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
JUNE 30, 2001 OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
__   SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM
TO

COMMISSION FILE NUMBER: 0-21013

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

|                             |  |                                    
|---------------------------- |  | -----------------------------------
|DELAWARE                     |  | 54-1799851                         
|                            
|                            
|                            
|                            
|(STATE OR OTHER JURISDICTION |  | (I.R.S. EMPLOYER IDENTIFICATIONNO.)
|                            
|                            
|                            
|                            
|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                          |  | Outstanding at August 8, 2001
|                              
|                              
|                              
|                              
|Common stock  $0.01 par value |  | 52,743,624                   

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                                             |                                                             |   | 21   |   | 
|                              
|                              
|                              
|                              
|PART II  OTHER INFORMATION   
|                              
|                              
|                              
|                              
|                               | Item 6  Exhibits and Reports on Form8-K                                                                        |                                                             |   | 23   |  

2



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XYBERNAUT CORPORATIONCONDENSED CONSOLIDATED BALANCE SHEETS(UNAUDITED)

|                                                    |                                                                                                                          |                                            |         |             |            |              |         |             |            | 
|--------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------ | ------- | ----------- | ---------- | ------------ | ------- | ----------- | ---------- | 
|                                                    |                                                                                                                          |                                            |         |             |            |             
|                                                    |                                                                                                                          |                                            |         | June 30,    |            | December 31,
|                                                    |                                                                                                                          |                                            |         | 2001        |            | 2000        
|                                                    |                                                                                                                          |                                            |         |             |            |             
|Current assets:                                    
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Cash and cash equivalents                                                                                                |                                            | $       | 8,236,603   |            |              | $       | 9,273,632   |           
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Accounts receivable, net of allowances of $129,355                                                                       |                                            |         | 2,874,158   |            |              |         | 3,470,600   |           
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Inventory, net of reserves of $1,767,513 and $1,370,000                                                                  |                                            |         | 1,217,917   |            |              |         | 3,207,939   |           
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Notes and interest receivable from officers, net                                                                         |                                            |         | 1,091,123   |            |              |         | 998,581     |           
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Prepaid and other current assets                                                                                         |                                            |         | 1,152,299   |            |              |         | 877,045     |           
|                                                    |                                                                                                                          |                                            |         |             |            |              |         |            
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    |                                                                                                                          | Total current assets                       |         |             | 14,572,100 |              |         |             | 17,827,797 | 
|                                                    |                                                                                                                          |                                            |         |             |            |              |         |            
|                                                   
|                                                   
|                                                   
|                                                   
|Property and equipment, net                         |                                                                                                                          |                                            | 781,244 |             |            |              | 841,875 |            
|                                                    |                                                                                                                          |                                            |         |             |            |              |         |            
|Other assets:                                      
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Patent costs, net of accumulated amortization of $930,657
and $777,431                                                   |                                            |         | 929,602     |            |              |         | 790,014     |           
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Tooling costs, net of accumulated amortization of $59,182
and $735,985, and     reserves of $0 and $250,000              |                                            |         | 1,017,238   |            |              |         | 197,578     |           
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Other                                                                                                                    |                                            |         | 671,784     |            |              |         | 585,418     |           
|                                                    |                                                                                                                          |                                            |         |             |            |              |         |            
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    |                                                                                                                          | Total other assets                         |         |             | 2,618,624  |              |         |             | 1,573,010  | 
|                                                    |                                                                                                                          |                                            |         |             |            |              |         |            
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    |                                                                                                                          | Total assets                               |         | $           | 17,971,968 |              |         | $           | 20,242,682 | 
|                                                    |                                                                                                                          |                                            |         |             |            |              |         |            
|Current liabilities:                               
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Accounts payable                                                                                                         |                                            | $       | 1,926,035   |            |              | $       | 1,900,924   |           
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Accrued expenses and other                                                                                               |                                            |         | 2,323,970   |            |              |         | 2,054,359   |           
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Deferred revenue                                                                                                         |                                            |         | 707,984     |            |              |         | 468,534     |           
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Notes and loans payable                                                                                                  |                                            |         | 21,823      |            |              |         | 492,263     |           
|                                                    |                                                                                                                          |                                            |         |             |            |              |         |            
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    |                                                                                                                          | Total current liabilities                  |         | $           | 4,979,812  |              |         | $           | 4,916,080  | 
|                                                    |                                                                                                                          |                                            |         |             |            |              |         |            
|Commitments and contingencies
Stockholders equity:
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Common stock, $0.01 par value, 80,000,000 shares authorized,
51,399,121 and     45,395,818 shares issued and outstanding |                                            | $       | 513,991     |            |              | $       | 453,958     |           
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Additional paid-in capital                                                                                               |                                            |         | 99,503,219  |            |              |         | 87,301,374  |           
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Foreign currency translation                                                                                             |                                            |         | (391,723    | )          |              |         | (185,983    | )         
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Accumulated deficit                                                                                                      |                                            |         | (86,633,331 | )          |              |         | (72,242,747 | )         
|                                                    |                                                                                                                          |                                            |         |             |            |              |         |            
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    |                                                                                                                          | Total stockholders equity                 |         | $           | 12,992,156 |              |         | $           | 15,326,602 | 
|                                                    |                                                                                                                          |                                            |         |             |            |              |         |            
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    |                                                                                                                          | Total liabilities and stockholders equity |         | $           | 17,971,968 |              |         | $           | 20,242,682 | 
|                                                    |                                                                                                                          |                                            |         |             |            |              |         |            

