. These warrants have an exercise price of $1.25
  if exercised in the first year, $2.50 if exercised in the second year and $3.75
  if exercised in the third and final year.

During September 2003, the Company received gross proceeds of $5,000,000
through a private placement of 6,849,315 shares of its common stock to an
investor. The shares were sold at $0.73 per share, representing an approximate
20% discount to the closing price of its common stock on the date of the
agreement. In connection with this private placement, the Company issued to
the investor three-year callable warrants to purchase 3,424,658 shares of
common stock. These warrants have an exercise price of $0.91 if exercised in
the first year, $1.82 if exercised in the second year and $2.73 if exercised in
the third and final year.

During September 2003, the Company
  received gross proceeds of $2,000,000 through a private placement of 1,600,000
  shares of its common stock to an investor. The shares were sold at $1.25 per
  share, representing an approximate 18% discount to the closing price of its
  common stock on the date of the agreement. In connection with this private placement,
  the Company issued to the investor three-year callable warrants to purchase
  800,000 shares of common stock. These warrants have an exercise price of $1.25
  if exercised in the first year, $2.50 if exercised in the second year and $3.75
  if exercised in the third and final year.

The Company issues warrants to purchase shares of its common stock,
primarily in connection with the Companys financings and borrowings.
Exclusive of the exercises made in connection with the note repayment discussed
in Borrowings above, the Company received net proceeds of $3,191,176 and
$6,295,343 through the issuance of 7,722,768 and 19,597,769 shares of its
common stock during the three and nine months ended September 30, 2003,
respectively, and $926,593 and $1,698,773 through the issuance of 6,034,837 and
7,579,198 shares of its common stock during the three and nine months ended
September 30, 2002, respectively. Concurrently with their exercise, during the
nine months ended September 30, 2003, the exercise price of 16,316,852 of the
warrants was reduced from a weighted average of $1.13 per share to $0.31 per
share. Concurrently with their exercise, during the nine months ended
September 30, 2002, the exercise price of 6,034,837 of the warrants was reduced
from a weighted average of $1.48 per share to $0.15 per share. At September 30,
2003, the Company had warrants outstanding to purchase 8,367,397 shares of its
common stock at prices that range from $0.50 to $5.00 per share, with a
weighted average of $2.25 per share.

6.     SEGMENT AND ENTERPRISE WIDE REPORTING

The Company discloses certain financial and supplementary information
about its operating segments, products and services, geographic areas and major
customers pursuant to SFAS No. 131, Disclosures About Segments of an
Enterprise and Related Information. Operating segments are defined as
components of an enterprise about which separate discrete financial information
is evaluated regularly by the chief operating decision maker or decision making
group, in deciding how to allocate resources and assess performance. The
financial information disclosed herein materially presents all of the financial
information related to the Companys principal operating segments as a provider
of wearable computing and communications systems and software and service
solutions.

Revenues by geographical destination as a percentage of total revenues for
the three and nine months ended September 30, 2003 and 2002 are as follows:

|                            |  |                    |    |                   |  |      |    |      |  |  |    |   |  |  |    |  
|--------------------------- |  | ------------------ | -- | ----------------- |  | ---- | -- | ---- |  |  | -- | - |  |  | -- | -
|                            |  | Three Months Ended |    | Nine Months Ended
|                            |  | September 30,      |    | September 30,    
|                            |  |                    |    |                  
|                            |  | 2003               |    | 2002              |  | 2003 |    | 2002
|                            |  |                    |    |                   |  |      |    |     
|United States               |  |                    | 88 | %                 |  |      | 87 | %    |  |  | 86 | % |  |  | 82 | %
|Europe, principally Germany |  |                    | 10 | %                 |  |      | 11 | %    |  |  | 11 | % |  |  | 14 | %
|Asia, principally Japan     |  |                    | 2  | %                 |  |      | 2  | %    |  |  | 3  | % |  |  | 4  | %

Operations in various geographical areas are summarized as follows:

11



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|               |                     |  |                                |            |                               |  |      |           |      |  |   |            |  |  |   |            | 
|-------------- | ------------------- |  | ------------------------------ | ---------- | ----------------------------- |  | ---- | --------- | ---- |  | - | ---------- |  |  | - | ---------- | 
|               |                     |  | As of and for the Three Months |            | As of and for the Nine Months
|               |                     |  | Ended September 30,            |            | Ended September 30,          
|               |                     |  |                                |            |                              
|               |                     |  | 2003                           |            | 2002                          |  | 2003 |           | 2002
|               |                     |  |                                |            |                               |  |      |           |     
|North America: |                     |  |                                |            |                               |  |      |           |      |  |   |            |  |  |   |           
|               | Total revenue       |  | $                              | 2,372,537  |                               |  | $    | 2,222,243 |      |  | $ | 6,265,164  |  |  | $ | 6,058,331  | 
|               | Net loss            |  |                                | 4,346,372  |                               |  |      | 6,051,551 |      |  |   | 12,289,793 |  |  |   | 18,627,169 | 
|               | Identifiable assets |  |                                | 20,093,756 |                               |  |      | 9,863,977 |      |  |   | 20,093,756 |  |  |   | 9,863,977  | 
|               |                     |  |                                |            |                               |  |      |           |      |  |   |            |  |  |   |           
|Europe (1):    |                     |  |                                |            |                               |  |      |           |      |  |   |            |  |  |   |           
|               | Total Revenue       |  | $                              | 288,050    |                               |  | $    | 273,452   |      |  | $ | 803,056    |  |  | $ | 988,276    | 
|               | Net loss            |  |                                | 277,212    |                               |  |      | 1,737,318 |      |  |   | 932,326    |  |  |   | 3,613,630  | 
|               | Identifiable assets |  |                                | 1,072,214  |                               |  |      | 2,124,806 |      |  |   | 1,072,214  |  |  |   | 2,124,806  | 
|               |                     |  |                                |            |                               |  |      |           |      |  |   |            |  |  |   |           
|Asia:          |                     |  |                                |            |                               |  |      |           |      |  |   |            |  |  |   |           
|               | Total revenue       |  | $                              | 42,534     |                               |  | $    | 49,632    |      |  | $ | 210,459    |  |  | $ | 322,104    | 
|               | Net loss            |  |                                | 50,655     |                               |  |      | 84,546    |      |  |   | 87,464     |  |  |   | 304,407    | 
|               | Identifiable assets |  |                                | 425,359    |                               |  |      | 415,637   |      |  |   | 425,359    |  |  |   | 415,637    | 



| |  | (1) Included in the Companys operations in Europe are expenses related to
research and development activities conducted by a branch of the Company
operating in Germany. These expenses were $146,182 and $87,083 for the
three months ended September 30, 2003 and 2002, respectively, and $534,656
and $593,371 for the nine months ended September 30, 2003 and 2002,
respectively.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The following table summarizes the number of customers that individually
comprise greater than 10% of total revenue or total accounts receivable and
their aggregate percentage of the Companys total revenue or total accounts
receivable.

|                                     |  |                            |    |                            |  |      |    |      |  |  |    |   |  |  |    |  
|------------------------------------ |  | -------------------------- | -- | -------------------------- |  | ---- | -- | ---- |  |  | -- | - |  |  | -- | -
|                                     |  | As of and for the Three    |    | As of and for the Nine    
|                                     |  | Months Ended September 30, |    | Months Ended September 30,
|                                     |  |                            |    |                           
|                                     |  | 2003                       |    | 2002                       |  | 2003 |    | 2002
|                                     |  |                            |    |                            |  |      |    |     
|Revenue:                             |  |                            |    |                            |  |      |    |      |  |  |    |   |  |  |    |  
|Number of Customers                  |  |                            | 2  |                            |  |      | 1  |      |  |  | 2  |   |  |  | 1  |  
|Percent of Total Revenue             |  |                            | 43 | %                          |  |      | 19 | %    |  |  | 38 | % |  |  | 10 | %
|                                     |  |                            |    |                            |  |      |    |      |  |  |    |   |  |  |    |  
|Accounts Receivable:                 |  |                            |    |                            |  |      |    |      |  |  |    |   |  |  |    |  
|Number of Customers                  |  |                            | 2  |                            |  |      | 2  |      |  |  | 2  |   |  |  | 2  |  
|Percent of Total Accounts Receivable |  |                            | 48 | %                          |  |      | 45 | %    |  |  | 48 | % |  |  | 45 | %

