##### 



SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q
(MARK ONE)

X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED
SEPTEMBER 30, 2001 OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
      SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROMTO
COMMISSION FILE NUMBER: 0-21013

XYBERNAUT CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

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

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)

N/A
(FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED
SINCE LAST REPORT)

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or
15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.YES X NO

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING
THE PRECEDING FIVE YEARS:
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court.
YES NO

APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practicable date.

|                                     |  |                                           
|------------------------------------ |  | ------------------------------------------
|Class
Common stock  $0.01 par value |  | Outstanding at November 8, 2001
52,758,624



1



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##### 



INDEX

|                                                                       |  |      |    | 
|---------------------------------------------------------------------- |  | ---- | -- | 
|                                                                       |  | PAGE
|                                                                       |  |     
|COVER PAGE                                                             |  |      | 1  | 
|INDEX                                                                  |  |      | 2  | 
|PART I  FINANCIAL INFORMATION                                         |  |      |    | 
|Item 1  Financial Statements                                          |  |      |    | 
|Condensed Consolidated Balance Sheets (unaudited)                      |  |      | 3  | 
|Condensed Consolidated Statements of Operations (unaudited)            |  |      | 4  | 
|Condensed Consolidated Statements 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                                                |  |      | 12 | 
|Item 3  Quantitative and Qualitative Disclosures About Market Risk    |  |      | 20 | 
|PART II  OTHER INFORMATION                                            |  |      |    | 
|Item 2  Changes in Securities and Use of Proceeds                     |  |      | 22 | 
|Item 6  Exhibits and Reports on Form 8-K                              |  |      | 22 | 



2



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##### 



XYBERNAUT CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

|                              |                                                                |              |                                                         |             |               |            |              |             |         |            | 
|----------------------------- | -------------------------------------------------------------- | ------------ | ------------------------------------------------------- | ----------- | ------------- | ---------- | ------------ | ----------- | ------- | ---------- | 
|                              |                                                                |              |                                                         |             |               |            |             
|                              |                                                                |              |                                                         |             | September 30, |            | December 31,
|                              |                                                                |              |                                                         |             | 2001          |            | 2000        
|                              |                                                                |              |                                                         |             |               |            |             
|Current assets:               |                                                                |              |                                                         |             |               |            |              |            
|                              | Cash and cash equivalents                                      |              | $                                                       | 2,958,550   |               |            | $            | 8,848,715   |        
|                              | Restricted cash                                                |              |                                                         | 500,000     |               |            |              | 424,917     |        
|                              | Accounts receivable, net of allowances of $90,334 and $129,355 |              |                                                         | 3,237,894   |               |            |              | 3,470,600   |        
|                              | Inventory, net of reserves of $1,625,803 and $1,370,000        |              |                                                         | 2,259,378   |               |            |              | 3,207,939   |        
|                              | Notes and interest receivable from officers, net               |              |                                                         | 1,066,919   |               |            |              | 998,581     |        
|                              | Prepaid and other current assets                               |              |                                                         | 1,473,069   |               |            |              | 877,045     |        
|                              |                                                                |              |                                                         |             |               |            |              |            
|                              |                                                                |              | Total current assets                                    |             |               | 11,495,810 |              |             |         | 17,827,797 | 
|                              |                                                                |              |                                                         |             |               |            |              |            
|Property and equipment, net   |                                                                |              | 990,271                                                 |             |               |            | 841,875      |            
|                              |                                                                |              |                                                         |             |               |            |              |            
|Other assets:                 |                                                                |              |                                                         |             |               |            |              |            
|                              | Patent costs, net of accumulated amortization of $1,018,323    |              |                                                         |             |               |            |              |             |        
|                              |                                                                | and $777,431 |                                                         |             | 1,028,536     |            |              |             | 790,014 |           
|                              | Tooling costs, net of accumulated amortization of $138,874     |              |                                                         |             |               |            |              |             |        
|                              |                                                                |              | and $735,985, and reserves of $0 and $250,000           |             |               | 1,183,836  |              |             |         | 197,578    | 
|                              | Other                                                          |              |                                                         | 554,026     |               |            |              | 585,418     |        
|                              |                                                                |              |                                                         |             |               |            |              |            
|                              |                                                                |              | Total other assets                                      |             |               | 2,766,398  |              |             |         | 1,573,010  | 
|                              |                                                                |              |                                                         |             |               |            |              |            
|                              |                                                                |              | Total assets                                            |             | $             | 15,252,479 |              |             | $       | 20,242,682 | 
|                              |                                                                |              |                                                         |             |               |            |              |            
|Current liabilities:          |                                                                |              |                                                         |             |               |            |              |            
|                              | Accounts payable                                               |              | $                                                       | 3,874,726   |               |            | $            | 1,900,924   |        
|                              | Accrued expenses and other                                     |              |                                                         | 2,134,180   |               |            |              | 2,054,359   |        
|                              | Deferred revenue                                               |              |                                                         | 430,046     |               |            |              | 468,534     |        
|                              | Notes and loans payable                                        |              |                                                         | 19,814      |               |            |              | 492,263     |        
|                              |                                                                |              |                                                         |             |               |            |              |            
|                              |                                                                |              | Total current liabilities                               |             | $             | 6,458,766  |              |             | $       | 4,916,080  | 
|                              |                                                                |              |                                                         |             |               |            |              |            
|Commitments and contingencies |                                                                |              |                                                         |             |               |            |              |            
|Stockholders equity:         |                                                                |              |                                                         |             |               |            |              |            
|                              | Common stock, $0.01 par value, 80,000,000 shares authorized,   |              |                                                         |             |               |            |              |             |        
|                              |                                                                |              | 52,758,624 and 45,395,818 shares issued and outstanding |             | $             | 527,586    |              |             | $       | 453,958    | 
|                              | Additional paid-in capital                                     |              |                                                         | 103,413,844 |               |            |              | 87,301,374  |        
|                              | Foreign currency translation                                   |              |                                                         | (441,150    | )             |            |              | (185,983    | )      
|                              | Accumulated deficit                                            |              |                                                         | (94,706,567 | )             |            |              | (72,242,747 | )      
|                              |                                                                |              |                                                         |             |               |            |              |            
|                              |                                                                |              | Total stockholders equity                              |             | $             | 8,793,713  |              |             | $       | 15,326,602 | 
|                              |                                                                |              |                                                         |             |               |            |              |            
|                              |                                                                |              | Total liabilities and stockholders equity              |             | $             | 15,252,479 |              |             | $       | 20,242,682 | 
|                              |                                                                |              |                                                         |             |               |            |              |            

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,
|                                         |                                     |                                                    |                                        |                                  |            |                                  |            |                                
|                                         |                                     |                                                    |                                        |                                  |            | 2001                             |            | 2000                            |            | 2001       |            | 2000     
|                                         |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |          
|Revenue:                                 |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          
|                                         | Product                             |                                                    | $                                      | 1,398,771                        |            |                                  | $          | 1,049,509                       |            |            | $          | 3,836,434 |             |             | $           | 4,665,807 |            
|                                         | Consulting, licensing and other     |                                                    |                                        | 917,642                          |            |                                  |            | 967,297                         |            |            |            | 2,776,764 |             |             |             | 2,387,906 |            
|                                         |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          
|                                         |                                     | Total revenue                                      |                                        |                                  | 2,316,413  |                                  |            |                                 | 2,016,806  |            |            |           | 6,613,198   |             |             |           | 7,053,713   |            
|Cost of sales:                           |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          
|                                         | Product                             |                                                    |                                        | 938,968                          |            |                                  |            | 871,588                         |            |            |            | 2,844,380 |             |             |             | 3,546,191 |            
|                                         | Consulting, licensing and other     |                                                    |                                        | 598,163                          |            |                                  |            | 574,796                         |            |            |            | 1,826,747 |             |             |             | 1,482,646 |            
|                                         | Provision for inventory and tooling |                                                    |                                        |                                 |            |                                  |            | 1,000,000                       |            |            |            | 1,149,020 |             |             |             | 1,000,000 |            
|                                         |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          
|                                         |                                     |                                                    | Gross income/(loss)                    |                                  |            | 779,282                          |            |                                 |            | (429,578   | )          |           |             | 793,051     |             |           |             | 1,024,876   |            
|Operating expenses:                      |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          
|                                         |                                     | Sales and marketing                                |                                        |                                  | 4,721,158  |                                  |            |                                 | 2,416,910  |            |            |           | 11,977,407  |             |             |           | 8,376,105   |            
|                                         |                                     | General and administrative                         |                                        |                                  | 1,757,036  |                                  |            |                                 | 1,600,535  |            |            |           | 4,789,075   |             |             |           | 4,436,030   |            
|                                         |                                     | Research and development                           |                                        |                                  | 2,438,846  |                                  |            |                                 | 1,246,278  |            |            |           | 6,723,476   |             |             |           | 3,455,861   |            
|                                         |                                     | Merger costs                                       |                                        |                                  |           |                                  |            |                                 |           |            |            |           |            |             |             |           | 621,048     |            
|                                         |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          
|                                         |                                     |                                                    |                                        | Total operating expenses         |            |                                  | 8,917,040  |                                 |            |            | 5,263,723  |           |             |             | 23,489,958  |           |             |             | 16,889,044  |  
|                                         |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          
|                                         |                                     |                                                    |                                        | Operating loss                   |            |                                  | (8,137,758 | )                               |            |            | (5,693,301 | )         |             |             | (22,696,907 | )         |             |             | (15,864,168 | )
|Interest and other income/(expense), net |                                     |                                                    | 70,329                                 |                                  |            |                                  | (247,519   | )                               |            |            | 253,722    |           |             |             | (676,868    | )        
|                                         |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          
|                                         |                                     |                                                    | Loss before provision for income taxes |                                  |            | (8,067,429                       | )          |                                 |            | (5,940,820 | )          |           |             | (22,443,185 | )           |           |             | (16,541,036 | )          
|Provision for income taxes               |                                     |                                                    | 5,807                                  |                                  |            |                                  | 1,143      |                                 |            |            | 20,635     |           |             |             | 38,344      |          
|                                         |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          
|                                         |                                     |                                                    | Net loss                               |                                  |            | (8,073,236                       | )          |                                 |            | (5,941,963 | )          |           |             | (22,463,820 | )           |           |             | (16,579,380 | )          
|Provision for preferred stock dividends  |                                     |                                                    |                                       |                                  |            |                                  |           |                                 |            |            |           |           |             |             | 10,438      |          
|                                         |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          
|                                         |                                     | Net loss applicable to holders of common stock     |                                        | $                                | (8,073,236 | )                                |            | $                               | (5,941,963 | )          |            | $         | (22,463,820 | )           |             | $         | (16,589,818 | )          
|                                         |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          
|                                         |                                     | Net loss per common share applicable to holders of |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |           |             |            
|                                         |                                     |                                                    |                                        | common stock (basic and diluted) |            | $                                | (0.15      | )                               |            | $          | (0.15      | )         |             | $           | (0.46       | )         |             | $           | (0.44       | )
|                                         |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          
|                                         |                                     | Weighted average number of common shares           |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |           |             |            
|                                         |                                     |                                                    |                                        | outstanding (basic and diluted)  |            |                                  | 52,309,601 |                                 |            |            | 38,579,676 |           |             |             | 49,114,344  |           |             |             | 37,304,405  |  
|                                         |                                     |                                                    |                                        |                                  |            |                                  |            |                                 |            |            |            |           |             |             |             |          