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

3



---



XYBERNAUT CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(UNAUDITED)



|                                         |                                     |                                                                                     |        |                             |            |                           |          |           |            |      |         |           |             |   |          |           |             |  
|---------------------------------------- | ----------------------------------- | ----------------------------------------------------------------------------------- | ------ | --------------------------- | ---------- | ------------------------- | -------- | --------- | ---------- | ---- | ------- | --------- | ----------- | - | -------- | --------- | ----------- | -
|                                         |                                     |                                                                                     |        | Three Months Ended June 30, |            | Six Months Ended June 30,
|                                         |                                     |                                                                                     |        |                             |            |                          
|                                         |                                     |                                                                                     |        | 2001                        |            | 2000                      |          | 2001      |            | 2000
|                                         |                                     |                                                                                     |        |                             |            |                           |          |           |            |     
|Revenue:                                
|                                        
|                                        
|                                        
|                                        
|                                         | Product                             |                                                                                     | $      | 1,079,512                   |            |                           | $        | 2,125,774 |            |      | $       | 2,437,663 |             |   | $        | 3,616,298 |            
|                                        
|                                        
|                                        
|                                        
|                                         | Consulting, licensing and other     |                                                                                     |        | 942,051                     |            |                           |          | 806,661   |            |      |         | 1,859,122 |             |   |          | 1,420,609 |            
|                                         |                                     |                                                                                     |        |                             |            |                           |          |           |            |      |         |           |             |   |          |          
|                                         |                                     | Total revenue                                                                       |        |                             | 2,021,563  |                           |          |           | 2,932,435  |      |         |           | 4,296,785   |   |          |           | 5,036,907   |  
|                                        
|                                        
|                                        
|                                        
|Cost of sales:                          
|                                        
|                                        
|                                        
|                                        
|                                         | Product                             |                                                                                     |        | 785,973                     |            |                           |          | 1,583,310 |            |      |         | 1,905,412 |             |   |          | 2,674,603 |            
|                                        
|                                        
|                                        
|                                        
|                                         | Consulting, licensing and other     |                                                                                     |        | 643,648                     |            |                           |          | 442,615   |            |      |         | 1,228,584 |             |   |          | 907,850   |            
|                                        
|                                        
|                                        
|                                        
|                                         | Provision for inventory and tooling |                                                                                     |        | 1,149,020                   |            |                           |          |          |            |      |         | 1,149,020 |             |   |          |          |            
|                                         |                                     |                                                                                     |        |                             |            |                           |          |           |            |      |         |           |             |   |          |          
|                                         |                                     | Gross income/(loss)                                                                 |        |                             | (557,078   | )                         |          |           | 906,510    |      |         |           | 13,769      |   |          |           | 1,454,454   |  
|                                        
|                                        
|                                        
|                                        
|Operating expenses:                     
|                                        
|                                        
|                                        
|                                        
|                                         | Sales and marketing                 |                                                                                     |        | 4,155,875                   |            |                           |          | 2,858,291 |            |      |         | 7,256,249 |             |   |          | 5,959,195 |            
|                                        
|                                        
|                                        
|                                        
|                                         | General and administrative          |                                                                                     |        | 1,385,103                   |            |                           |          | 1,399,921 |            |      |         | 3,032,039 |             |   |          | 2,835,495 |            
|                                        
|                                        
|                                        
|                                        