7.     TRANSACTIONS WITH RELATED AND CERTAIN OTHER PARTIES

The Company has entered into various agreements with IBM. The Company has
contracted with IBM to design, develop and manufacture certain components of
the MA V product line, including the computer portion and two versions of FPDs
(the Engineering and Inventory Agreement). Under the Engineering and
Inventory Agreement, the Company was obligated to purchase certain components
of the MA V system, including 24,000 computing units, as well as various
numbers of FPDs and other accessories. The total cost to the Company of these
purchases would have been over approximately $40,000,000. Under the Engineering
and Inventory Agreement, the Company had the right to cancel this purchase
commitment by paying a cancellation fee in an amount of approximately
$4,000,000. In March 2003, the Company entered into an agreement with IBM under
which the Company was released of its obligation to pay the penalty or procure
this inventory other than $4,910,000 in MA V computing units, FPDs, peripherals
and component parts. The final pricing provided to the Company represents a
discount from the original contractual prices. Under the March 2003 agreement,
IBM agreed to ship inventory monthly from March 2003 through December 2003 and
the Company agreed to remit payments monthly from March 2003 through January
2004. IBM Global Finance provided a credit facility to the Company which
provides credit to the
Company for purchases of inventory under the March 2003 agreement. In
connection with this credit facility, IBM Global Finance was granted a security
interest in certain of the Companys assets and the Company obtained a letter
of credit from a third party lender for the benefit of IBM Global Finance in
the amount of $375,000, for which the Company posted an equal amount of
restricted cash. This security interest does not include patents and
intellectual property. The Company has also entered into agreements with IBM
under which IBM purchases MA V and Atigo products from the Company and markets
and sells the systems worldwide to its own customers (the Sales and Marketing
Agreement). During the three and nine months ended September 30, 2003, the
Company paid $1,296,012

12



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and $3,369,311, respectively, to IBM related to design and development services
and inventory purchases. During the same periods in 2002, the Company paid
$707,440 and $2,077,457, respectively by IBM related to design and development
services and inventory purchases. During the three and nine months ended
September 30, 2003, the Company recorded revenues of $12,985 and $47,417,
respectively, related to sales of MA V and Atigo products to IBM. During the
same periods in 2002, the Company recorded revenues of $471,939 and $531,529,
respectively, related to sales of MAV products to IBM. Before selecting IBM as
its partner for the Engineering and Inventory Agreement, the Company reviewed
IBMs proposal to provide such services, which included discussion of the
estimated costs to be incurred, IBMs track-record of bringing new technologies
to market, IBMs reputation for quality and other customary evaluations. The
Sales and Marketing Agreement was reached with similar terms and conditions
provided to other volume resellers of the Companys products. As a result, the
Companys management believes that the Engineering and Inventory Agreement and
the Sales and Marketing Agreement contain arms-length terms and conditions.

Certain of the end-users of the Companys wearable computer products are
universities and other not-for-profit entities (collectively, the End-Users)
that purchase these products from a Value Added Reseller (the VAR) of
Xybernaut GmbH. The Company also contracts with certain of the End-Users to
provide research and development and sales and marketing services to the
Company. The research and development services provided to the Company include
activities such as hardware and software development, product testing and
evaluation. The sales and marketing services include activities such as Company
participation in and sponsorship of industry trade shows, the preparation of
competitive market analysis and the use of the End-Users as named reference
accounts. During the three and nine months ended September 30, 2003, the
Company recorded revenues of $162,558 and $577,112, respectively, related to
sales of its products to the VAR. During the three and nine months ended
September 30, 2003, the Company recorded total research and development and
sales and marketing expenses of $181,020 and $590,910, respectively, related to
services performed by the End-Users. During the three and nine months ended
September 30, 2002, the Company recorded revenues of $225,365 and $714,224,
respectively, related to sales of its products to the VAR. During the three and
nine months ended September 30, 2002, the Company recorded total research and
development and sales and marketing expenses of $633,296 and $1,030,913,
respectively, related to services performed by the End-Users. The Company
compares the cost of the projects performed by the End-Users against the cost
it would likely incur if it were to obtain these services from entities other
than the End-Users. Management also evaluates the cost if the Company performed
these services in-house, including expenses that would be incurred for salary
and benefits, training, travel, supplies and equipment, and overhead. As a
result, the Companys management believes that the agreements and contracts
underlying both the sale of the products and the performance of the services
contain arms-length terms and conditions.

ITEM 2.  MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

To keep investors informed of the Companys future plans and objectives,
this Quarterly Report on Form 10-Q and other reports and statements issued by
the Company and its officers from time to time contain certain statements
concerning the Companys future results, future performance, intentions,
objectives, plans and expectations that are, or may be deemed to be,
forward-looking statements. The Companys ability to do this has been
fostered by the Private Securities Litigation Reform Act of 1995 which provides
a safe harbor for forward-looking statements to encourage companies to
provide prospective information so long as those statements are accompanied by
meaningful cautionary statements identifying important factors that could cause
actual results to differ materially from those discussed in the statement. 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 execute
its business strategy, to profit from its products and services as expected, to
compete, to maintain superior technological capability, to foresee changes and
to continue to identify, develop and commercialize innovative and competitive
products and services, to penetrate different markets and successfully expand
its revenue, to attract and retain technologically qualified personnel,
particularly in the areas of research and development, and the Companys
ability to generate such cash flow and obtain financing to support its
operations and growth (see generally Managements Discussion and Analysis of
Financial Condition and Results of Operations and Liquidity and Capital
Resources contained therein) and other risks described in this Quarterly
Report on Form 10-Q and other filings with the SEC.

OVERVIEW

Xybernaut Corporation, a Delaware corporation (Xybernaut or the
Company), is engaged in the research, development, manufacture, marketing and
sale of mobile, wearable computing and communication systems as well as
software and service solutions designed to enhance productivity and improve
product management, asset management and the accuracy, timeliness and
utilization of captured data. The Company offers solutions with a software and
services focus through its wholly-owned subsidiary Xybernaut Solutions, Inc.
(XSI). The Company offers solutions with a hardware focus through its U.S.
operations and through its wholly-owned subsidiaries Xybernaut K.K. (Japan) and
Xybernaut GmbH (Germany).

13



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The Company was originally incorporated in 1990 and completed its initial
public offering (IPO) in July 1996. In April 2000, Xybernaut acquired XSI.
The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries: XSI (Virginia, U.S.), Xybernaut Development
Corporation (Virginia, U.S.), Xybernaut K.K. (Yokohama, Japan), and Xybernaut
GmbH (Böblingen, Germany). All significant intercompany accounts and
transactions have been eliminated in the consolidation.

Introduced in 1995, the Mobile Assistant® (MA®) series is the Companys
primary line of wearable computer hardware products, the current versions of
which are the MA V and MA TC. Introduced in 2002, the Atigo product line is a
family of mobile wireless web panels that can be used either as stand-alone
handheld personal computers (PCs) or as displays for an MA system, a laptop
or a conventional PC. The Company derives its revenues from sales of its
wearable computers, software products and consulting services. In the future,
the Company expects to obtain additional revenues from the licensing of its
intellectual property. Since their commercial introductions, the Company has
recognized revenue of approximately $24,000,000 on sales of approximately 6,500
MA and Atigo systems.

A number of trends are expected to have a significant effect on the
Companys operations in the future. In past quarters, many of the Companys
large customers deferred or delayed anticipated purchases of the Companys
products because of uncertain economic conditions and other concerns. If these
conditions and issues persist or worsen, it is possible that more potential
customers will defer, delay or cancel scheduled purchases, which would have an
adverse effect on Company operations. While the Company expects general
economic conditions to begin improving during late 2003 and early 2004, there
can be no assurance that this expectation will be realized. Additionally, to
the extent that potential customers have concerns about purchases from smaller
suppliers as a result of challenging economic conditions for small
capitalization technology companies, such concerns could have a negative impact
on the Companys revenues.

Beginning with the widespread use of the internet on desktop computers,
there has been an increasing demand for mobile computing and wireless
communications devices that can bring the desktop internet experience to mobile
users. The rapid growth of internet-enabled cell phones, PDAs, interactive
pagers and similar products result in a growing number of devices that cater to
the mobile data user and which may compete with the Companys products and
which may also present opportunities for licensing in the future.

The Company believes that sales of its wearable and mobile computers will
rely to a large extent on the availability of wireless broadband services that
can take advantage of the extensive processing power and display capabilities
of the Companys hardware products. Wireless local area networks (WLANs) are
now well established in commercial markets worldwide that provide broadband
capabilities over a limited physical range in places such as corporate offices,
warehouses, factory floors and airfields. However, wide-range wireless access
that allows a user to move freely over large geographic areas and still
maintain broadband access (commonly referred to as Third Generation or 3G)
is still only available in limited areas, including Japan and parts of Europe.
The Company predicts that 3G service will be available in large metropolitan
areas worldwide in the next few years. For example, NTT DoCoMo has announced
plans to launch 3G service in select U.S. cities in 2004. The Company believes
that while the commercial markets can still be successfully penetrated prior to
the widespread introduction of wireless broadband access, such service will be
needed prior to successful large-scale sales in the consumer markets.