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,
|                                                             |                                                       |                                                               |                                                  |             |                                
|                                                             |                                                       |                                                               |                                                  |             | 2001                            |           | 2000     
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |          
|Cash flows from operating activities:                        |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             | Net loss                                              |                                                               | $                                                | (22,463,820 | )                               |           | $         | (16,579,380 | )          
|                                                             | Adjustments to reconcile net loss to net cash used in |                                                               |                                                  |             |                                 |           |           |             |            
|                                                             |                                                       | operating activities:Depreciation and amortization            |                                                  |             | 1,069,330                       |           |           |             | 1,240,710   |           
|                                                             |                                                       | Provision for inventory and tooling                           |                                                  |             | 1,149,020                       |           |           |             | 1,000,000   |           
|                                                             |                                                       | Provision for bad debts                                       |                                                  |             |                                |           |           |             | 72,794      |           
|                                                             |                                                       | Amortization of note discount                                 |                                                  |             |                                |           |           |             | 652,633     |           
|                                                             |                                                       | Non-cash charges for equity securities issued for services    |                                                  |             | 542,916                         |           |           |             | 1,070,502   |           
|                                                             |                                                       | Changes in assets and liabilities:                            |                                                  |             |                                 |           |           |             |             |           
|                                                             |                                                       |                                                               | Inventory                                        |             |                                 | 71,554    |           |             |             | 451,111    |  
|                                                             |                                                       |                                                               | Accounts receivable                              |             |                                 | 216,316   |           |             |             | (2,203,078 | )
|                                                             |                                                       |                                                               | Prepaid and other current assets                 |             |                                 | (651,659  | )         |             |             | 64,991     |  
|                                                             |                                                       |                                                               | Notes and interest receivable from officers, net |             |                                 | (15,976   | )         |             |             |           |  
|                                                             |                                                       |                                                               | Other assets                                     |             |                                 | 76,732    |           |             |             | (23,102    | )
|                                                             |                                                       |                                                               | Accounts payable                                 |             |                                 | 1,984,567 |           |             |             | (2,354,896 | )
|                                                             |                                                       |                                                               | Accrued expenses and other                       |             |                                 | 24,461    |           |             |             | (367,406   | )
|                                                             |                                                       |                                                               | Deferred revenue                                 |             |                                 | (38,488   | )         |             |             |           |  
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             |                                                       | Net cash used in operating activities                         |                                                  |             | (18,035,047                     | )         |           |             | (16,975,121 | )         
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|Cash flows from investing activities:                        |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             | Acquisition of property and equipment                 |                                                               |                                                  | (812,924    | )                               |           |           | (170,808    | )          
|                                                             | Restricted cash deposits                              |                                                               |                                                  | (84,343     | )                               |           |           | (716,674    | )          
|                                                             | Acquisition of patents                                |                                                               |                                                  | (537,240    | )                               |           |           | (262,319    | )          
|                                                             | Capitalization of tooling costs                       |                                                               |                                                  | (1,175,653  | )                               |           |           | (177,674    | )          
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             |                                                       | Net cash used in investing activities                         |                                                  |             | (2,610,160                      | )         |           |             | (1,327,475  | )         
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|Cash flows from financing activities:                        |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             | Proceeds from:                                        |                                                               |                                                  |             |                                 |           |           |             |            
|                                                             |                                                       | Common stock offerings, net                                   |                                                  |             | 13,714,939                      |           |           |             | 8,945,837   |           
|                                                             |                                                       | Exercise of warrants and stock options                        |                                                  |             | 1,948,691                       |           |           |             | 9,775,866   |           
|                                                             |                                                       | Notes and loans                                               |                                                  |             |                                |           |           |             | 4,425,000   |           
|                                                             | Payments for:                                         |                                                               |                                                  |             |                                 |           |           |             |            
|                                                             |                                                       | Notes and loans                                               |                                                  |             | (466,668                        | )         |           |             | (2,155,381  | )         
|                                                             |                                                       | Loan costs                                                    |                                                  |             | (10,000                         | )         |           |             |            |           
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             |                                                       | Net cash provided by financing activities                     |                                                  |             | 15,186,962                      |           |           |             | 20,991,322  |           
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|Effect of exchange rate changes on cash and cash equivalents |                                                       |                                                               | (431,920                                         | )           |                                 |           | (58,774   | )          
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |             |             |            |  
|Net (decrease) increase in cash and cash equivalents         |                                                       |                                                               | (5,890,165                                       | )           |                                 |           | 2,629,952 |            
|Cash and cash equivalents, beginning of period               |                                                       |                                                               | 8,848,715                                        |             |                                 |           | 2,126,000 |            
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|Cash and cash equivalents, end of period                     |                                                       | $                                                             | 2,958,550                                        |             |                                 | $         | 4,755,952 |            
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|Supplemental disclosure of cash flow information:            |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             |                                                       | Cash paid for interest                                        |                                                  | $           | 5,340                           |           |           | $           | 218,202     |           
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             |                                                       | Cash paid for taxes                                           |                                                  | $           | 51,298                          |           |           | $           | 44,946      |           
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|Supplemental disclosure of non-cash financing activities:    |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             |                                                       | Equity securities issued for future services                  |                                                  | $           | 317,448                         |           |           | $           | 272,343     |           
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             |                                                       | Equity securities issued as payment of accounts payable       |                                                  | $           |                                |           |           | $           | 109,740     |           
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             |                                                       | Provision for preferred stock dividend requirements           |                                                  | $           |                                |           |           | $           | 10,438      |           
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             |                                                       | Charges to conform accounting policies during merger          |                                                  | $           |                                |           |           | $           | 168,365     |           
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            
|                                                             |                                                       | Common stock issued for preferred stock dividend requirements |                                                  | $           |                                |           |           | $           | 153,904     |           
|                                                             |                                                       |                                                               |                                                  |             |                                 |           |           |            

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



5



---



##### 



XYBERNAUT CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The accompanying unaudited, condensed and consolidated financial
statements of Xybernaut Corporation (Xybernaut or 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
generally accepted accounting principles for complete financial statements. In
the opinion of Company 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, 2001 and December 31, 2000 and the results of
their operations and cash flows for the three and nine months ended September
30, 2001 and 2000. Results of operations for the three and nine months ended
September 30, 2001 are not necessarily indicative of results of operations
expected for the full fiscal year ending December 31, 2001. Please refer to the
Companys Annual Report on Form 10-K/A for the complete financial statements.

On April 7, 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. All financial data of the Company, including
Xybernauts previously issued financial statements for the periods presented in
this Form 10-Q, have been restated to include the historical financial
information of XSI.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Consolidation

The condensed consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries: XSI (Vienna, Virginia, U.S.A),
Xybernaut GmbH (Boeblingen, Germany), Xybernaut K.K. (Yokohama, Japan) and
Xybernaut Development Corporation (Fairfax, Virginia, U.S.A.). All significant
intercompany accounts and transactions have been eliminated in the
consolidation. Net gains and losses resulting from foreign currency
transactions have not been material.

Software Development Costs

The Company records software development costs in accordance with
Statement of Financial Accounting Standards (SFAS) No. 86, Accounting for
the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed,
which requires the capitalization of certain software development costs once
technological feasibility is established, which the Company defines as the
completion of a working model. Capitalized software costs are amortized either
on a straight-line basis over the estimated product life or based on the ratio
of current revenues to total projected product revenues. The Company has not
historically capitalized software development costs because the projects have
not reached the point of technological feasibility. As of and for the three
and nine months ended September 30, 2001 and 2000, there are no capitalized
software development costs or related amortization in the financial statements.
Software development costs incurred on projects that have not reached
technological feasibility are included as a component of research and
development expense and are recorded during the period in which they are
incurred.