|                                         | Research and development            |                                                                                     |        | 2,439,479                   |            |                           |          | 1,619,755 |            |      |         | 4,284,630 |             |   |          | 2,209,583 |            
|                                        
|                                        
|                                        
|                                        
|                                         | Merger costs                        |                                                                                     |        |                            |            |                           |          | 621,048   |            |      |         |          |             |   |          | 621,048   |            
|                                         |                                     |                                                                                     |        |                             |            |                           |          |           |            |      |         |           |             |   |          |          
|                                         |                                     | Total operating expenses                                                            |        |                             | 7,980,457  |                           |          |           | 6,499,015  |      |         |           | 14,572,918  |   |          |           | 11,625,321  |  
|                                         |                                     |                                                                                     |        |                             |            |                           |          |           |            |      |         |           |             |   |          |          
|                                         |                                     | Operating loss                                                                      |        |                             | (8,537,535 | )                         |          |           | (5,592,505 | )    |         |           | (14,559,149 | ) |          |           | (10,170,867 | )
|                                        
|                                        
|                                        
|                                        
|Interest and other income/(expense), net |                                     |                                                                                     | 92,379 |                             |            |                           | (258,515 | )         |            |      | 183,393 |           |             |   | (429,349 | )        
|                                         |                                     |                                                                                     |        |                             |            |                           |          |           |            |      |         |           |             |   |          |          
|                                         |                                     | Loss before provision for income taxes                                              |        |                             | (8,445,156 | )                         |          |           | (5,851,020 | )    |         |           | (14,375,756 | ) |          |           | (10,600,216 | )
|                                        
|                                        
|                                        
|                                        
|Provision for income taxes               |                                     |                                                                                     | 8,839  |                             |            |                           | 10,992   |           |            |      | 14,828  |           |             |   | 37,201   |          
|                                         |                                     |                                                                                     |        |                             |            |                           |          |           |            |      |         |           |             |   |          |          
|                                         |                                     | Net loss                                                                            |        |                             | (8,453,995 | )                         |          |           | (5,862,012 | )    |         |           | (14,390,584 | ) |          |           | (10,637,417 | )
|                                        
|                                        
|                                        
|                                        
|Provision for preferred stock dividends  |                                     |                                                                                     |       |                             |            |                           | 2,308    |           |            |      |        |           |             |   | 10,438   |          
|                                         |                                     |                                                                                     |        |                             |            |                           |          |           |            |      |         |           |             |   |          |          
|                                         |                                     | Net loss applicable to holders of common stock                                      |        | $                           | (8,453,995 | )                         |          | $         | (5,864,320 | )    |         | $         | (14,390,584 | ) |          | $         | (10,647,855 | )
|                                         |                                     |                                                                                     |        |                             |            |                           |          |           |            |      |         |           |             |   |          |          
|                                         |                                     | Net loss per common share applicable to holders of
common stock (basic and diluted) |        | $                           | (0.17      | )                         |          | $         | (0.15      | )    |         | $         | (0.30       | ) |          | $         | (0.29       | )
|                                         |                                     |                                                                                     |        |                             |            |                           |          |           |            |      |         |           |             |   |          |          
|                                         |                                     | Weighted average number of common shares
outstanding (basic and diluted)            |        |                             | 49,561,637 |                           |          |           | 37,898,185 |      |         |           | 47,490,235  |   |          |           | 36,659,762  |  
|                                         |                                     |                                                                                     |        |                             |            |                           |          |           |            |      |         |           |             |   |          |          