RESULTS OF OPERATIONS

The following table sets forth certain consolidated financial data as a
percentage of revenues for the three and nine months ended September 30, 2003
and 2002.

14



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|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |   |  |        |       | 
|----------------------------------- | ------------------------------------------ |  | ------------------ | ----- | ----------------- |  | ------ | ----- | ---- |  | ------ | ----- | - |  | ------ | ----- | 
|                                    |                                            |  | Three months ended |       | Nine months ended
|                                    |                                            |  | September 30,      |       | September 30,    
|                                    |                                            |  |                    |       |                  
|                                    |                                            |  | 2003               |       | 2002              |  | 2003   |       | 2002
|                                    |                                            |  |                    |       |                   |  |        |       |     
|Revenue                             |                                            |  | 100.0              | %     |                   |  | 100.0  | %     |      |  | 100.0  | %     |   |  | 100.0  | %    
|Cost of sales                       |                                            |  | 73.7               |       |                   |  | 77.8   |       |      |  | 69.3   |       |   |  | 77.1   |      
|Provision for inventory and tooling |                                            |  | 55.5               |       |                   |  | 14.1   |       |      |  | 44.6   |       |   |  | 5.6    |      
|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |   |  |        |      
|                                    | Gross (loss) / income                      |  |                    | (29.2 | )                 |  |        | 8.1   |      |  |        | (14.0 | ) |  |        | 17.3  | 
|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |   |  |        |      
|Operating expenses:                 |                                            |  |                    |       |                   |  |        |       |      |  |        |       |   |  |        |      
|                                    | Sales and marketing                        |  |                    | 76.2  |                   |  |        | 147.3 |      |  |        | 85.2  |   |  |        | 171.6 | 
|                                    | General and administrative                 |  |                    | 38.6  |                   |  |        | 54.0  |      |  |        | 41.5  |   |  |        | 63.1  | 
|                                    | Research and development                   |  |                    | 26.2  |                   |  |        | 62.9  |      |  |        | 37.2  |   |  |        | 69.6  | 
|                                    | Provision for note receivable from officer |  |                    |      |                   |  |        | 39.9  |      |  |        |      |   |  |        | 13.8  | 
|                                    | Restructuring charges                      |  |                    |      |                   |  |        | 14.2  |      |  |        |      |   |  |        | 7.0   | 
|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |   |  |        |      
|Total operating expenses            |                                            |  | 140.9              |       |                   |  | 318.3  |       |      |  | 163.9  |       |   |  | 325.0  |      
|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |   |  |        |      
|Interest and other                  |                                            |  | (2.7               | )     |                   |  | 0.9    |       |      |  | (5.0   | )     |   |  | 1.7    |      
|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |   |  |        |      
|Net loss                            |                                            |  | (172.9             | %)    |                   |  | (309.3 | %)    |      |  | (182.9 | %)    |   |  | (306.0 | %)   
|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |   |  |        |      

THREE MONTHS ENDED SEPTEMBER 30, 2003 AND SEPTEMBER 30, 2002

REVENUE. The Company derives its revenue from product sales of its wearable and
mobile computers and components, product sales of software and consulting
services. Total revenue for the three months ended September 30, 2003 was
$2,703,121, an increase of $157,794, or 6%, compared to the three months ended
September 30, 2002. Sales from the Companys mobile/wearable computers
increased $68,513, or 4%, to $1,621,532 for the three months ended September
30, 2003 compared to the same period in 2002. This growth in hardware revenues
was driven primarily from the Companys U.S. operations which increased
$101,627 from the prior year. This growth was due to increased Atigo and MA V
sales of $254,278 and $102,955, respectively, partially offset by a $157,350
decrease in sales of MA TC systems and a $98,256 decrease in MA IV and poma®
systems. European hardware sales decreased 8%, or $20,336, in the third quarter
of 2003 compared with the same period in 2002, due primarily to a $95,382
increase in sales of MA V and Atigo systems and accessories offset by a
$115,718 decrease in sales of MA TC and pomasystems. Hardware revenues from
Asia, consisting primarily of MA V systems, in the third quarter of 2003
decreased by $12,778 compared with the same period in 2002. There were no
software revenue sales in either the third quarter of 2003 or 2002. Revenue
from software products generally consists of a few large transactions that
periodically occur that are unrelated to the Companys hardware products. The
Companys consulting, licensing and other revenue for the three months ended
September 30, 2003 was $1,081,589, an increase of $89,281, or 9%, from revenue
for the three months ended September 30, 2002. This increase is largely due to
a $69,517, or 7%, increase in consulting sales related to U.S. operations due
to increased activity on large consulting contracts in 2003 compared with 2002.

COST OF SALES. The Companys cost of sales includes the costs of components for
the Companys wearable and mobile computer product lines, purchased software,
direct labor and materials, amortization of tooling costs, warranty costs,
fulfillment and shipping costs, and inventory and tooling reserves. Total cost
of sales for the three months ended September 30, 2003 was $3,493,488, an
increase of $1,154,880, or 49%, compared to the three months ended September
30, 2002. This increase is primarily the result of a $1,500,000 provision for
inventory and tooling recorded in the third quarter of 2003. In comparison in
2002, management recorded a $990,773 general reserve to cover estimated
valuation issues in its various inventory components offset by a $631,556
decrease in the pomaaccrual, resulting in a net provision for the three months
ended September 30, 2002 of $359,217. Total gross margins, excluding the
provision for inventory, were 26% and 22%, for the third quarter of 2003 and
2002, respectively. Gross margins from hardware sales from the third quarter of
2003 were 20% compared to 12% for 2002. The more favorable gross margin in 2003
can be attributed to sales of the Atigo product line. The Atigo product line
continues to generate strong margins one year after its initial launch in the
third quarter of 2002 largely because the product is continually being improved
as evidenced by the Companys recent launch of its third version in the product
line. Consulting cost of sales in the third quarter of 2003 compared to the
same period in 2002 increased $80,022, or 13%. Consulting, licensing and other
gross margins were consistent at 36% and 38% for the 2003 and 2002 periods,
respectively.

SALES AND MARKETING EXPENSES. Sales and marketing expenses for the three months
ended September 30, 2003 were $2,058,762, a decrease of $1,690,861, or 45%,
compared to the corresponding period in 2002. In the U.S. operations, sales and
marketing expenses in the third quarter of 2003 relating to salaries and
benefits decreased approximately $475,000 compared to the same period in 2002
due primarily to cost saving measures. Additional cost saving measures in the
Companys European and Asian operations resulted in decreases of approximately
$473,000 in salaries and benefits, facilities and consulting in the third
quarter of 2003 compared to the third quarter of 2002. Included in sales and
marketing expenses during the third quarter of 2002 was a $729,511 non-cash,
non-recurring charge related to the cancellation of an agreement for marketing
services and certain retail space at the Waldorf Astoria for

15



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##### 



which there is no comparable charge in 2003.
An additional decrease of $155,842 related to non-cash marketing expenses for
outside services that were funded through the issuance of the Companys equity
securities; such expenses during the three months ended September 30, 2003
totaled $33,480 compared to $189,322 during the same period in 2002.

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses for
the three months ended September 30, 2003 were $1,042,434, a decrease of
$330,806, or 24%, compared to the same period in 2002. As a result of the
Companys cost saving measures, general and administrative expenses in the
third quarter of 2003 relating to salaries, benefits, travel and consulting
decreased approximately $196,000, $23,000, $22,000, and $78,000, respectively,
compared to the same period in 2002.

RESEARCH AND DEVELOPMENT EXPENSES. The Companys research
  and development expenses consist primarily of personnel costs, the purchase
  of test equipment and payments to consultants and other third-parties which
  provide research and development services for mobile and wearable computing
  technologies. Research and development expenses for the three months ended September 30,
  2003 were $708,520, a decrease of $893,755, or 56%, compared to the corresponding
  period in 2002. This decrease resulted largely from research and development
  expenses related to salaries and benefits of the Companys U.S., German
  and Asian operations which decreased by $124,000, $437,000 and $14,000, respectively,
  from the three months ended September 30, 2002 to 2003 due to cost saving
  measures. In addition, the Companys German operations experienced an approximate
  $67,000 decline in outside research services for general wearable technology.
  The Company also had a $242,000 decline in consulting, travel and other expenditures
  as a result of general cost saving measures.