Revenue Recognition

The Companys revenues are principally derived from sales of its hardware
and software products and from consulting services. Revenue from hardware
product sales is recognized upon shipment of the Companys products to
end-users pursuant to binding customer purchase orders. When shipments are made
to distributors, revenue is recognized upon ultimate sale by the distributors
to end-users, when the distributors purchase product for their own use pursuant
to separate binding purchase orders, or when returns can be reasonably
estimated. For hardware product sales, the Company generally provides a
one-year warranty on its parts and labor. However, the Companys suppliers for
its significant hardware components, including the computing unit, flat panel
and head mounted



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displays, and batteries, 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 Company recognizes software revenue in accordance with Statement of
Position (SOP) No. 97-2, Software Revenue Recognition and SOP No. 98-9,
Modification of SOP 97-2, Software Revenue Recognition, With Respect to
Certain Transactions. If a contract requires significant production,
modification, or customization of the software, the arrangement is accounted
for as a long-term service contract. If it does not, software revenue is
realizable when the following criteria are met: persuasive evidence of an
arrangement exists, delivery has occurred or services have been rendered, the
sellers price to the buyer is fixed or determinable, and collectibility is
reasonably assured. Other criteria that must be met include the determination
of whether the revenue in multiple-element arrangements can be recognized
separately for each element as performance occurs and the determination of the
fee based on vendor-specific objective evidence (VSOE) of fair value for each
element. The Company determines VSOE of fair value of each element by the
price charged when the same element is sold separately or based on managements
established prices for elements such as consulting rates on comparable service
contracts or the price of software with the same functionality available in the
industry. If management is unable to determine the VSOE of a delivered
element, the revenue is recognized by the residual method. As performance
occurs, the fee for the delivered item is determined by the total fee of the
arrangement less the total fair value of the undelivered elements. The total
fair value of the undelivered elements is deferred and subsequently recognized
as performance occurs. If management is unable to determine the VSOE of an
undelivered element, all revenue from the contract is deferred until the VSOE
is established or all performance has occurred. If the only undelivered
element without VSOE of fair value is services that can be accounted for
separately, the entire fee is recognized over the service period.

The Company recognizes revenue from long-term service contracts in
accordance with Accounting Research Bulletin (ARB) No. 45, Long-Term
Construction Type Contracts, using the relevant guidance in SOP 81-1,
Accounting for Performance of Construction-Type and Certain Production-Type
Contracts, as determined by the terms and conditions of the Companys various
consulting contracts with its customers. Revenue is typically recognized
ratably over the contractual periods or as the services are provided. In time
and materials contracts, revenue is recognized as the Company incurs billable
costs. In fixed price contracts, revenue is recognized based on the percentage
of completion method by calculating the ratio of costs incurred over total
estimated costs to complete.

Comprehensive Income

The Company separately reports net loss and other comprehensive income or
loss pursuant to SFAS No. 130, Reporting Comprehensive Income. Other
comprehensive income refers to revenues, expenses, gains and losses that under
U.S. GAAP are recorded as an element of stockholders equity and are excluded
from net income. The Companys other comprehensive income is comprised
principally of foreign currency translation and unrealized gains or losses on
investments. For the three and nine months ended September 30, 2001,
comprehensive loss was $8,122,663 and $22,718,987, consisting of a net loss of
$8,073,236 and $22,463,820, and foreign currency translation losses of $49,427
and $255,167, respectively. For the three and nine months ended September 30,
2000, comprehensive loss was $6,057,362 and $16,751,261, consisting of a net
loss of $5,941,963 and $16,579,380 and foreign currency translation losses of
$115,399 and $171,881, respectively.

Net Loss per Share

Basic earnings (or loss) per share is calculated using the weighted
average number of shares of common stock outstanding during a reporting period.
Diluted 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.
For all periods presented in this Form 10-Q, the Companys diluted loss per
share is equal to its basic loss per share because the effects of exercise were
anti-dilutive given the losses the Company incurred during such periods.



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3. NEW ACCOUNTING PRONOUNCEMENTS

In June 1998, the Financial Accounting Standards Board (the FASB) issued
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.
In 1999, the required implementation date of SFAS 133 was delayed to fiscal
years beginning after June 15, 2000. SFAS 133 requires that all derivative
instruments be recorded on the balance sheet at their fair value. Changes in
the fair value of derivatives are recorded each period in current earnings or
other comprehensive income, depending on whether a derivative is designated as
part of a hedge transaction and, if it is, the type of hedge transaction.
Currently, the Company does not utilize derivative instruments, but may elect
to do so to hedge foreign currency, interest rate or other exposures if such
exposures become significant. The Company adopted SFAS 133 during the quarter
ended March 31, 2001. The adoption did not have a significant effect on the
Companys results of operations or its financial position.

In July 2001, the FASB issued SFAS No. 141, Business Combinations, which
supercedes Accounting Principles Board (APB) Opinion No. 16, Business
Combinations. SFAS 141 eliminates the pooling of interests method of
accounting for business combinations and modifies the application of the
purchase accounting method. The elimination of the pooling of interests method
is effective for transactions initiated after June 30, 2001. The remaining
provisions of SFAS 141 will be effective for transactions accounted for using
the purchase method that are completed after June 30, 2001. The Company
believes that the adoption of SFAS 141 will not have a material impact on the
financial position or the results of operations of the Company.

In July 2001, the FASB issued SFAS No. 142, Goodwill and Intangible
Assets, which supercedes APB No. 17, Intangible Assets. SFAS 142 eliminates
the current requirement to amortize goodwill and indefinite-lived intangible
assets, addresses the amortization of intangible assets with a defined life and
addresses the impairment testing and recognition for goodwill and intangible
assets. SFAS 142 will apply to goodwill and intangible assets arising from
transactions completed before and after the Statements effective date. SFAS
142 is effective for 2002. The Company believes that the adoption of this
Statement will not have a material impact on the financial position or the
results of operations of the Company.

In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial
Statements, which provides guidance related to revenue recognition, income
statement presentation and financial disclosures. The Company adopted SAB 101
during 2000. At September 30, 2001 and December 31, 2000, the Company has
deferred $42,500 and $309,780, respectively, in revenue associated with
shipments of its hardware products pursuant to sales contracts which included
provisions for future upgrades of its products. The remaining $387,546 in
deferred revenue at September 30, 2001 is from payments received from customers
in accordance with consulting contracts, for which services have not yet been
performed by the Company. The Company expects to recognize these deferred
revenue balances as the upgraded products are shipped to the customers and as
services are performed under the consulting contracts.

4. INVENTORY AND TOOLING

Inventory consists primarily of component hardware parts held for resale
and allocated tooling costs, and is comprised primarily of finished goods.
Unallocated capitalized tooling costs are separately recorded on the balance
sheet and consist primarily of payments made to third-party vendors for their
products and services used in the manufacture of the Companys hardware product
lines. Inventory is stated at the lower of cost or market, with cost being
determined on a first-in, first-out basis. At September 30, 2001, the Companys
inventory balance consisted of its current product lines, the Mobile Assistant
® (MA ® ) V and the MA TC, as well as its older product line, the MA IV.

Management periodically assesses the need to provide for obsolescence of
inventory and tooling and adjusts their current carrying values to their net
realizable value when required. The Companys management believes that it can
sell the inventory of its older MA IV product line at an amount approximating
its current carrying value, which reflects certain reserves recorded during
2000 and 2001 to cover potential losses in selling the MA IV product line held
in inventory, and related tooling, given the uncertainties created by the
introduction of the MA V and MA TC products. To determine the size of the
reserve, management reviewed the carrying value of its MA IV inventory in light
of the introduction of the new product lines. As a result of this review, it
was determined that certain of the existing MA IV inventory would be
slow-moving and also risked becoming obsolete. Based upon a specific review of
the carrying costs for the MA IV 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



8



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be recoverable. This analysis also took into account estimated price
concessions which management believed would be necessary in disposing of this
inventory. Management does not expect to record significant gains or losses
upon the ultimate sale of the remaining MA IV inventory. In the event that
anticipated sales of the Companys MA IV products do not materialize,
additional adjustments may be necessary to write down the remaining carrying
value of this inventory. No inventory or tooling reserves or write-offs have
been recorded related to the MA V and MA TC product lines.

As of September 30, 2001 and December 31, 2000, the allowance to reduce
inventory balances to net realizable value was $1,625,803 and $1,370,000,
respectively, and the allowance to reduce tooling balances to net realizable
value was $0 and $250,000, respectively.

5. FINANCINGS

Common Stock

On January 3, 2000, the Company received net proceeds of $2,460,500
through the issuance of 647,500 shares its common stock.

On June 23, 2000, the Company received net proceeds of $3,453,470 through
the issuance of 437,500 shares of its common stock. In connection with this
private placement, the Company issued warrants to purchase 87,500 shares of its
common stock for $10.00 per share.

On September 29, 2000, the Company received net proceeds of $2,989,970
through the issuance of 717,703 shares of its common stock. In connection with
this private placement, the Company issued warrants to purchase 119,880 shares
of its common stock for $6.25 per share.