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

4



---



XYBERNAUT CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW(UNAUDITED)

|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |             |             |            |  
|------------------------------------------------------------ | ------------------------------------------------------------------------------- | ---------------------------------------------------------- | ------------------------------------------------ | ----------- | ------------------------- | -------- | --------- | ----------- | ----------- | ---------- | -
|                                                             |                                                                                 |                                                            |                                                  |             | Six Months Ended June 30,
|                                                             |                                                                                 |                                                            |                                                  |             |                          
|                                                             |                                                                                 |                                                            |                                                  |             | 2001                      |          | 2000     
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |          
|Cash flows from operating activities:                       
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Net loss                                                                        |                                                            | $                                                | (14,390,584 | )                         |          | $         | (10,637,417 | )          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Adjustments to reconcile net loss to net cash used in
operating     activities:
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 | Depreciation and amortization                              |                                                  |             | 736,718                   |          |           |             | 953,530     |           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 | Provision for inventory and tooling                        |                                                  |             | 1,149,020                 |          |           |             |            |           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 | Provision for bad debts                                    |                                                  |             |                          |          |           |             | 22,794      |           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 | Amortization of note discount                              |                                                  |             |                          |          |           |             | 422,332     |           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 | Non-cash charges for equity securities issued for services |                                                  |             | 479,425                   |          |           |             | 891,014     |           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 | Changes in assets and liabilities:                        
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 |                                                            | Inventory                                        |             |                           | 941,760  |           |             |             | 293,026    |  
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 |                                                            | Accounts receivable                              |             |                           | 494,210  |           |             |             | (1,695,232 | )
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 |                                                            | Prepaid and other current assets                 |             |                           | (387,474 | )         |             |             | (658       | )
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 |                                                            | Notes and interest receivable from officers, net |             |                           | (40,180  | )         |             |             |           |  
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 |                                                            | Other assets                                     |             |                           | (4,196   | )         |             |             | 51,110     |  
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 |                                                            | Accounts payable                                 |             |                           | 56,618   |           |             |             | (2,208,537 | )
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 |                                                            | Accrued expenses and other                       |             |                           | 232,407  |           |             |             | (61,086    | )
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 |                                                            | Deferred revenue                                 |             |                           | 239,450  |           |             |             |           |  
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |            
|                                                             |                                                                                 | Net cash used in operating activities                      |                                                  |             | (10,492,826               | )        |           |             | (11,969,124 | )         
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |            
|Cash flows from investing activities:                       
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Acquisition of property and equipment                                           |                                                            |                                                  | (382,035    | )                         |          |           | (291,336    | )          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Acquisition of patents                                                          |                                                            |                                                  | (325,204    | )                         |          |           | (168,631    | )          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Capitalization of tooling costs                                                 |                                                            |                                                  | (931,297    | )                         |          |           | (58,725     | )          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |            
|                                                             |                                                                                 | Net cash used in investing activities                      |                                                  |             | (1,638,536                | )        |           |             | (518,692    | )         
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |            
|Cash flows from financing activities:                       
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Proceeds from:                                                                 
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 | Common stock offerings, net                                |                                                  |             | 9,842,469                 |          |           |             | 5,955,867   |           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 | Exercise of warrants and stock options                     |                                                  |             | 1,870,691                 |          |           |             | 9,573,630   |           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 | Notes and loans                                            |                                                  |             |                          |          |           |             | 3,025,000   |           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Payments for:                                                                  
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 | Notes and loans                                            |                                                  |             | (466,668                  | )        |           |             | (1,420,238  | )         
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                                 | Loan costs                                                 |                                                  |             | (10,000                   | )        |           |             |            |           
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |            
|                                                             |                                                                                 | Net cash provided by financing activities                  |                                                  |             | 11,236,492                |          |           |             | 17,134,259  |           
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |            
|Effect of exchange rate changes on cash and cash equivalents |                                                                                 |                                                            | (142,159                                         | )           |                           |          | (49,183   | )          
|                                                            
|                                                            
|                                                            
|                                                            
|Net (decrease) increase in cash and cash equivalents         |                                                                                 |                                                            | (1,037,029                                       | )           |                           |          | 4,597,260 |            
|                                                            
|                                                            
|                                                            
|                                                            
|Cash and cash equivalents, beginning of period               |                                                                                 |                                                            | 9,273,632                                        |             |                           |          | 2,126,000 |            
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |            
|Cash and cash equivalents, end of period                     |                                                                                 | $                                                          | 8,236,603                                        |             |                           | $        | 6,723,260 |            
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |            
|Supplemental disclosure of cash flow information:           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Cash paid for interest                                                          |                                                            | $                                                | 4,435       |                           |          | $         | 52,837      |            
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |             |             |           
|                                                             | Cash paid for taxes                                                             |                                                            | $                                                | 29,657      |                           |          | $         | 42,293      |            
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |             |             |           
|Supplemental disclosure of non-cash financing activities:   
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Equity securities issued for future services                                    |                                                            | $                                                | 380,938     |                           |          | $         | 453,256     |            
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |            
|                                                             | 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 services rendered                                       |                                                            | $                                                |            |                           |          | $         | 891,014     |            
|                                                             |                                                                                 |                                                            |                                                  |             |                           |          |           |             |             |           
|                                                             | 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 CORPORATIONNOTES 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 June 30, 2001 and
December 31, 2000 and the results of their operations and cash flows for
the three and six months ended June 30, 2001 and 2000. Results of operations
for the three and six months ended June 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 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.