PROVISION FOR NOTE RECEIVABLE FROM OFFICER. At September 30, 2002, the Company
recorded a $1,015,575 reserve to reduce the net carrying value of a promissory
note due from an executive officer of the Company. The reserve was calculated
based on the value of the shares of common stock that collateralized this note
on September 30, 2002. This reserve was reversed in the fourth quarter of 2002
upon repayment of the note by the executive officer. No comparable expense was
recorded during the nine months ended September 30, 2003.

RESTRUCTURING COSTS. Restructuring costs were $361,227 for the third quarter
of 2002. These expenses relate to the Companys cost cutting efforts
undertaken during 2002, for which no comparable qualifying expenses were
recorded during 2003. These expenses consisted of severance extended to
terminated employees and a reduction of facilities.

INTEREST AND OTHER, NET. Net interest and other expense for the three months
ended September 30, 2003 was $74,007, an increase of $98,588 compared to net
interest and other income of $24,581 for the same period in 2002.

PROVISION FOR INCOME TAXES. The provision for income taxes for the three months
ended September 30, 2003 was $149, a decrease of $2,626, compared to the income
tax provision for the three months ended September 30, 2002. These amounts
relate to the operations of the Companys foreign subsidiaries. The Companys
U.S. operations had a net loss during these periods and, therefore, no
provision for U.S. income taxes was made.

NET LOSS. As a result of the factors described above, the net loss for the
three months ended September 30, 2003 was $4,674,239, a decrease of $3,199,176
or 41%, compared to the three months ended September 30, 2002.

NINE MONTHS ENDED SEPTEMBER 30, 2003 AND SEPTEMBER 30, 2002

REVENUE. The Company derives its revenue from product sales of its wearable and
mobile computers and components, product sales of software and consulting
services. Total revenue for the nine months ended September 30, 2003 was
$7,278,679, a decrease of $90,032, or 1%, compared to the nine months ended
September 30, 2002. Sales from the Companys mobile/wearable computers
decreased $249,598, or 6%, to $4,222,036 for the nine months ended September
30, 2003 compared to the same period in 2002. Hardware revenues from U.S.
operations increased by $141,677, or 4%, in the first nine months of 2003
compared with the same period in 2002. Atigo sales from U.S. operations
increased $1,570,595 in the nine months ended September 30, 2003 compared to
the same period in 2002. These increases are offset by a decline of $684,871
related to sales of MA V and a decline of $380,311 related to sales of MA IV
and pomasystems in 2003 compared to 2002. In addition, the revenues for the
first nine months of 2002 include $363,736 of revenues related to the bulk sale
of components for the MA V system for which there was no corresponding revenues
in 2003. There was also a $275,201, or 30%, decrease in European hardware sales
in the nine months ended September 30, 2003 compared with the same period in
2002, due primarily to a decrease of $414,547 in sales of MA systems, which is
offset by an increase in Atigo systems sales of $139,346. Hardware revenues
from Asia, consisting primarily of MA V systems, decreased by $116,074, or 36%,
in the first nine months of 2003 compared with the same period in 2002. There
were no software revenue sales in 2003 or 2002. Revenue from software products
generally consists of a few large transactions that periodically occur that are
unrelated to the Companys hardware products. The Companys consulting,
licensing and other revenue for the nine months ended September 30, 2003 was
$3,056,643, an increase of $159,566, or 6%, from revenue for the nine months
ended September 30, 2002.

COST OF SALES. The Companys cost of sales includes the costs of components for
the Companys wearable and mobile computer product lines, purchased software,
direct labor and materials, amortization of tooling costs, warranty costs,
fulfillment and shipping costs, and inventory and tooling reserves. Total cost
of sales for the nine months ended September 30, 2003 was $8,294,954, an increase
of $2,202,598 or 36%, compared to the nine months ended September 30, 2002. This
increase resulted from the $3,249,354 provision for

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inventory and tooling related primarily to
the MA V product line recorded in the first and third quarters of 2003 compared
to a $413,175 provision for inventory and tooling recorded in 2002. Total gross
margins, excluding the provision for inventory, were 31% and 23%, for the first
three quarters of 2003 and 2002, respectively. The cost of sales related to the
Companys hardware products decreased by $714,940, or 19%, for the nine months
ended September 30, 2003 compared to the same period in 2002. This decrease in
hardware product cost of sales is more than the 6% decrease in hardware product
sales. Gross margins from hardware sales for the first nine months of 2003 were
26% compared to 14% for 2002. The more favorable gross margin in 2003 can be
attributed to sales of the Atigo product line. The Atigo product line continues
to generate strong margins one year after its initial launch in the third
quarter of 2002 largely because the product is continually being improved as
evidenced by the Companys recent launch of its third version in the product
line. Also, the 2002 margin was adversely effected by the $363,736 sale of
components for the MA V system in the first quarter of 2002 which had less than
a 1% margin because the components were deemed obsolete in 2001 and were
written down to their estimated net realizable value. Consulting, licensing and
other gross margins were consistent at 37% for both the 2003 and 2002 periods,
respectively.

SALES AND MARKETING EXPENSES. Sales and marketing expenses for the nine months
ended September 30, 2003 were $6,199,691, a decrease of $6,442,125, or 51%,
compared to the corresponding period in 2002. Sales and marketing expenses in
the U.S. in the first nine months of 2003 relating to salaries and benefits,
consulting, conferences, promotional items and travel expenses decreased
approximately $1,838,000, $171,000, $826,000, $120,000 and $165,000,
respectively, compared to the same period in 2002. This was primarily the
result of cost saving measures that started in the second quarter of 2002. The
reduction in conference expenses also occurred due to the fact that the
Companys International Conference on Wearable Computing (ICWC) was held at
Chicago Comdex during 2002; a similar event did not occur during the 2003
period. Additional cost savings measures in the Companys European and Asian
operations resulted in decreases of approximately $1,339,000 in salaries and
benefits, facilities and consulting in the first nine months of 2003 compared
to the first nine months of 2002. Included in sales and marketing expenses
during the third quarter of 2002 was a $729,511 non-cash, non-recurring charge
related to the cancellation of an agreement for marketing services and certain
retail space at the Waldorf Astoria for which there is no comparable charge in
2003. Another decrease of $488,209 was related to non-cash marketing expenses
for outside services funded through the issuance of the Companys equity
securities for the nine months ended September 30, 2003 of $102,656 compared to
$590,865 during the same period in 2002.

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative
  expenses for the nine months ended September 30, 2003 were $3,022,809,
  a decrease of $1,626,893, or 35%, compared to the same period in 2002. As a
  result of the cost saving measures, general and administrative expenses in 2003
  relating to salaries, benefits, travel, insurance and consulting decreased approximately
  $564,000, $109,000, $62,000, $66,000 and $313,000, respectively, compared to
  the same period in 2002. An additional decrease of $341,934 related to non-cash
  general and administrative expenses for outside services that were funded through
  the issuance of the Companys equity securities; such expenses during
  the nine months ended September 30, 2003 totaled $115,657 compared to $457,591
  during the same period in 2002.

RESEARCH AND DEVELOPMENT EXPENSES. The Companys research and development
expenses consist primarily of personnel costs, the purchase of test equipment
and payments to consultants and other third-parties which provide research and
development services for general mobile and wearable computing technologies.
Research and development expenses for the nine months ended September 30, 2003
were $2,708,848, a decrease of $2,417,565, or 47%, compared to the
corresponding period in 2002. This decrease resulted largely from research and
development expenses related to salaries and benefits and consulting expenses
of the Companys U.S., German and Asian operations which decreased by $415,000,
$997,000 and $89,000, respectively, from the nine months ended September 30,
2002 to 2003 due to cost saving measures. In addition, German operations
experienced an approximate $271,000 decline in outside research services for
general wearable technology. There was an additional decrease resulting from an
approximate $199,000 decline in expenditures to third parties and consultants
for design and development of the Companys mobile/wearable product lines.
Expenditures during the 2002 period related to the Atigo product line.

PROVISION FOR NOTE RECEIVABLE FROM OFFICER. At September 30, 2002, the Company
recorded a $1,015,575 reserve to reduce the net carrying value of a promissory
note due from an executive officer of the Company. The reserve was calculated
based on the value of the shares of common stock that collateralized this note
on September 30, 2002. This reserve was reversed in the fourth quarter of 2002
upon repayment of the note by the executive officer. No comparable expense was
recorded during the nine months ended September 30, 2003.

RESTRUCTURING COSTS. Restructuring costs were $516,461 for the nine months
ended September 30, 2002. These expenses relate to the Companys cost cutting
efforts undertaken during 2002, for which no comparable qualifying expenses
were recorded during 2003. These expenses consisted of severance extended to
terminated employees and a reduction of facilities.