During April and May 2001, the Company received net proceeds of
$10,192,469 through the private placement of 5,238,094 shares of its common
stock to several investors. In connection with these private placements, the
Company issued warrants to purchase 1,616,427 shares of its common stock at an
exercise price of $5.00 per share and paid $350,000 in finders fees.

On July 31, 2001, the Company received gross proceeds of $4,000,000
through a private placement of 1,324,503 shares of its common stock to an
investor. These shares were sold at $3.02 per share, representing an
approximate 10% discount to the closing price of the shares on the day
preceding the finalization of negotiations between the Company and the
investors. In connection with this private placement, the Company issued to the
investor callable warrants to purchase 331,126 shares of its common stock at an
exercise price of $4.53 per share. The Company also paid $120,000 in cash and
issued callable warrants to purchase 39,735 shares of common stock with the
same terms to a financial advisor.

Employees and consultants of the Company have exercised stock options that
had been issued pursuant to the Companys various stock incentive plans. During
the nine months ended September 30, 2001 and 2000, the Company received gross
proceeds of $130,285 and $1,500,891, respectively, and issued 53,738 and
638,834 shares, respectively, of its common stock related to these exercises.

The Company has issued equity securities to certain consultants for
services provided to the Company, including legal, investor relations, and
sales and marketing services. 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 provided, whichever was more reliably measured. The Company
recorded expenses associated with these services of $63,490 and $194,202 during
the three months ended September 30, 2001 and 2000, respectively, and $542,916
and $1,070,502 during the nine months ended September 30, 2001 and 2000,
respectively. At September 30, 2001, an additional $317,448 was recorded as
prepaid expenses that will be amortized over the remaining lives of the
underlying service agreements.

In connection with the Companys financing and consulting agreements, the
Company has issued warrants to purchase common stock. During the nine months
ended September 30, 2001 and 2000, the Company received gross proceeds of
$1,818,406 and $8,274,975, respectively, and issued 731,471and 2,077,700
shares, respectively,



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of its common stock related to exercises of these warrants. At September
30, 2001, the Company had warrants outstanding to purchase 5,270,754 shares of
its common stock at prices that range from $2.00 to $18.00 per share, with a
weighted average of $4.67 per share.

Borrowings

On December 2, 1999, the Company entered into a financing facility (the
1999 IBM Facility) with IBM Global Finance (IBM Finance). Borrowings under
the 1999 IBM Facility were secured by the Companys equipment, inventory and
accounts receivable balances. Under the terms of the facility, the Company
borrowed $1,000,000 under a six-month term loan and was extended a $3,000,000
credit line to finance customer purchases upon presentation to the lender of
certain documentation supporting the underlying sales. The borrowing under the
term loan accrued interest at up to the prime rate plus 2.5% per annum and was
repaid in three equal installments in February, April and June 2000. Borrowings
under the credit line accrue interest at up to the prime rate plus 2.75% per
annum, depending on certain specifics of the underlying sales being financed,
such as the type of customer and the age of the accounts receivable balance.
There are no borrowings on this facility as of September 30, 2001.

In January 2000, the Company borrowed $3,025,000 from several lenders
pursuant to promissory notes that required the Company to repay the borrowings
by January 2001 unless repaid earlier upon a public or private placement of
common stock in excess of $10,000,000. Interest on the notes accrued at 10% per
annum. In connection with these borrowings, the Company issued warrants to
purchase 302,500 shares of unregistered common stock at $0.10 per share. Based
on the relative fair values of the securities issued, these warrants were
assigned a value of $921,452, which was recorded as a note discount that was
amortized into interest expense over the lives of the notes. In November and
December 2000, the principal and unpaid interest were repaid upon completion by
the Company of a private placement of common stock. Upon repayment, the
remaining note discount balance was amortized as interest expense.

In July 2000, subsequent to the repayment of the 1999 IBM Facility term
loan, the Company entered into a new six-month $1,400,000 term loan with IBM
Finance (the 2000 IBM Facility), the terms of which were similar to those in
the 1999 IBM Facility. The borrowing was secured by certain of the Companys
equipment, inventory and accounts receivable balances. The borrowing accrued
interest at the prime rate plus 1.5% and was repaid in three equal installments
in September and November 2000 and January 2001.

The Company is in continuing negotiations with IBM Finance to obtain a
$3,000,000 revolving credit facility
to replace the existing facility which will be
 secured by substantially all assets of the
Company, excluding intellectual property, but there can be no assurance that
this facility will be finalized.

Preferred Stock

As of June 30, 2000, all remaining shares of the Series D and Series E
Preferred Stock were converted into shares of common stock. Subsequent to this
conversion, all classes of preferred stock had been converted into shares of
common stock and there was no preferred stock outstanding as of September 30,
2001 or December 31, 2000.

6. SEGMENT AND ENTERPRISE WIDE REPORTING

Operating segments are defined in accordance with SFAS No. 131,
Disclosures About Segments of an Enterprise and Related Information, 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 represents 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.



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Revenues by geographical destination as a percentage of total revenues for
the three months and nine months ended September 30, 2001 and 2000 are as
follows:

|                                             |  |                    |    |                   |  |      |    |      |  |  |    |   |  |  |    |  
|-------------------------------------------- |  | ------------------ | -- | ----------------- |  | ---- | -- | ---- |  |  | -- | - |  |  | -- | -
|                                             |  | Three Months Ended |    | Nine Months Ended
|                                             |  | September 30,      |    | September 30,    
|                                             |  | 2001               |    | 2000              |  | 2001 |    | 2000
|                                             |  |                    |    |                   |  |      |    |     
|North America, principally the United States |  |                    | 70 | %                 |  |      | 74 | %    |  |  | 74 | % |  |  | 71 | %
|Europe, principally Germany                  |  |                    | 26 | %                 |  |      | 22 | %    |  |  | 22 | % |  |  | 18 | %
|Asia, principally Japan                      |  |                    | 4  | %                 |  |      | 4  | %    |  |  | 4  | % |  |  | 11 | %

Operations in various geographical areas are summarized as follows:

|                    |  |                    |            |                   |  |      |            |      |  |   |            |  |  |   |            | 
|------------------- |  | ------------------ | ---------- | ----------------- |  | ---- | ---------- | ---- |  | - | ---------- |  |  | - | ---------- | 
|                    |  | As of and for the  |            | As of and for the
|                    |  | Three Months Ended |            | Nine Months Ended
|                    |  | September 30,      |            | September 30,    
|                    |  | 2001               |            | 2000              |  | 2001 |            | 2000
|                    |  |                    |            |                   |  |      |            |     
|North America:      |  |                    |            |                   |  |      |            |      |  |   |            |  |  |   |            | 
|Total revenue       |  | $                  | 1,633,169  |                   |  | $    | 1,486,509  |      |  | $ | 4,904,611  |  |  | $ | 4,986,633  | 
|Net loss            |  |                    | 7,060,456  |                   |  |      | 5,456,383  |      |  |   | 18,369,884 |  |  |   | 14,921,630 | 
|Identifiable assets |  |                    | 11,969,142 |                   |  |      | 12,027,259 |      |  |   | 11,969,142 |  |  |   | 12,027,259 | 
|                   
|Europe:             |  |                    |            |                   |  |      |            |      |  |   |            |  |  |   |            | 
|Total Revenue       |  | $                  | 601,505    |                   |  | $    | 441,292    |      |  | $ | 1,420,580  |  |  | $ | 1,300,796  | 
|Net loss            |  |                    | 729,406    |                   |  |      | 206,625    |      |  |   | 2,387,636  |  |  |   | 928,451    | 
|Identifiable assets |  |                    | 2,592,073  |                   |  |      | 1,284,341  |      |  |   | 2,592,073  |  |  |   | 1,284,341  | 
|                   
|Asia:               |  |                    |            |                   |  |      |            |      |  |   |            |  |  |   |            | 
|Total revenue       |  | $                  | 81,739     |                   |  | $    | 89,005     |      |  | $ | 288,007    |  |  | $ | 766,284    | 
|Net loss            |  |                    | 283,374    |                   |  |      | 278,955    |      |  |   | 1,706,300  |  |  |   | 729,299    | 
|Identifiable assets |  |                    | 691,264    |                   |  |      | 3,405,850  |      |  |   | 691,264    |  |  |   | 3,405,850  | 

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
months and nine months ended September 30, 2001 and 2000 are as follows:

|                                     |  |                    |      |                   |  |      |      |      |  |  |      |   |  |  |      |  
|------------------------------------ |  | ------------------ | ---- | ----------------- |  | ---- | ---- | ---- |  |  | ---- | - |  |  | ---- | -
|                                     |  | As of and for the  |      | As of and for the
|                                     |  | Three Months Ended |      | Nine Months Ended
|                                     |  | September 30,      |      | September 30,    
|                                     |  | 2001               |      | 2000              |  | 2001 |      | 2000
|                                     |  |                    |      |                   |  |      |      |     
|Revenue:                             |  |                    |      |                   |  |      |      |      |  |  |      |   |  |  |      |  
|Number of Customers                  |  |                    | 3    |                   |  |      | 2    |      |  |  | 3    |   |  |  | 1    |  
|Percent of Total Revenue             |  |                    | 47.7 | %                 |  |      | 20.6 | %    |  |  | 38.6 | % |  |  | 15.1 | %
|                                    
|Accounts Receivable:                 |  |                    |      |                   |  |      |      |      |  |  |      |   |  |  |      |  
|Number of Customers                  |  |                    | 2    |                   |  |      | 1    |      |  |  | 2    |   |  |  | 1    |  
|Percent of Total Accounts Receivable |  |                    | 55.6 | %                 |  |      | 28.2 | %    |  |  | 55.6 | % |  |  | 28.2 | %



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

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 profit
from its products and services as expected, the Companys ability to meet
competition, the Companys ability to maintain superior technological
capability, foresee changes and continue to identify, develop and commercialize
innovative and competitive products and services, the Companys ability to
penetrate different markets and successfully expand its revenue, and the
Companys ability to generate cash flow and obtain financing to support its
operations and growth.