Revenues

The Companys revenues are principally
derived from sales of its hardware and software products and from consulting
services. Revenue from 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
pursuant to binding purchase orders, or when returns can be reasonably
estimated.

Revenue recognition related to consulting
services is dependent on the terms and conditions of the Companys various
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 recorded on the basis of estimated percentage
of completion, based on the ratio of costs incurred over total estimated costs
to complete.

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

6



---



recognition, income statement presentation and financial disclosures. The
Company adopted SAB 101 during 2000. At June 30, 2001 and December 31,
2000, the Company has deferred $309,780 in revenue associated with shipments of
its hardware products pursuant to sales contracts which included provisions for
future upgrades of its products. The remaining $398,204 in deferred revenue at
June 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.

Comprehensive Income

The Company separately reports net loss and
other comprehensive income or loss pursuant to Statement of Financial
Accounting Standards (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 months and six months ended June 30, 2001,
comprehensive loss was $8,332,879 and $14,596,324, consisting of a net loss of
$8,453,995 and $14,390,584, and foreign currency translation gain of $121,116
and foreign currency translation loss of $205,740, respectively. For the three
and six months ended June 30, 2000, comprehensive loss was $6,012,383 and
$10,693,899, consisting of a net loss of $5,862,012 and $10,637,417 and foreign
currency translation loss of $150,371 and $56,482, respectively.

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.

7



---



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.
Management periodically assesses the need to provide for obsolescence of
inventory and tooling and adjusts the carrying values to their net realizable
value when required.

The Company has received shipments of inventory related to its current
product lines, the Mobile Assistant®
(MA®) V and
the MA TC. However, the majority of the Companys inventory at June 30,
2001 still consisted of the Companys prior product line, the MA IV. At June
30, 2001, management estimated the net realizable value of its assets related
to the MA IV product line and wrote-off $611,468 of inventory and the remaining
$329,496 of unamortized tooling costs. The Company reserved an additional
$439,110 against MA IV inventory, increasing the inventory reserve at June 30,
2001 to $1,767,513, net of the effects of currency fluctuation. In recording
these adjustments, the existing $250,000 tooling reserve was reversed,
resulting in a $1,149,020 charge, adjusted for the effects of currency
fluctuation, recorded during the three months ended June 30, 2001. While the
Companys management believes that it can sell the remaining MA IV inventory at
above its recorded cost, 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.