INTEREST AND OTHER, NET. Net interest and other expense for the nine months
ended September 30, 2003 was $361,552, a decrease of $497,338, compared to net
interest and other income of $135,786 for the same period in 2002. Included in
the 2003 net interest and other expense balance is $393,594 in non-cash
amortization of a note discount.

PROVISION FOR INCOME TAXES. The provision for income taxes for the nine months
ended September 30, 2003 was $408, a decrease of $6,972, compared to the income
tax provision for the nine months ended September 30, 2002. These amounts
relate to the operations of the Companys foreign subsidiaries. The Companys
U.S. operations had a net loss during these periods and, therefore, no
provision for U.S. income taxes was made.

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NET LOSS. As a result of the factors described above, the net loss for the nine
months ended September 30, 2003 was $13,309,583, a decrease of $9,235,623 or
41%, compared to the nine months ended September 30, 2002.

OTHER OPERATING ACTIVITIES

For the nine months ended September 30, 2003, the Companys operating
activities used cash of $10,827,144 as a result of its net loss of $13,309,583
and net working capital requirements of $2,544,495, offset by non-cash expenses
of $5,026,934. The Companys investing activities used cash of $863,279. These
activities were funded through the Companys financing activities which
provided cash of $22,689,854 through the private placement of common stock,
exercise of warrants and borrowings. As a result, the Companys cash balance
increased to $13,063,053 at September 30, 2003 from $1,967,710 at December 31,
2002.

For the nine months ended September 30, 2002, the Companys operating
activities used cash of $17,280,927 as a result of its net loss of $22,545,206
as offset by a net working capital increase of $451,075 and non-cash expenses
of $4,813,204. The Companys investing activities used cash of $1,116,581.These
activities were funded through the Companys financing activities which
provided cash of $16,133,885, principally through the private placement of
common stock, exercise of warrants and borrowings. As a result, the Companys
cash balance decreased to $627,139 at September 30, 2002 from $3,172,609 at
December 31, 2001.

For hardware product sales, the Company generally provides standard
warranties of one-year on parts and six-months on labor. The Company also
offers additional extended warranties. The Companys suppliers for the
significant components of the MA and Atigo products generally provide the
Company with similar warranties. A provision for estimated future warranty
costs is recorded at the time of shipment as a component of cost of sales. The
provision represents an estimate of costs to be incurred above and beyond the
warranties offered to the Company by its suppliers. In the event that the
Company is not able to obtain from its suppliers the necessary products or
services to meet its warranty obligations, the Company may incur warranty
expenses in the future that are significantly greater than those incurred in
the past.

The Companys consolidated financial statements contain a provision for
income tax expense related to its operations outside the United States. Subject
to realization, the Company has generated net operating losses in the U.S. 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. At December 31, 2002, the Company had
approximately $116,312,000 and $6,560,000 of net operating loss carry forwards
for U.S. federal and foreign income tax purposes, respectively. The U.S. losses
will begin to expire in 2010 and the losses from foreign operations do not
expire. The use of the U.S. carryforwards may be limited in any one year under
Internal Revenue Code Section 382 if significant ownership changes occur.

The Company is involved in routine legal and administrative proceedings
and claims of various types. While any such proceeding or claim contains an
element of uncertainty, management does not expect that they will have a
material adverse effect on the Companys results of operations or financial
position.

RELATED PARTY TRANSACTION

Between November 2000 and February 2001, the Company loaned a net balance
of $940,188 to the Companys former President and current Chief Executive
Officer and Chairman of the Board of Directors. The proceeds were used to
prevent a forced sale of a portion of this officers personal common stock
holdings of the Company that secured a personal margin loan from an investment
bank. The loan was made pursuant to a promissory note that was secured by
shares of the officers personal common stock holdings of the Company and
accrued interest at 8% per year. On December 31, 2001, the Companys Board of
Directors increased the number of shares securing the loan from 200,000 shares
to 250,000 shares, extended the maturity date from December 31, 2001 to
December 31, 2002 and reduced the interest rate to 6%, reflective of a general
decline in interest rates over this period. On December 17, 2002, the
$1,086,891 in outstanding principal and interest was repaid in full through the
i) transfer by the officer to the Company of 1,108,343 shares of the Companys
common stock personally held by the officer, which amount includes the shares
that were pledged as collateral, which were valued at $681,631, and ii)
cancellation of all of the officers 742,049 options to purchase shares of the
Companys common stock that had been granted prior to the date of repayment,
which were valued at $405,260. Effective December 31, 2002, the Company
cancelled the 1,108,343 shares of common stock transferred through this
repayment. To determine the fair market value of the transfer of shares of
stock and the cancellation of stock options, the Company used the market price
of the Companys common stock on the date of repayment and the Black-Scholes
option-pricing model, respectively. The variables used in the Black-Scholes
option-pricing model were as follows: i) the risk free rate was 3.03%, which
was the yield of 5-year Treasury Notes issued November 15, 2002, and ii) the
standard deviation of stock return was 131.25%, which was the volatility of the
Companys stock calculated using the end of the month stock price for the
period from January 1, 2000 through December 31, 2002. The outstanding
principal and interest owed by the officer to the Company under this promissory
note totaled $0 at both September 30, 2003 and December 31, 2002.

LIQUIDITY AND CAPITAL RESOURCES

From its inception until the completion of its initial public offering
(IPO), the Company financed its operations through the private sale of its
equity securities, vendor credit, and short-term loans received from
management, stockholders and others. During and

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subsequent to the IPO, the
Company has financed its operations from public and private sales of its common
and preferred stock, borrowings from financial institutions, management and
investors, proceeds from the exercise of warrants and stock options, and sales
of its products and services. The Companys financing and borrowing activities
for the twelve months ended December 31, 2002 and the nine months ended
September 30, 2003 are provided below.

Common Stock

During March 2002, the Company received gross proceeds of $9,000,000
through a private placement of 5,625,000 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 1,406,250 shares of common stock at an
exercise price of $3.00 per share. In connection with this placement, the
Company paid $270,000 in cash to financial advisors.

During June 2002, the Company received gross proceeds of $4,000,000
through a private placement of 6,666,666 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 1,666,666 shares of common stock at an
exercise price of $1.50 per share. In connection with this placement, the
Company issued 740,740 shares of its common stock to financial and business
development advisors.

During August 2002, the Company received gross proceeds of $2,000,000
through a private placement of 5,714,286 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 5,714,286 shares of common stock at an
exercise price of $0.70 per share and callable warrants to purchase 5,714,286
shares of common stock at an exercise price of $1.50 per share. A portion of
the proceeds from this private placement was used to repay a $250,000 note
payable.

During November 2002, the Company received gross proceeds of $4,100,000
through a private placement of 17,083,332 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors callable warrants to purchase 8,541,668 shares of common stock at an
exercise price of $1.25 per share.

During February 2003, the Company received gross proceeds of $2,000,000
through a private placement of 6,666,667 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor callable warrants to purchase 3,333,333 shares of common stock at an
exercise price of $1.25 per share.

During May 2003, the Company received gross proceeds of $3,000,000 through
a private placement of 9,375,000 shares of its common stock to certain
investors. In connection with this private placement, the Company issued to the
investors three-year callable warrants to purchase 3,281,250 shares of common
stock. These warrants have an exercise price of $0.45 if exercised in the first
year, $0.90 if exercised in the second year and $1.35 if exercised in the third
and final year.

During June 2003, the Company received gross proceeds of $2,000,000
through a private placement of 5,405,405 shares of its common stock to an
investor. In connection with this private placement, the Company issued to the
investor three-year callable warrants to purchase 4,054,054 shares of common
stock. These warrants have an exercise price of $0.75 if exercised in the first
year, $1.50 if exercised in the second year and $2.25 if exercised in the third
and final year.

During September 2003, the Company received gross proceeds of $5,000,000
through a private placement of 6,849,315 shares of its common stock to an
investor. The shares were sold at $0.73 per share, representing an approximate
20% discount to the closing price of its common stock on the date of the
agreement. In connection with this private placement, the Company issued to
the investor three-year callable warrants to purchase 3,424,658 shares of
common stock. These warrants have an exercise price of $0.91 if exercised in
the first year, $1.82 if exercised in the second year and $2.73 if exercised in
the third and final year.

During September 2003, the Company received gross proceeds of $2,000,000
through a private placement of 1,600,000 shares of its common stock to an
investor. The shares were sold at $1.25 per share, representing an approximate
18% discount to the closing price of its common stock on the date of the
agreement. In connection with this private placement, the Company issued to
the investor three-year callable warrants to purchase 800,000 shares of common
stock. These warrants have an exercise price of $1.25 if exercised in the first
year, $2.50 if exercised in the second year and $3.75 if exercised in the third
and final year.