OVERVIEW

Xybernaut Corporation (the Company), a Delaware corporation originally
incorporated in 1990, is engaged in the research, development, manufacture,
marketing and sales 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).

The Mobile Assistant ® (MA ® ) series is the Companys current line of
hardware products. The Companys current models are the MA V and MA TC. The
Mobile Assistant is a wearable personal computer which combines the speed,
memory, processing, multimedia and communications capabilities of a desktop PC
in a lightweight, user-supported unit with hands-free operation and
simultaneous user mobility. The Mobile Assistant is a combination of hardware
and software designed to be worn on the body to perform complex and time
consuming tasks such as remote video teleconferencing, installation,
maintenance, repair and inspection of complex technological and mechanical
systems, retrieval and analysis of information from remote locations, and
coordination of remote commercial and industrial activities, or military field
operations.

The Mobile Assistant incorporates technologically advanced optional
features such as real-time, two-way video and audio communications through
radio frequency transmissions or cellular linkups, global positioning system
(GPS) tracking capabilities and access to information through intranets, the
Internet and the World Wide Web. The head-mounted display includes a two-way
audio system and optional built-in video camera, and presents a desk-top
quality color image that is equivalent to that of a desktop PC monitor at a
distance of 18 inches. An optional light-weight, daylight readable, full color
flat panel display, with an integrated digitizer, is offered for those users
who may not need to be fully hands-free, may need to capture signatures or
other forms-related data, or may need to share the displayed data with others.
The lightweight body-worn computing unit is designed to allow operation in
conditions in which conventional portable computers can not operate and is
designed to run software applications designed for Microsoft ® Windows ® as
well as DOS, SCO UNIX ® and LINUX.

A consumer wearable computer, the poma, is scheduled for availability in
2002. Hitachi, Ltd. will manufacture and sell the poma under its brand name
under a royalty-bearing license from the Company and will also provide product
to the Company, who will sell and market it under the Xybernaut brand. The poma
provides users



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with instant on/off Internet access and targets a suite of services such
as entertainment in the form of distance learning, music, video and games, GPS,
cellular voice communications and paging, interactive banking, shopping, and
stock market trading. The poma is equipped with a SVGA head-mounted display and
is powered by a newly developed Hitachi 32-Bit 128 MHz RISC processor with
companion coprocessor. The 10.9-ounce poma will run Microsoft Windows CE and
incorporates a Compact Flash slot, USB port, 32 MB of RAM, 32 MB of ROM and a
removable internal rechargeable battery.

Through XSI, formerly known as Selfware, Inc., the Company provides a full
line of software development and implementation services. XSI provides
programming capabilities in a variety of advanced languages including Visual
Basic and Visual C++, along with database experience in Microsoft SQL server,
Oracle and Sybase. Telecommunication and information technology for asset
management are also provided by XSI for computers, hubs, routers and data
lines, along with asset management software for linear referenced assets
including roads, railways, utility, and pipelines. XSIs solutions have been
developed for use with Windows, UNIX and Novell Netware.

XSI offers the proprietary OPMIST asset management system that has been
installed in over 200 sites worldwide at shipyards, utilities, manufacturers,
departments of transportation (DOTs), military bases and railroads. Also
offered by XSI is the Program and Project Management System (PPMS) solution
that has been provided to six state DOTs. The PPMS is a fully integrated
program, project and task management system designed by XSI in conjunction with
state DOT organizations to help manage capital improvement programs. The PPMS
is a total solution that includes commercial-off-the-shelf project scheduling
systems, such as Artemis, Primavera, OPX2 and Microsoft Project. By using the
PPMS, state DOT organizations have the ability to model every project included
in capital improvement programs.

RESULTS OF OPERATIONS

Historically, the Company has derived its revenues from sales of the
Mobile Assistant series and software products and through consulting services.
In the future, the Company expects to derive additional revenues from the
licensing of its intellectual property.

The Companys cost of sales includes the costs of components for the
Mobile Assistant series, costs of purchased and licensed software, direct labor
and related costs, reserves, amortization of tooling costs and fulfillment and
shipping costs.

The Company incurs sales and marketing expenses primarily related to its
(i) direct sales force for its product and consulting businesses, including
salary, commissions, travel and other costs, (ii) channel sales strategy,
including the management of relationships with high-volume generic
distributors, strategic partners, system integrators, value added resellers and
original equipment manufacturers, (iii) strategic marketing initiatives,
including analysis related to customer needs and competition and (iv)
advertising and marketing programs, including participation in
industry-specific trade shows, selected press coverage, marketing literature,
website development and maintenance, and exhibitions at special events such as
the annual International Conference on Wearable Computing. In addition, the
Company unveiled a new logo and literature package in the third quarter of
2001.

The Company has historically made, and intends to continue to make,
significant expenditures on research and development of hardware and software
products and has made substantial efforts to enhance its current line and to
design and engineer its next generations of wearable products. Research and
development activities relate primarily to the research and design of new
products, test components and equipment costs required to conduct the Companys
development activities. Software development costs are expensed as incurred
until technological feasibility is established in accordance with Statement of
Financial Accounting Standards (SFAS) No. 86, Accounting for the Costs of
Computer Software to be Sold, Leased or Otherwise Marketed, after which any
additional costs are capitalized until the software is ready for release.

General and administrative expenses consist of costs associated with the
Companys legal, tax and accounting, information technology, executive and
other general activities.



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For the nine months ended September 30, 2001, the Companys operating
activities used cash of $18,035,047, primarily as a result of its net loss
adjusted for non-cash charges and provisions, which are offset by changes in
working capital. During this period, the Companys investing activities used
cash of $2,610,160, principally through expenditures for tooling, property and
equipment, and patents. These activities were funded through the Companys
financing activities which provided cash of $15,186,962, principally through the
issuance of common stock through private placements and the exercise of
warrants, which is offset by a loan repayment. As a result, the Companys cash
balance decreased to $2,958,550 at September 30, 2001 from $8,848,715 at
December 31, 2000.

For the nine months ended September 30, 2000, the Companys operating
activities used cash of $16,975,121, primarily as a result of its net loss
adjusted for non-cash charges and changes in working capital and its investing
activities used cash of $1,327,475. These activities were funded through the
Companys financing activities which provided cash of $20,991,322, principally
through the issuance of common stock through private placements and the exercise
of warrants and options and through borrowings, which is offset by the repayment
of a loan for $2,155,381. As a result, the Companys cash balance increased to
$4,755,952 at September 30, 2000 from $2,126,000 at December 31, 1999.

At September 30, 2001, the Company had accounts receivable, net of
allowances, of $3,237,894, a decrease of $232,706, or 7%, from the December 31,
2000 balance of $3,470,600. This decrease corresponds with the 5% decline in
revenues for the three months ended September 30, 2001 when compared with
revenues for the three months ended December 31, 2000. The Companys receivables
were not significantly impacted by qualitative factors related to its business
such as changes in credit terms, slower paying customers or the impact of a
change in economic environment.

The following table sets forth certain consolidated financial data as a
percentage of revenues:

|                                               |                          |  |                                  |       |                                 |  |        |       |      |  |        |       |   |  |        |       |  
|---------------------------------------------- | ------------------------ |  | -------------------------------- | ----- | ------------------------------- |  | ------ | ----- | ---- |  | ------ | ----- | - |  | ------ | ----- | -
|                                               |                          |  | Three Months Ended September 30, |       | Nine Months Ended September 30,
|                                               |                          |  | 2001                             |       | 2000                            |  | 2001   |       | 2000
|                                               |                          |  |                                  |       |                                 |  |        |       |     
|Revenue                                        |                          |  | 100.0                            | %     |                                 |  | 100.0  | %     |      |  | 100.0  | %     |   |  | 100.0  | %    
|Cost of sales                                  |                          |  | 66.4                             | %     |                                 |  | 71.7   | %     |      |  | 70.6   | %     |   |  | 71.3   | %    
|Provision for inventory and tooling            |                          |  | 0.0                              | %     |                                 |  | 49.6   | %     |      |  | 17.4   | %     |   |  | 14.2   | %    
|                                               |                          |  |                                  |       |                                 |  |        |       |      |  |        |       |   |  |        |      
|                                               | Gross margin             |  |                                  | 33.6  | %                               |  |        | (21.3 | %)   |  |        | 12.0  | % |  |        | 14.5  | %
|                                               |                          |  |                                  |       |                                 |  |        |       |      |  |        |       |   |  |        |      
|Operating expenses:                            |                          |  |                                  |       |                                 |  |        |       |      |  |        |       |   |  |        |      
|                                               | Sales & marketing        |  |                                  | 203.8 | %                               |  |        | 119.8 | %    |  |        | 181.1 | % |  |        | 118.7 | %
|                                               | General & administrative |  |                                  | 75.9  | %                               |  |        | 79.4  | %    |  |        | 72.4  | % |  |        | 62.9  | %
|                                               | Research & development   |  |                                  | 105.3 | %                               |  |        | 61.8  | %    |  |        | 101.7 | % |  |        | 49.0  | %
|                                               | Merger costs             |  |                                  | 0.0   | %                               |  |        | 0.0   | %    |  |        | 0.0   | % |  |        | 8.8   | %
|                                               |                          |  |                                  |       |                                 |  |        |       |      |  |        |       |   |  |        |      
|Total operating expenses                       |                          |  | 385.0                            | %     |                                 |  | 261.0  | %     |      |  | 355.2  | %     |   |  | 239.4  | %    
|                                               |                          |  |                                  |       |                                 |  |        |       |      |  |        |       |   |  |        |      
|Interest and other                             |                          |  | 2.9                              | %     |                                 |  | (12.3  | %)    |      |  | 3.5    | %     |   |  | (10.1  | %)   
|                                               |                          |  |                                  |       |                                 |  |        |       |      |  |        |       |   |  |        |      
|Net loss                                       |                          |  | (348.5                           | %)    |                                 |  | (294.6 | %)    |      |  | (339.7 | %)    |   |  | (235.0 | %)   
|                                               |                          |  |                                  |       |                                 |  |        |       |      |  |        |       |   |  |        |      
|Provisions for preferred stock                 |                          |  | 0.0                              | %     |                                 |  | 0.0    | %     |      |  | 0.0    | %     |   |  | 0.2    | %    
|                                               |                          |  |                                  |       |                                 |  |        |       |      |  |        |       |   |  |        |      
|Net loss applicable to holders of common stock |                          |  | (348.5                           | %)    |                                 |  | (294.6 | %)    |      |  | (339.7 | %)    |   |  | (235.2 | %)   
|                                               |                          |  |                                  |       |                                 |  |        |       |      |  |        |       |   |  |        |      