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.

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. These shares were sold at a
weighted average price of $1.95, representing an approximate 13% discount to
the closing bid price of the shares on the days preceding the finalization of
negotiations between the Company and the 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.

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 six months ended June 30, 2001 and
2000, the Company received gross proceeds of $52,285 and $1,298,752
respectively, and issued 33,738 and 535,334 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

8



---



measured. The Company recorded expenses associated with these services of
$398,625 and $361,842 during the three months ended June 30, 2001 and 2000,
respectively, and $479,425 and $891,014 during the six months ended June 30,
2001 and 2000, respectively. At June 30, 2001, an additional $380,938 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 six months ended June 30, 2001 and 2000, the Company
received gross proceeds of $1,818,406 and $7,582,475, respectively, and issued
731,471 and 1,947,700 shares, respectively, of its common stock related to
exercises of these warrants. At June 30, 2001, the Company had warrants
outstanding to purchase 4,899,893 shares of its common stock at prices that
range from $2.00 to $18.00 per share, with a weighted average of $4.68 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. 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. The Company repaid the
remaining $333,333 balance of the term loan and incurred $22,246 in interest
expense during the three months ended March 31, 2000.

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 incurred $0 and $6,702 in interest expense
during the three and six months ended June 30, 2001, respectively, associated
with the 2000 IBM Facility. The Company has received a proposal from IBM
Finance to obtain a revolving credit facility on more favorable terms and
conditions secured by the Companys inventory and accounts receivable balances,
but there can be no assurance that this facility will be finalized.

Preferred Stock

During the six months ended 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 June 30, 2001 and 2000.

9



---



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.

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

|                                             |  |                    |    |                  |  |      |    |      |  |  |    |   |  |  |    |  
|-------------------------------------------- |  | ------------------ | -- | ---------------- |  | ---- | -- | ---- |  |  | -- | - |  |  | -- | -
|                                             |  | Three Months Ended |    | Six Months Ended
|                                             |  | June 30,           |    | June 30,        
|                                             |  |                    |    |                 
|                                             |  | 2001               |    | 2000             |  | 2001 |    | 2000
|                                             |  |                    |    |                  |  |      |    |     
|North America, principally the United States |  |                    | 80 | %                |  |      | 78 | %    |  |  | 76 | % |  |  | 70 | %
|                                            
|                                            
|                                            
|                                            
|Europe, principally Germany                  |  |                    | 19 | %                |  |      | 16 | %    |  |  | 19 | % |  |  | 17 | %
|                                            
|                                            
|                                            
|                                            
|Asia, principally Japan                      |  |                    | 1  | %                |  |      | 6  | %    |  |  | 5  | % |  |  | 13 | %

Operations in various geographical areas are summarized as follows:

|                    |  |          |  |          |  |                    |            |                   |  |   |            |  |  |   |            |  |  |   |            | 
|------------------- |  | -------- |  | -------- |  | ------------------ | ---------- | ----------------- |  | - | ---------- |  |  | - | ---------- |  |  | - | ---------- | 
|                    |  |          |  |          |  | As of and for the  |            | As of and for the
|                    |  |          |  |          |  | Three Months Ended |            | Six Months Ended 
|                    |  | June 30, |  | June 30,
|                    |  |          |  |         
|                    |  | 2001     |  | 2000     |  | 2001               |            | 2000             
|                    |  |          |  |          |  |                    |            |                  
|North America:     
|                   
|                   
|                   
|                   
|Total revenue       |  |          |  |          |  | $                  | 1,606,758  |                   |  | $ | 2,275,156  |  |  | $ | 3,271,442  |  |  | $ | 3,500,124  | 
|                   
|                   
|                   
|                   
|Net loss            |  |          |  |          |  |                    | 6,239,706  |                   |  |   | 5,297,242  |  |  |   | 11,309,428 |  |  |   | 9,465,247  | 
|                   
|                   
|                   
|                   
|Identifiable assets |  |          |  |          |  |                    | 15,573,732 |                   |  |   | 13,332,845 |  |  |   | 15,573,732 |  |  |   | 13,332,845 | 
|                   
|                   
|                   
|                   
|Europe:            
|                   
|                   
|                   
|                   
|Total Revenue       |  |          |  |          |  | $                  | 390,525    |                   |  | $ | 484,141    |  |  | $ | 819,075    |  |  | $ | 859,504    | 
|                   
|                   
|                   
|                   
|Net loss            |  |          |  |          |  |                    | 1,003,661  |                   |  |   | 277,275    |  |  |   | 1,658,230  |  |  |   | 721,826    | 
|                   
|                   
|                   
|                   
|Identifiable assets |  |          |  |          |  |                    | 1,731,141  |                   |  |   | 996,773    |  |  |   | 1,731,141  |  |  |   | 996,773    | 
|                   
|                   
|                   
|                   
|Asia:              
|                   
|                   
|                   
|                   
|Total revenue       |  |          |  |          |  | $                  | 24,280     |                   |  | $ | 173,138    |  |  | $ | 206,268    |  |  | $ | 677,279    | 
|                   
|                   
|                   
|                   
|Net loss            |  |          |  |          |  |                    | 1,210,628  |                   |  |   | 287,495    |  |  |   | 1,422,926  |  |  |   | 450,344    | 
|                   
|                   
|                   
|                   
|Identifiable assets |  |          |  |          |  |                    | 667,095    |                   |  |   | 4,556,047  |  |  |   | 667,095    |  |  |   | 4,556,047  | 

10



---



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 for the three months and six months ended June 30, 2001 and 2000 are
as follows:

|                                     |  |                    |      |                   |  |      |      |      |  |  |      |   |  |  |      |  
|------------------------------------ |  | ------------------ | ---- | ----------------- |  | ---- | ---- | ---- |  |  | ---- | - |  |  | ---- | -
|                                     |  | As of and for the  |      | As of and for the
|                                     |  | Three Months Ended |      | Six Months Ended 
|                                     |  | June 30,           |      | June 30,         
|                                     |  |                    |      |                  
|                                     |  | 2001               |      | 2000              |  | 2001 |      | 2000
|                                     |  |                    |      |                   |  |      |      |     
|Revenue:                            
|                                    
|                                    
|                                    
|                                    
|Number of Customers                  |  |                    | 5    |                   |  |      | 1    |      |  |  | 3    |   |  |  | 1    |  
|                                    
|                                    
|                                    
|                                    
|Percent of Total Revenue             |  |                    | 86.6 | %                 |  |      | 32.0 | %    |  |  | 36.9 | % |  |  | 18.6 | %
|                                    
|                                    
|                                    
|                                    
|Accounts Receivable:                
|                                    
|                                    
|                                    
|                                    
|Number of Customers                  |  |                    | 1    |                   |  |      | 1    |      |  |  | 1    |   |  |  | 1    |  
|                                    
|                                    
|                                    
|                                    
|Percent of Total
Accounts Receivable |  |                    | 27.4 | %                 |  |      | 31.8 | %    |  |  | 27.4 | % |  |  | 31.8 | %

The Company has contracted with IBM to design, develop and manufacture the
computer and certain display components of its MA V product line. As of June
30, 2001, substantially all of the design and development of these products
were complete. Under the terms of the underlying agreements, Xybernaut pays IBM
for design and development work and retains ownership of the manufacturing
package including the tools, dies and other items needed for production.
Management believes that other partners could provide the remaining design,
development and manufacturing services on similar terms if required. However, a
delay in supply of the necessary parts and components, as a result of a change
in partner, could have a material adverse effect on the Companys results of
operations.

A customer of the Company provides marketing services to the Company. The
Company recorded revenues on sales of its hardware products to this customer of
$0 and $252,139 during the six months ended June 30, 2001 and 2000,
respectively. No revenues were recorded to this customer for the three months
ended June 30, 2001 or 2000. The Company recorded expenses related to the
marketing services performed by this customer of $71,250 and $124,455 during
the three months ended June 30, 2001 and 2000, respectively, and $142,500 and
$248,910 during the six months ended June 30, 2001 and 2000, respectively.
These services were paid through the issuance of the Companys equity
securities during 2000.