The Company issues warrants to purchase shares of its common stock,
primarily in connection with the Companys financings and borrowings.
Exclusive of the exercises made in connection with the note repayment discussed
in Borrowings below, the Company received net proceeds of $6,295,343 and
$3,146,183 through the issuance of 19,597,769 and 17,350,627 shares of its
common stock during the nine months ended September 30, 2003 and twelve months
ended December 31, 2002, respectively. Concurrently with their exercise,
during the nine months ended September 30, 2003, the exercise price of
16,316,852 of the warrants was reduced from a weighted average of $1.13 per
share to $0.31 per share. Concurrently with their exercise, during the twelve
months ended December 31, 2002, the exercise price of 17,350,627 of the
warrants was reduced from a weighted average of $1.61 per share to $0.18 per
share. At September 30, 2003, the Company had warrants outstanding to purchase 8,367,397
shares of its common stock at prices that range from $0.50 to $5.00 per share,
with a weighted average of $2.25 per share.

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Borrowings

During June 2002, the Company received $250,000 in cash from an investor
that was recorded by the Company as a note payable. This note bore interest at
6.0% per annum and was due on or before June 30, 2003. This note was repaid in
August 2002 from the proceeds of a private placement.

On March 26, 2003, the Company borrowed $1,750,000 from a lender pursuant
to a one-year promissory note that bore interest at 3.5% per annum. In
connection with this borrowing, the Company issued to the lender warrants to
purchase 1,750,000 shares of common stock at an exercise price of $1.25 per
share and warrants to purchase 2,000,000 shares of common stock at an exercise
price of $0.43 per share. Based on the relative fair values of the securities
issued, these warrants were assigned a value of $393,594, which amount was
recorded as a note discount to be amortized into interest expense over the life
of the note. On May 30, 2003, the Company repaid $860,000 in principal when the
lender elected to exercise the 2,000,000 warrants at $0.43 per share.
Subsequent to this partial repayment, the lender provided the Company with a
10% discount on the remaining unpaid principal to induce the Company to repay
the remaining principal prior to its original maturity date. The remaining
principal and interest was repaid on May 30, 2003 through the: i) $89,000
discount, which was applied against the Companys Additional Paid-In Capital,
ii) application of the $560,000 aggregate exercise price related to the
exercise of the warrants to purchase 1,750,000 shares of common stock at $0.32
per share, a reduction from the original $1.25 per share exercise price, iii)
issuance of 651,351 shares of common stock valued at $241,000, or $0.37 per
share, and iv) issuance of 30,350 shares of common stock valued at $11,229, or
$0.37 per share, as repayment of accrued interest. During the nine months ended
September 30, 2003, the Company fully amortized the $393,594 note discount into
interest expense. The Company had no outstanding principal or interest related
to this note at either September 30, 2003 or December 31, 2002.

Commitments

Inventory.At September 30, 2003, the Company had commitments to purchase
inventory, tooling and/or engineering and other services from its suppliers and
manufacturers related to its current and future hardware product lines. The
Company expects that it will enter into similar commitments in the future as it
designs, develops and procures future mobile and wearable computer product
lines.

Under its original agreements with IBM, the Company was obligated to
purchase certain components of the MA V system, including 24,000 computing
units, as well as various numbers of flat panel displays and other accessories.
The total cost to the Company of these purchases would have been over
approximately $40,000,000. Under the original agreements, the Company had the
right to cancel this purchase commitment by paying a cancellation fee in an
amount of approximately $4,000,000. In March 2003, the Company entered into an
agreement with IBM under which the Company was released of its obligation to
pay the penalty or procure this inventory other than $4,910,000 in MA V
computing units, FPDs, peripherals and component parts. The final pricing
provided to the Company represents a discount from the original contractual
prices. Under the March 2003 agreement, IBM agreed to ship inventory monthly
from March 2003 through December 2003 and the Company agreed to remit payments
monthly from March 2003 through January 2004. IBM Global Finance provided a
credit facility to the Company which provides credit to the Company for
purchases of inventory under the March 2003 agreement. In connection with this
credit facility, IBM Global Finance was granted a security interest in certain
of the Companys assets and the Company obtained a letter of credit from a
third party lender for the benefit of IBM Global Finance in the amount of
$375,000, for which the Company posted an equal amount of restricted cash. This
security interest does not include patents and intellectual property.

In addition to the above obligation to IBM related to the MA V, the
Company has commitments from time to time to purchase computing units, flat
panel and head mounted displays, miscellaneous computing components as well as
engineering and other services from its various vendors related to the MA V,
Atigo, MA TC and future product lines. The Company believes that, if needed,
the timing and amount of many of these shipments, services and payments may be
adjusted through the payment of cancellation fees, contract negotiations or the
satisfaction of obligations through the issuance of the Companys equity
securities. However, there can be no assurance that the Company can or will
successfully modify these contracts or commitments.

Excluding the potential impact of contract modifications, the Company
estimates that it will make total payments of approximately $2,500,000 during
the period from October 2003 through January 2004 related to inventory
commitments as of September 30, 2003, which amount includes the commitment to
purchase the additional MA V products from IBM discussed above. The Company may
enter into similar inventory and engineering commitments in the future as it
designs, develops and procures future mobile and wearable computer product
lines.

Operating Leases and Other.The Company leases operating facilities and
equipment under operating leases expiring on various dates through 2005. Future
minimum payments under noncancelable operating leases as of September 30, 2003
are:

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|                                 |  |   |           | 
|-------------------------------- |  | - | --------- | 
|For the Year Ending December 31,
|                                
|2003                             |  | $ | 165,904   | 
|2004                             |  |   | 621,132   | 
|2005                             |  |   | 262,959   | 
|2006                             |  |   |          | 
|2007                             |  |   |          | 
|                                 |  |   |           | 
|                                 |  | $ | 1,049,995 | 
|                                 |  |   |           | 

Other Liquidity and Capital Resources Disclosures

At September 30, 2003, the Company had accounts receivable, net of
allowances and unbilled accounts receivable, of $2,153,549, a decrease of
$127,116, or 6%, from the December 31, 2002 balance of $2,280,665. Since total
revenues for the three months ended December 31, 2002 of $2,604,850 were
generally in line with total revenues for the three months ended September 30,
2003 of $2,703,121, it is expected that the net accounts receivable balances
would be generally consistent. The Companys total accounts receivable
balances at September 30, 2003 and December 31, 2002 include $45,697 and
$1,130,206, respectively, of unbilled accounts receivable representing amounts
earned and recorded under the percentage of completion method of accounting on
a long-term contract of XSI. This balance decreased significantly as the
Company reached certain contractual milestones during 2003 and billed the
customer for such services. Management does not believe the change in accounts
receivable was caused by qualitative factors related to the Companys business
such as changes in credit terms, slower paying customers or the impact of
changes in the economic environment.

At September 30, 2003, the Company had gross inventory of $5,385,052, an
increase of $2,991,587 from the December 31, 2002 balance of $2,393,465. This
increase was primarily due to the receipt of MA V inventory from IBM under the
March 2003 agreement discussed in the Commitments section above.

The deferred revenue balances at September 30, 2003 and December 31, 2002
result primarily from billings to customers that were in excess of revenue
recognized on service contracts and hardware warranties. It is expected that
such deferred revenue will be recognized as revenue as the revenue recognition
criteria are met.

The Company has recorded net losses since its inception, including during
the periods presented in this Form 10-Q. These losses are primarily
attributable to the operating expenses incurred by the Company to design,
develop, market and sell its mobile and wearable computer products and to
provide general and administrative support for these operating activities.
During these periods, the Companys revenues and gross margins have not been
sufficient to fund these operating activities. As a result, the Company has
consistently recorded negative cash flows from operating activities and net
losses and had an accumulated deficit of $144,332,742 at September 30, 2003.
The combination of the Companys operating losses and its working capital
requirements has severely impacted the Companys financial position and
liquidity. During 2003 and 2002, the Company has funded its operating and
investing activities through its financing activities, which consist primarily
of private placements of common stock, warrant and stock option exercises and
borrowings.

The Companys management has taken steps that it believes are necessary to
improve the Companys operations and raise additional capital, both of which
are needed to enhance its ability to meet its cash flow needs through December
31, 2003 and thereafter. Beginning in April 2002, management has performed
reviews of the Companys operations and implemented various cost cutting
programs to significantly reduce the Companys operating expenses.