THREE MONTHS ENDED SEPTEMBER 30, 2001 AND 2000

REVENUE. The Company derives its revenue from product sales of its
wearable computers and software, and from consulting services. Total revenue for
the quarter ended September 30, 2001 was $2,316,413, an increase of $299,607, or
15%, compared to $2,016,806 for the quarter ended September 30, 2000. Product
revenue for the third quarter of 2001 was $1,398,771, an increase of $349,262,
or 33%, compared to $1,049,509 for the third quarter of 2000. The increase in
product revenue was attributable to an increase in volume sales of the Companys
hardware products, which totaled $1,370,559 in the three months ended September
30, 2001, compared with $1,043,597 in the three months ended September 30, 2000,
for an increase of $326,962. This increase resulted primarily from customer
demand for the Companys new product lines, the MA V and MA TC, which began
shipping in volume in the latter part of the third quarter of 2001. The increase in hardware revenue was also
accompanied by a slight increase in software revenue



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from $5,912 in the third quarter of 2000 to $28,212 in the third quarter
of 2001. The Companys consulting, licensing and other revenue during the
third quarter of 2001 decreased from $967,297 in the second quarter of 2000 to
$917,642 in the third quarter of 2001, a decline of $49,655 or 5%. There were
no significant changes in contract activity between the third quarter of 2001
and 2000.

COST OF SALES. Total cost of sales for the quarter ended September 30,
2001 was $1,537,131, a decrease of $909,253 or 37%, compared to $2,466,384 for
the quarter ended September 30, 2000. This decrease resulted primarily from a
$1,000,000 provision for obsolescence of inventory and tooling related to the
MA IV product line that was recorded during the quarter ended September 30,
2000. The Companys cost of its product sales for the third quarter of 2001 was
$938,968, an increase of $67,380, or 8%, from the $871,588 recorded during
2000. This relatively small increase in cost of sales in relation to the 33%
increase in product revenue over the same periods is primarily due to a charge
of approximately $136,000 in the third quarter of 2000 recorded for software
used on the MA IV, for which no similar charge was taken in the corresponding
quarter in 2001 because this product is not currently being licensed by the
Company. The Companys gross margins on product sales increased from 17% in
2000 to 33% in 2001. This was caused by a combination of higher margins earned
on 2001 sales of the new MA V systems, lower margins earned on 2001 sales of
the MA IV systems because of decreased demand for these older systems, as well
as the higher software license fees recorded in 2000. The impact of software
sales was not significant to either product cost of sales or gross margins due
to the low volume of such sales during the third quarters of 2001 and 2000.
The Companys cost of sales associated with its consulting, licensing and other
revenues increased to $598,163 during 2001 from $574,796 during 2000, an
increase of $23,367, or 4%. During the comparable periods, related revenues
decreased by 5%, resulting in a decrease in gross margins to 35% in 2001 from
40% in 2000. This decline was primarily the result of the mix of ongoing
contracts and an increase in outside consulting costs on certain contracts.

The Company introduced the MA V and MA TC product lines during the quarter
ended September 30, 2001. The Companys management believes that it can sell
the inventory of its older MA IV product line at an amount approximating its
current carrying value, which reflects certain reserves recorded during 2000
and 2001 to cover potential losses in selling the MA IV product line held in
inventory, and related tooling, given the uncertainties created by the
introduction of the new product lines. To determine the size of the reserve,
management reviewed the carrying value of its MA IV inventory in light of the
introduction of the new product lines. As a result of this review, it was
determined that certain of the existing MA IV inventory would be slow-moving
and also risked becoming obsolete. Based upon a specific review of the
carrying costs for the MA IV 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. This analysis
also took into account estimated price concessions which management believed
would be necessary in disposing of this inventory. Management does not expect
to record significant gains or losses upon the ultimate sale of the remaining
MA IV inventory.

SALES AND MARKETING EXPENSES. Sales and marketing expenses for the quarter
ended September 30, 2001 were $4,721,158, an increase of $2,304,248, or 95%,
from $2,416,910 in the comparable 2000 quarter. This increase is primarily a
result of an increase of approximately $1,350,000 in personnel and recruiting
costs for sales and marketing staff hired in connection with the introduction
of the new product lines. Additionally, outside marketing services, customer
support, and collateral and promotional expenses increased by approximately
$475,000 from the third quarter of 2000 related to the release of the new
product lines, efforts to increase brand awareness and the introduction of a
new corporate logo. Included in these amounts were non-cash expenses of
$84,067 and $160,914 for outside marketing services funded through the issuance
of the Companys equity securities during the comparable 2001 and 2000 periods,
respectively.

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
for the quarter ended September 30, 2001 were $1,757,036, an increase of
$156,501, or 10%, from $1,600,535 in the comparable 2000 quarter. This
increase is primarily due to an increase in personnel and travel costs of
approximately $130,000 and $22,000, respectively. The relative consistency of
these expenses was achieved during a period of growth, primarily as the result
of a refocusing of internal efforts from overhead areas to sales and marketing
and product development functions.

RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses for
the quarter ended September 30, 2001 were $2,438,846, an increase of
$1,192,568, or 96%, from $1,246,278 in the comparable



15



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2000 quarter. This is primarily the result of an increase of approximately
$543,000 in expenditures to third parties in the third quarter of 2001 related
to the design and development of the MA V and MA TC product lines from the
corresponding quarter in 2000. Additionally, outside consulting services and
other costs related to product research and development increased by
approximately $259,000 in the third quarter of 2001 compared to the third
quarter of 2000. Approximately $224,000 of the remaining difference resulted
from increased personnel costs.

INTEREST AND OTHER, NET. Interest and other income for the quarter ended
September 30, 2001 was $70,329, an increase of $317,848, or 128%, compared to
interest and other expense of $247,519 for the corresponding period in 2000.
This increase was primarily the result of approximately $306,000 of interest
expense on loans and the amortization of note discount for the third quarter of
2000 for which no similar loan and notes were outstanding for the corresponding
period in 2001. The Companys primary source of interest and other income
relates to interest earned on the Companys cash balances.

PROVISION FOR TAXES. The Company accrued $5,807 for a tax provision for
the three months ended September 30, 2001 related to the operations of its
foreign subsidiaries. The Companys U.S. operations had a net loss for the
three months ended September 30, 2001 and, therefore, no provision for U.S.
income taxes is required.

NET LOSS ATTRIBUTABLE TO HOLDERS OF COMMON STOCK. As a result of the
factors described above, the net loss attributable to holders of common stock
for the quarter ended September 30, 2001 was $8,073,236, an increase of
$2,131,273, or 36%, compared to $5,941,963 for the corresponding period in
2000.

NINE MONTHS ENDED SEPTEMBER 30, 2001 AND 2000

REVENUE. The Company derives its revenue from product sales of its
wearable computers and software, and from consulting services. Total revenue
for the nine months ended September 30, 2001 was $6,613,198, a decrease of
$440,515, or 6%, compared to $7,053,713 for the nine months ended September 30,
2000. Product revenue for the first nine months of 2001 was $3,836,434, a
decrease of $829,373, or 18%, compared to $4,665,807 for the first nine months
of 2000. The decrease in product revenue was attributable to sales of the
Companys hardware and software products, which decreased $327,776, or 9%, and
$501,597, or 45%, from $3,548,903 and $1,116,904, respectively. The decrease in
hardware sales resulted primarily from slightly lower volume as the Company
emphasized new and enhanced product lines, the MA V and MA TC, which began
shipping in volume in the latter part of the third quarter of 2001. Additionally, the Companys
current product line, the MA IV, was sold at a larger discount in the first
nine months of 2001 than in the comparable period in 2000 in anticipation of
the new product lines. The decrease in software sales was primarily the result
of a $925,000 sale of one of the Companys software products in the first nine
months of 2000, for which a comparably sized order was not received in 2001.
The Companys consulting, licensing and other revenue during the first nine
months of 2001 was $2,776,764, an increase of $388,858 or 16%, from revenue of
$2,387,906 in the first nine months of 2000. This increase was the result of
additional contract activity in the first nine months of 2001 compared with the
corresponding period in 2000.

COST OF SALES. Total cost of sales for the nine months ended September 30,
2001 was $5,820,147, a decrease of $208,690, or 3%, compared to $6,028,837 for
the nine months ended September 30, 2000. Cost of sales for the first nine
months of 2001 and 2000 include a provision for inventory and tooling of
$1,149,020 and $1,000,000, respectively. The Companys cost of its product
sales for 2001 was $2,844,380, a decrease of $701,811, or 20%, from costs for
2000 of $3,546,191. This fluctuation was in line with the 18% decline in
related product revenue. As a result, overall product gross margins remained
consistent at 26% and 24% for 2001 and 2000, respectively. During these
periods, the Companys hardware gross margins were impacted by higher margin
sales of the newly introduced MA V systems that were partially offset by lower
margin sales on the older MA IV product line. The Companys software margins
remained consistent at 35% in 2001 and 36% in 2000. The Companys cost of
services from consulting, license and other revenue increased 23%,
corresponding roughly to the increase in consulting, license and other revenue,
resulting in gross margins of 34% in 2001 and 38% in 2000. This decrease
resulted primarily from the mix of ongoing contracts and an increase in outside
consulting costs on certain contracts.

The Company introduced the MA V and MA TC product lines during the quarter
ended September 30, 2001. The Companys management believes that it can sell
the inventory of its older MA IV product line at an amount approximating its
current carrying value, which reflects certain reserves recorded during 2000
and 2001 to cover potential losses in selling the MA IV product line held in
inventory, and related tooling, given the



16



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uncertainties created by the introduction of the new product lines. To
determine the size of the reserve, management reviewed the carrying value of
its MA IV inventory in light of the introduction of the new product lines. As
a result of this review, it was determined that certain of the existing MA IV
inventory would be slow-moving and also risked becoming obsolete. Based upon a
specific review of the carrying costs for the MA IV 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. This analysis also took into account estimated price concessions
which management believed would be necessary in disposing of this inventory.
Management does not expect to record significant gains or losses upon the
ultimate sale of the remaining MA IV inventory.

SALES AND MARKETING EXPENSES. Sales and marketing expenses for the nine
months ended September 30, 2001 were $11,977,407, an increase of $3,601,302 or
43%, compared to the nine months ended September 30, 2000. This increase is
primarily a result of an approximate $1,567,000 increase in personnel and
recruiting costs for sales and marketing staff related to the introduction of
the new product lines. Additionally, outside marketing services, customer
support, and collateral and promotional expenses increased approximately
$789,000 from the third quarter of 2000 related to the release of the new
product lines, efforts to increase brand awareness and the introduction of a
new corporate logo. Included in these amounts were non-cash expenses of
$217,781 and $921,140 for outside marketing services funded through the
issuance of the Companys equity securities during the comparable 2001 and 2000
periods, respectively.

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
for the nine months ended September 30, 2001 were $4,789,075, an increase of
$353,045, or 8%, compared to $4,436,030, for the corresponding period in 2000.
This increase was primarily the result of an increase in spending in the first
quarter of 2001 to expand the Companys infrastructure, including costs
associated with new inventory and accounting information systems that were not
capitalizable that were incurred in anticipation of increased sales transaction
volume.

RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses for
the nine months ended September 30, 2001 were $6,723,476, an increase of
$3,267,615, or 95%, compared to $3,455,861 for the corresponding period in
2000. This is primarily the result of an increase of approximately $1,771,000
in expenditures to third parties in the first nine months of 2001 related to
the final design and development of the MA V and MA TC product lines from the
corresponding period in 2000. Additionally, outside consulting services
related to product research and development increased approximately $602,000 in
the third quarter of 2001 compared to the third quarter of 2000. Approximately
$491,000 of the remaining difference resulted from increased personnel costs.
Increased activity related to other
R&D activities was also reflected in the nine months ended
September 30, 2001 when compared with the corresponding period in 2000.

MERGER COSTS. Merger expenses were $621,048 for 2000. These non-recurring
expenses related to the Companys April 2000 merger with XSI, for which no
comparable expenses were recorded in 2001. These expenses consist of $452,683
in direct costs, including fees for investment banking, legal and accounting
services, and $168,365 in non-cash charges to conform XSIs accounting policies
to those of the Company.

INTEREST AND OTHER, NET. Other income for the nine months ended September
30, 2001 was $253,722, an increase of $930,590, or 137%, compared to other
expense of $676,868 for the corresponding period in 2000. This increase was
primarily the result of approximately $900,000 of interest expense on loans and
the amortization of note discount for the first nine months of 2000 for which
no similar loan and notes were outstanding for the corresponding period in
2001. The Companys primary source of interest and other income relates to
interest earned on the Companys cash balances.

PROVISION FOR TAXES. The Company accrued $20,635 for a tax provision for
the nine months ended September 30, 2001 related to the operations of its
foreign subsidiaries. The Companys U.S. operations had a net loss for the nine
months ended September 30, 2001 and, therefore, no provision for U.S. income
taxes is required.

DIVIDEND ON PREFERRED STOCK. The Company accrued dividends at 5% per annum
on the outstanding principal amount of its preferred stock. For the six months
ended June 30, 2001, the amount of



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dividends accrued was $0, a decrease of $10,438, or 100%, compared for the
same period of the prior year. All outstanding preferred stock was converted to
common stock as of June 30, 2000.

NET LOSS ATTRIBUTABLE TO HOLDERS OF COMMON STOCK. As a result of the
factors described above, the net loss attributable to holders of common stock
for the nine months ended September 30, 2001 was $22,463,820, an increase of
$5,874,002, or 35%, compared to $16,589,818 for the corresponding period in
2000.

LIQUIDITY AND CAPITAL RESOURCES

From its inception until the 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
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 has
raised approximately $104,000,000 through its various financings from its
inception through September 30, 2001.

The Companys significant financing activities for the nine months ended
September 30, 2001 and for the year ended December 31, 2000 are summarized
below.

On January 3, 2000, the Company received net proceeds of $2,460,500
through the issuance of 647,500 shares of its common stock.

In January 2000, the Company borrowed $3,025,000 from several lenders
pursuant to promissory notes. Interest on the notes accrued at 10% per annum.
In connection with these borrowings, the Company issued warrants to purchase
302,500 shares of unregistered common stock at $0.10 per share. In November and
December 2000, the principal and unpaid interest were repaid.

On June 23, 2000, the Company received net proceeds of $3,453,470 through
the issuance of 437,500 shares of its common stock. In connection with this
private placement, the Company issued warrants to purchase 87,500 shares of its
common stock for $10.00 per share.

In July 2000, the Company entered into a six-month $1,400,000 term loan
with IBM Global Finance (IBM Finance). The borrowing was secured by certain
of the Companys equipment, inventory and accounts receivable balances. The
borrowing accrued interest at the prime rate plus 1.5% and was repaid in three
equal installments in September and November 2000 and January 2001.

On September 29, 2000, the Company received net proceeds of $2,989,970
through the issuance of 717,703 shares of its common stock. In connection with
this private placement, the Company issued warrants to purchase 119,880 shares
of its common stock for $6.25 per share.

On November 15, 2000, the Company received proceeds of $15,393,554 through
the issuance of 5,970,656 shares of its common stock. In connection with this
private placement, the Company issued warrants to the investors to purchase
2,239,057 shares of its common stock for $4.33 per share. The Company paid
investment banking and other financing fees in cash of $1,133,849 and issued
warrants to purchase an additional 866,000 shares of its common stock for $4.33
per share.

During April and May 2001, the Company raised net proceeds of $10,192,469
through the private placement of 5,238,094 shares of its common stock to
several investors. In connection with these private placements, the Company
issued warrants to purchase 1,616,427 shares of its common stock at an exercise
price of $5.00 per share and paid $350,000 in finders fees.

On July 31, 2001, the Company received gross proceeds of $4,000,000
through a private placement of 1,324,503 shares of its common stock to an
investor. These shares were sold at $3.02 per share, representing a discount of
approximately 10% to the closing price of the shares on the day preceding the
finalization of negotiations between the Company and the investors. In
connection with this private placement, the Company issued to the investor
callable warrants to purchase 331,126 shares of its common stock at an exercise
price of $4.53 per



18



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share. In connection with this placement, the Company also paid $120,000
in cash and issued callable warrants to purchase 39,735 shares of common stock
with the same terms to a financial advisor.

Employees and consultants of the Company have exercised stock options that
had been issued pursuant to the Companys various stock incentive plans. During
the nine months ended September 30, 2001 and the year ended December 31, 2000,
the Company received gross proceeds of $130,285 and $1,547,011, respectively,
and issued 53,738 and 662,724 shares, respectively, of its common stock related
to these exercises.

The Company has issued equity securities to certain consultants for
services provided to 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 provided, whichever was more reliably
measured. The Company recorded expenses associated with these services of
$542,916 and $1,312,630 during the nine months ended September 30, 2001 and the
year ended December 31, 2000, respectively. At September 30, 2001, an
additional $317,448 was recorded as prepaid expenses that will be amortized
over the remaining lives of the underlying service agreements.