Assuming there are no significant changes to the Companys business plan,
management expects to maintain savings of over 50% from annualized fourth
quarter 2001 levels. Beginning in the fourth quarter of 2002 and continuing
through the first three quarters of 2003, management met its current target to
reach a quarterly net operating expense level of between approximately
$4,000,000 and $4,500,000. Through the third quarter of 2003, the Company had
reduced its net operating expenses for seven consecutive quarters, resulting in
a 62% decline from fourth quarter 2001 levels.

The term net operating expense represents a non-GAAP financial measure
within the meaning of Securities and Exchange Commission (SEC) regulations.
The Companys management uses net operating expenses in reviewing the results
of its operations as well as in analyzing the impact of the various cost-saving
initiatives it has implemented or plans to implement in the future. When used
herein, net-operating expenses represent total operating expenses as reported
on the Companys consolidated statements of operations (as reported in
accordance with U.S. GAAP) as adjusted for restructuring charges (as reported
in accordance with U.S. GAAP) as well as certain other non-recurring
transactions (that do not meet the criteria for recordation as restructuring
charges). Management believes that by reviewing net operating expenses it is
better able to focus on the Companys recurring operations than it would be if
it reviewed total operating expenses, which include charges such as severance
payments to terminated employees, charges related to reductions in facilities
and other large charges related to non-recurring activities. The net operating
expenses discussed or presented in the Companys press releases, SEC filings,
conference calls or other public disclosures reconcile to the total operating
expenses included on the Companys consolidated statements of operations as
follows:

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|                                                            |  |                |            |               |  |                |           |               |  |   |           |   |  |   |            |  
|----------------------------------------------------------- |  | -------------- | ---------- | ------------- |  | -------------- | --------- | ------------- |  | - | --------- | - |  | - | ---------- | -
|                                                            |  | Fourth quarter |            | First quarter |  | Second quarter |           | Third quarter
|                                                            |  | of 2001        |            | of 2002       |  | of 2002        |           | of 2002      
|                                                            |  |                |            |               |  |                |           |              
|Total operating expenses                                    |  | $              | 10,114,109 |               |  | $              | 8,745,553 |               |  | $ | 7,102,474 |   |  | $ | 8,101,940  |  
|Restructuring charges                                       |  |                |           |               |  |                |          |               |  |   | (155,234  | ) |  |   | (361,227   | )
|Charges for cancellation of a
marketing and lease agreement |  |                |           |               |  |                |          |               |  |   |          |   |  |   | (729,511   | )
|(Reserve), and subsequent reversal,
of note receivable      |  |                |           |               |  |                |          |               |  |   |          |   |  |   | (1,015,575 | )
|                                                            |  |                |            |               |  |                |           |               |  |   |           |   |  |   |            |  
|Net operating expenses                                      |  | $              | 10,114,109 |               |  | $              | 8,745,553 |               |  | $ | 6,947,240 |   |  | $ | 5,995,627  |  
|                                                            |  |                |            |               |  |                |           |               |  |   |           |   |  |   |            |  

|                                                            |  |                |           |               |  |                |           |               |  |   |           |  |  |   |           | 
|----------------------------------------------------------- |  | -------------- | --------- | ------------- |  | -------------- | --------- | ------------- |  | - | --------- |  |  | - | --------- | 
|                                                            |  | Fourth quarter |           | First quarter |  | Second quarter |           | Third quarter
|                                                            |  | of 2002        |           | of 2003       |  | of 2003        |           | of 2003      
|                                                            |  |                |           |               |  |                |           |              
|Total operating expenses                                    |  | $              | 4,092,317 |               |  | $              | 4,184,179 |               |  | $ | 3,937,453 |  |  | $ | 3,809,716 | 
|Restructuring charges                                       |  |                | (521,699  | )             |  |                |          |               |  |   |          |  |  |   |          | 
|Charges for cancellation of a
marketing and lease agreement |  |                | (127,500  | )             |  |                |          |               |  |   |          |  |  |   |          | 
|(Reserve), and subsequent reversal,
of note receivable      |  |                | 1,015,575 |               |  |                |          |               |  |   |          |  |  |   |          | 
|                                                            |  |                |           |               |  |                |           |               |  |   |           |  |  |   |           | 
|Net operating expenses                                      |  | $              | 4,458,693 |               |  | $              | 4,184,179 |               |  | $ | 3,937,453 |  |  | $ | 3,809,716 | 
|                                                            |  |                |           |               |  |                |           |               |  |   |           |  |  |   |           | 

Management believes that the Companys current staffing and resources will
be sufficient to carry out its business plan for the foreseeable future. In
addition to the cost cutting initiatives already undertaken, management
continues to review all aspects of the Companys operations and may take
additional actions to reduce operating expenses further. Future significant
fluctuations may still occur as a result of non-recurring charges associated
with cost-saving initiatives as well as the Companys research and development
activities, which will vary depending on the Companys wearable and mobile
computer product development cycle during any given period.

Based on historical results and the forecasted levels discussed above,
management expects that the Company will incur operating expenses of between
approximately $16,000,000 and $16,500,000 during 2003. However, there can be no
assurances that actual operating expenses during 2003 or later periods will not
be significantly higher. The Company will also be required to fund inventory
procurement and other expenditures. Management expects to fund these activities
through cash on hand, gross profits and outside financings. Potential sources
of additional financing include private equity offerings, warrant exercises,
strategic investments and various forms of debt financing. In certain
instances, concurrently with the exercise of warrants, the exercise prices were
reduced. Such reduction has resulted in the issuance of substantially more
shares of common stock than would have occurred had the exercise price of the
warrants not been reduced. The Company may reduce the exercise price of
additional warrants in the future. If additional funds are raised through the
issuance of equity securities, the percentage of ownership of current
stockholders of the Company will be reduced and if additional funds are raised
at current prices for the Companys stock, such dilution could be significant.
If additional funds are raised through borrowings, the Company will be subject
to interest charges and principal repayments, will likely be required to comply
with financial covenants or other restrictions, and will likely have to
collateralize such borrowings with its assets, which could be taken by the
lender in the event of default.

During the nine months ended September 30, 2003, the Company raised
approximately $23,000,000 through sales of its common stock to institutional
investors, through warrant and stock option exercises and through borrowings.
Based on the Companys $13,063,053 cash balance at September 30, 2003 and
forecasted operations, management does not believe that the Company will be
required to raise additional capital during the remainder of 2003 and for a
substantial portion of 2004. In recent quarters, the equity markets, especially
for small capitalization technology stocks, have remained depressed, and the
U.S. and world economies have generally been in a decline or recession. If a
sustained decline in the general equity markets, the price of the Companys
common stock, or the U.S. or world economy were to occur, the Company could
face difficulties in its ability to raise additional capital. Additionally, the
Company has historically made several private placements of its common stock
per year, primarily to a limited number of institutional investors who
specialize in making similar types of investments. If these institutional
investors were to choose to not participate in future private placements, the
Company could face difficulties in its ability to raise additional capital.

Certain of the Companys liabilities are past their stated terms of
payment, including those owed to vendors that provide services and inventory
which are required by the Company to execute its business plan. The Company
generally believes that it has a reasonably good relationship with most of its
vendors and creditors. However, certain of its vendors have filed legal actions
to recover overdue accounts payables and ceased providing services and products
to the Company. Management does not believe that these actions will have a
material adverse effect on the Company, but there can be no assurance that
other vendors will not pursue similar actions.

The Companys management believes that the combination of cash on hand,
cash flows from operations and outside funding will

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provide sufficient liquidity to meet the Companys ongoing cash requirements.
This is based both on the Companys historical ability to raise capital and on
debt and equity financings currently available to the Company. However, there can
be no assurance that the Company can or will obtain sufficient funds from operations
or from additional financings on terms acceptable to the Company.

If the Company is unable to obtain sufficient additional financing, it
will be required to reduce spending in order to maintain its operations at a
reduced level. Management believes that it will be able to reduce spending if
required. However, such reduction would negatively impact progress on
implementing the Companys business plan, and may require substantial
reductions in the purchase commitments disclosed herein.