In connection with the Companys financing and consulting agreements, the
Company has issued warrants to purchase common stock. During the nine months
ended September 30, 2001 and the year ended December 31, 2000, the Company
received gross proceeds of $1,818,406 and $8,274,975, respectively, and issued
731,471 and 2,077,700 shares, respectively, of its common stock related to
exercises of these warrants. At September 30, 2001, the Company had warrants
outstanding to purchase 5,270,754 shares of its common stock at prices that
range from $2.00 to $18.00 per share, with a weighted average of $4.67 per
share.

The Company currently has a $3,000,000 credit line with IBM Finance to
finance customer purchases upon presentation to the lender of certain
documentation supporting the underlying sales. This credit line is secured by
certain of the Companys equipment, inventory and accounts receivable balances.
Borrowings under the credit line accrue interest at up to the prime rate plus
2.75%, depending on certain specifics of the underlying sales being financed,
such as the type of customer and the age of the accounts receivable balance.
There are no borrowings on this facility as of September 30, 2001.
Additionally, the Company is in continuing negotiations with IBM Finance to
obtain a $3,000,000 revolving credit facility to replace the existing
credit facility which will be secured by substantially all
assets of the Company, excluding intellectual property, but there can be no
assurance that this facility will be finalized.

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.

At September 30, 2001, the Company had commitments to purchase inventory,
tooling and engineering and other services from its suppliers and manufacturers
related to the design, manufacture and procurement of its hardware product
lines. The Company is obligated to purchase certain components of the MA V
system from IBM, including approximately 24,000 computing units (the MA V
CPUs). The MA V CPUs are scheduled for purchase over an 18 month period
following final acceptance by the Company, which acceptance is determined by a
number of criteria including receipt of comprehensive product documentation and
other customary deliverables. All criteria for acceptance had not been met at
the time of this filing, but the Company expects that all criteria will be met
in the fourth quarter of 2001. Subsequent to acceptance, the Company may
cancel its purchase commitment by paying a cancellation fee in an amount not to
exceed approximately $4,000,000 and that decreases in proportion to the number
of MA V CPUs purchased over the contract period. In addition to the obligation
related to the MA V CPUs, the Company has commitments 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, MA TC, poma and future product lines. While the timing and amount of
many of these shipments and services may be adjusted through the payment of
cancellation fees or through contract negotiations, the total amount scheduled
to be paid for such items by the Company during the remainder of 2001 and 2002
is estimated at between $45,000,000 and $50,000,000.

The Company has incurred operating losses to date and expects such losses
to continue in the near term as it expands its product development and
marketing efforts. At September 30, 2001, the Company had an accumulated
deficit of approximately $95,000,000. The achievement of profitability is
primarily dependent upon the continued



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development and commercial acceptance of the Companys products, the
successful management of the business and managements ability to strategically
focus the Company. There can be no assurance as to whether or when profitable
operations will occur. In addition, the Company is experiencing negative cash
flow from operations and it is expected that it will continue to experience
negative cash flows through 2002 and potentially thereafter.

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. At December 31,
2000, the Company had approximately $66,000,000 and $2,000,000 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 anticipates that its working capital requirements and
operating expenses will increase as the Company expands production of its
Mobile Assistant series, develops new models in the Mobile Assistant and other
product lines, further expands its sales, service and marketing functions, and
develops the support structure for these activities. The timing of increases in
personnel and other expenses, the amount of working capital consumed by
operations, inventory procurement, marketing and rollout expenses for the
Mobile Assistant series and other products, and competitive pressures on gross
margins will impact the magnitude and timing of the Companys cash
requirements.

Management is currently exploring financing alternatives to supplement the
Companys cash position. Potential sources of additional financing include
private equity offerings, strategic investments, strategic partnerships and
various forms of debt financing. The Company also has a $3,000,000 borrowing
facility with IBM Finance which allows for the funding of large orders through
borrowings made at the time the Company receives a customers purchase order
through the collection of the customers receivable. Additionally, the Company
is in continuing negotiations with IBM Finance to obtain a $3,000,000 revolving
credit facility to replace the existing facility which will be secured by substantially all assets of the Company, excluding
intellectual property, but there can be no assurance that this facility will be
finalized.

If additional funds are raised through the issuance of equity securities,
the percentage of ownership of current stockholders of the Company will be
reduced. If additional funds are raised through borrowings, the Company will be
subject to additional interest charges and principal repayments and may be
required to comply with financial covenants or other restrictions. 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. Although the equity markets have
remained depressed in recent months, management believes the Company will be
successful in its efforts to obtain such additional financing, based both on
its 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 closing
additional financings on terms acceptable to the Company. If the Company is
unable to obtain sufficient additional financing, it will be required to reduce
discretionary spending in order to maintain its operations at a reduced level.
Management believes that it will be able to reduce discretionary spending if
required but that such reduction would negatively impact progress on
implementing the Companys business plan. In addition, management would intend
to renegotiate purchase commitments previously disclosed herein.

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, 2001. 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



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marketing, and other activities, the Company enters into transactions
denominated in other currencies, primarily the Japanese Yen, European Euro, and
German Deutsche Mark. As of January 1, 2001 Xybernaut GmbH converted its
functional currency from the German Deutsche Mark to the European Euro. The
effects of this conversion on beginning retained earnings was a decrease of
$151,123, which is included in foreign currency translation balance.
Historically, the Company has not had significant realized gains or losses in
transactions denominated in 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. As international sales and operations
increase, the Company may enter into foreign exchange forward and option
contracts to hedge transactions denominated in a foreign currency. For the
three months and nine months ended September 30, 2001, the Companys operations
in Europe comprised 26.0% and 21.5% of its total revenue and 9.0% and 10.6% of
its net loss compared to 21.9% and 18.4% of its total revenue and 3.5% and 5.6%
of its net loss in the same periods for 2000. For the three months and nine
months ended September 30, 2001, the Companys operations in Asia comprised
3.5% and 4.4% of its total revenue and 3.5% and 7.6% of its net loss compared
to 4.4% and 10.9% of its total revenue and 4.7% and 4.4% of its net loss in the
same periods for 2000. At September 30, 2001, the Companys assets in Europe
and Asia comprised 17.0% and 4.5% of its total assets, compared to 7.7% and
20.4% of its total assets at September 30, 2000. According to published
sources, the average fluctuation of the European Euro during the three and nine
months ended September 30, 2001 was 4.9% and 5.0%; the average fluctuation of
the German Deutsche Mark during the same periods in 2000 was 10.8% and 6.6%.
The average fluctuation of the Japanese Yen during the three months and nine
months ended September 30, 2001 was 2.6% and 5.7% compared to 5.0% and 4.6%
for the same periods in 2000. Management believes that these fluctuations did
not have a material impact on the Companys results of operations for the three
and nine months ended, September 30, 2001 and 2000 or financial position at
September 30, 2001 and December 31, 2000.

INTEREST RATE SENSITIVITY

As discussed in the Liquidity and Capital Resources section, the Company
has historically entered into debt financings, has established a borrowing
facility based on inventory and accounts receivable balances and is currently
exploring various new financing alternatives, including debt financing. If
additional funds are raised through borrowings, the Company will be subject to
additional interest charges and may be required to comply with financial
covenants or other restrictions. 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. As 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 2001 was
8.83%, 8.17% and 7.67%, respectively and the average prime interest rate during
the first three quarters of fiscal year 2000 was 8.67%, 8.92% and 9.11%,
respectively, or a prime interest rate change at September 30 compared to the
rate at the beginning of the fiscal year of 3.0% in 2001 and 1.0% in 2000,
respectively. Management believes that these fluctuations did not have a
material impact on the Companys results of operations or financial position
for 2001 and 2000.

EURO CONVERSION

On January 1, 1999, certain member countries of the European Union
established fixed conversion rates between their existing currencies and the
Euro. The transition period for the introduction of the Euro ends June 30,
2002. As of January 1, 2001, Xybernaut GmbH converted its functional currency
from the German Deutsche Mark to the European Euro. The effects of this
conversion on beginning retained earnings was a decrease of $151,123, which is
included in foreign currency translation balance. Issues that were addressed by
the Company as a result of the introduction of the Euro included the conversion
of information technology systems, reassessment of foreign currency exchange
risk, negotiation and amendment of existing agreements and contracts, and
processing of tax and accounting records. At September 30, 2001, the Company
did not experience significant issues with the Euro conversion and the
conversion did not have a material impact on the Companys results of
operations or financial position.



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PART II  OTHER INFORMATION

ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS

On July 31, 2001, the Company received gross proceeds of $4,000,000 through a
private placement of 1,324,503 shares of its common stock to an investor.
These shares were sold at $3.02 per share, representing an approximate 10%
discount to the closing price of the shares on the day preceding the
finalization of negotiations between the Company and the investors. In
connection with this private placement, the Company issued to the investor
callable warrants to purchase 331,126 shares of its common stock at an exercise
price of $4.53 per share. In connection with this placement, the Company also
paid $120,000 in cash and issued callable warrants to purchase 39,735 shares of
common stock with the same terms to a financial advisor. The net proceeds of
the sale 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

None.

B) REPORTS ON FORM 8-K

No reports on Form 8-K were filed during the quarterly period ended September
30, 2001.

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/s/ EDWARD G. NEWMANBy: Edward G. Newman
President, Chief Executive Officer and
Chairman of the Board of Directors/s/ JOHN F. MOYNAHAN
By: John F. Moynahan
Senior Vice President, Chief Financial
Officer and Treasurer



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