Contractual Obligations and Commercial Commitments

The Companys significant contractual obligations as of September 30, 2003
are for lease payments related to a reduction in facilities classified as
restructuring in 2002, operating leases (primarily for office space) and
inventory commitments.

|                        |  |       |           |      |  |                         |           |      |  |      |           |      |  |   |         |  |  |   |   |  |  |   |   | 
|----------------------- |  | ----- | --------- | ---- |  | ----------------------- | --------- | ---- |  | ---- | --------- | ---- |  | - | ------- |  |  | - | - |  |  | - | - | 
|                        |  |       |           |      |  | Payments Due by Periods
|                        |  |       |           |      |  |                        
|                        |  | Total |           | 2003 |  | 2004                    |           | 2005 |  | 2006 |           | 2007
|                        |  |      
|Restructuring Liability |  | $     | 137,098   |      |  | $                       | 17,803    |      |  | $    | 62,330    |      |  | $ | 56,965  |  |  | $ |  |  |  | $ |  | 
|Operating Lease         |  |       | 1,049,996 |      |  |                         | 165,904   |      |  |      | 621,132   |      |  |   | 262,959 |  |  |   |  |  |  |   |  | 
|Capital Lease           |  |       | 784       |      |  |                         | 784       |      |  |      |          |      |  |   |        |  |  |   |  |  |  |   |  | 
|Inventory Commitments   |  |       | 2,500,000 |      |  |                         | 2,000,000 |      |  |      | 500,000   |      |  |   |        |  |  |   |  |  |  |   |  | 
|                        |  |      
|                        |  | $     | 3,687,878 |      |  | $                       | 2,184,491 |      |  | $    | 1,183,462 |      |  | $ | 319,924 |  |  | $ |  |  |  | $ |  | 
|                        |  |      

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is exposed to market risk related to changes in foreign currency
exchange rates and changes in interest rates. The Company does not hold
investments or use derivative financial instruments for speculative or trading
purposes. All of the potential changes noted below are based on sensitivity
analyses performed on the Companys financial position at September 30, 2003.
Actual results may differ materially.

FOREIGN CURRENCY EXCHANGE RISK

The majority of the Companys revenue, expense, and capital purchasing
activities are transacted in U.S. dollars. However, as a result of the
Companys international manufacturing, research and development, sales and
marketing, inventory procurement and other activities, the Company enters into
transactions denominated in other currencies, primarily the Japanese Yen and
the European Euro, or in which the U.S. Dollar equivalent is determined by the
values of such currencies. Prior to the adoption of the Euro, the Company also
regularly entered into transactions denominated in the German Deutsche Mark. As
of January 1, 2001, Xybernaut GmbH converted its functional currency from the
Deutsche Mark to the Euro. The effect of this conversion was an increase of
$151,123 on beginning accumulated deficit, which is included in the foreign
currency translation balance. Historically, the Company has not realized
significant gains or losses in transactions denominated in, or determined by,
foreign currencies. To date, the Company has not entered into foreign exchange
forward or option contracts to hedge its exposure to future movements in
foreign exchange rates because the Companys management believes that the
potential impact of these movements does not justify the costs of entering into
such contracts or the use of capital to collateralize these contracts. In the
future, the Company may enter into foreign exchange forward and option
contracts to hedge transactions denominated in a foreign currency if management
determines that the levels of international sales or operations justify the use
of such contracts. For the three and nine months ended September 30, 2003, the
Companys operations in Europe comprised 10.7% and 11.0% of its total revenue
and 9.2% and 8.0% of its net loss, respectively, compared to 10.7% and 13.4% of
its total revenue and 22.1% and 16.0% of its net loss, respectively, in the
same periods for 2002. For the three and nine months ended September 30, 2003,
the Companys operations in Asia comprised 1.6% and 2.9% of its total revenue
and 1.7% and 0.8% of its net loss, respectively, compared to 1.9% and 4.4% of
its total revenue and 1.1% and 1.4% of its net loss, respectively, in the same
periods for 2002. At September 30, 2003, the Companys assets in Europe and
Asia comprised 4.6% and 1.8% of its total assets, respectively, compared to
17.1% and 3.4% of its total assets at September 30, 2002, respectively.
According to published sources, the average fluctuation of the European Euro
during the three and nine months ended September 30, 2003 was -1.6% and 5.5%,
respectively, compared to -0.4% and 3.7% for the same period in 2002,
respectively. According to published sources, the average fluctuation of the
Japanese Yen during the three and nine months ended September 30, 2003 was 1.8%
and 0.3%, respectively, compared to 0.5% and 3.7% for the same periods in 2002,
respectively. Management believes that these fluctuations did not have a
material impact on the Companys results of operations or financial position
for 2003 and 2002.

INTEREST RATE SENSITIVITY

From time to time, the Company is party to certain debt and credit
instruments and continues to explore various financing alternatives,
including debt financings. If additional funds are raised through borrowings,
the Company will be subject to additional interest charges.

23



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##### 



Interest rate increases may materially increase the Companys interest expense, hinder the
Companys ability to borrow additional funds or have a negative effect on the
ability of the Companys customers to purchase its products. To date, the
Company has not entered into interest rate forward or option contracts to hedge
its exposure to future movements in interest rates because the Companys
management believes that the potential impact of these movements does not
justify the costs of entering into such contracts or the use of capital to
collateralize these contracts. If the Companys exposure to interest rate
fluctuations becomes more significant, it may enter into interest rate forward
and option contracts to hedge against such fluctuations. According to published
sources, the average prime interest rate during the first three quarters of
fiscal year 2003 was 4.17%, compared to a 4.75% average prime interest rate
during the same periods in 2002, respectively. For 2003 and 2002, the prime
interest rate fluctuation from January 1 to September 30 of each year was
-0.25% and 0%, respectively. Management believes that these fluctuations did
not have a material impact on the Companys results of operations or financial
position for 2003 and 2002.

ITEM 4. CONTROLS AND PROCEDURES

As of the last day of the period covered by this report, the Company
carried out an evaluation, under the supervision and with the participation of
the Companys management, including the Companys Chief Executive Officer,
Chief Financial Officer and President, of the effectiveness of the design and
operation of the Companys disclosure controls and procedures pursuant to
Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive
Officer, Chief Financial Officer and President concluded that the Companys
disclosure controls and procedures are effective, as of such date, to ensure
that required information will be disclosed on a timely basis in its reports
under the Exchange Act.

There were no significant changes in the Companys internal control over
financial reporting during the last quarter that have materially affected, or
are reasonably likely to materially affect, the Companys internal control over
financial reporting.

PART II  OTHER INFORMATION

ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS

During September 2003, the Company received gross proceeds of $5,000,000
through a private placement of 6,849,315 shares of its common stock to an
investor. The shares were sold at $0.73 per share, representing an approximate
20% discount to the closing price of its common stock on the date of the
agreement. In connection with this private placement, the Company issued to
the investor three-year callable warrants to purchase 3,424,658 shares of
common stock. These warrants have an exercise price of $0.91 if exercised in
the first year, $1.82 if exercised in the second year and $2.73 if exercised in
the third and final year. The net proceeds of the placement were used for
working capital of the Company. The private placement was exempt from
registration pursuant to Section 4(2) of the Securities Act of 1933 and Rule
506 promulgated thereunder.

During September 2003, the Company
  received gross proceeds of $2,000,000 through a private placement of 1,600,000
  shares of its common stock to an investor. The shares were sold at $1.25 per
  share, representing an approximate 18% discount to the closing price of its
  common stock on the date of the agreement. In connection with this private placement,
  the Company issued to the investor three-year callable warrants to purchase
  800,000 shares of common stock. These warrants have an exercise price of $1.25
  if exercised in the first year, $2.50 if exercised in the second year and $3.75
  if exercised in the third and final year. The net proceeds of the placement
  were used for working capital of the Company. The private placement was exempt
  from registration pursuant to Section 4(2) of the Securities Act of 1933
  and Rule 506 promulgated thereunder.

ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K

A) EXHIBITS

|     |  |                                                                        
|---- |  | -----------------------------------------------------------------------
|31.1 |  | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|31.2 |  | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|31.3 |  | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|32   |  | Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

B) REPORTS ON FORM 8-K

On July 11, 2003, the Company filed a report on Form 8-K under Item 9
disclosing a press release that had been issued that announced certain
preliminary information relating to revenues for the fiscal quarter ended June
30, 2003.

On August 11, 2003, the Company filed a report on Form 8-K under Items 7 and 12
disclosing a press release that had been issued that announced results for the
fiscal quarter ended June 30, 2003 and disclosing certain information relating
to net operating expenses, a Non-GAAP Financial Measure as defined in
Regulation G.

24



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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant 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                       
|Chief Executive Officer and            
|Chairman of the Board of Directors     
|                                        |  |                     
|By:                                     |  | /s/ THOMAS D. DAVIS 
|Thomas D. Davis                        
|Senior Vice President and              
|Chief Financial Officer                
|                                        |  |                     
|By:                                     |  | /s/ STEVEN A. NEWMAN
|Steven A. Newman                       
|President, Chief Operating Officer and 
|Vice Chairman of the Board of Directors
|                                        |  |                     
|Date:
November 13, 2003                

25