7. SUBSEQUENT EVENTS

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 finder.

11



---



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 latest 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® 3.11,
95, 98, 2000 and NT, as well as DOS, SCO UNIX® and
LINUX.

12



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A consumer wearable computer, the Web Internet Appliance (WIA), is
scheduled for availability in late 2001. Hitachi, Ltd. will manufacture and
sell the WIA under its brand and will also provide product to the Company, who
will sell and market it under the Xybernaut brand. The WIA provides users 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 WIA 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 WIA will run Microsoft Windows CE 3.0
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
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, and exhibitions at special events such as the annual International
Conference on Wearable Computing.

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

13



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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.

For the six months ended June 30, 2001, the
Companys operating activities used cash of $10,492,826, primarily as a result
of its net loss adjusted for non-cash charges and provisions, which is offset
by changes in working capital, and its investing activities used cash of
$1,638,536. These activities were funded through the Companys financing
activities which provided cash of $11,236,492, principally through the issuance
of common stock through private placements and the exercise of warrants, which
is offset by the repayment of a loan for $466,668. As a result, the Companys
cash balance decreased to $8,236,603 at June 30, 2001 from $9,273,632 at
December 31, 2000.

For the six months ended June 30, 2000, the
Companys operating activities used cash of $11,969,124, 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 $518,692. These activities were
funded through the Companys financing activities which provided cash of
$17,134,259, principally through the issuance of common stock through private
placements and the exercise of warrants and options and through borrowings. As
a result, the Companys cash balance increased to $6,723,260 at June 30, 2000
from $2,126,000 at December 31, 1999.

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

|                                               |                            |  |        |                             |       |                           |        |      |      |      |        |       |     |   |        |       |      |  
|---------------------------------------------- | -------------------------- |  | ------ | --------------------------- | ----- | ------------------------- | ------ | ---- | ---- | ---- | ------ | ----- | --- | - | ------ | ----- | ---- | -
|                                               |                            |  |        | Three Months Ended June 30, |       | Six Months Ended June 30,
|                                               |                            |  |        | 2001                        |       | 2000                      |        | 2001 |      | 2000
|                                               |                            |  |        |                             |       |                           |        |      |      |     
|Revenue                                        |                            |  | 100.0  | %                           |       |                           | 100.0  | %    |      |      | 100.0  | %     |     |   | 100.0  | %    
|                                              
|                                              
|                                              
|                                              
|Cost of sales                                  |                            |  | 70.8   | %                           |       |                           | 69.1   | %    |      |      | 73.0   | %     |     |   | 71.1   | %    
|                                              
|                                              
|                                              
|                                              
|Provision for inventory and tooling            |                            |  | 56.8   | %                           |       |                           | 0.0    | %    |      |      | 26.7   | %    
|                                               |                            |  |        |                             |       |                           |        |      |      |      |        |      
|                                               | Gross margin               |  |        |                             | (27.6 | %)                        |        |      | 30.9 | %    |        |       | 0.3 | % |        |       | 28.9 | %
|                                               |                            |  |        |                             |       |                           |        |      |      |      |        |       |     |   |        |      
|Operating expenses:                           
|                                              
|                                              
|                                              
|                                              
|                                               | Sales and marketing        |  |        | 205.6                       | %     |                           |        | 97.5 | %    |      |        | 168.9 | %   |   |        | 118.3 | %   
|                                              
|                                              
|                                              
|                                              
|                                               | General and administrative |  |        | 68.5                        | %     |                           |        | 47.7 | %    |      |        | 70.6  | %   |   |        | 56.3  | %   
|                                              
|                                              
|                                              
|                                              
|                                               | Research and development   |  |        | 120.7                       | %     |                           |        | 55.2 | %    |      |        | 99.7  | %   |   |        | 43.9  | %   
|                                              
|                                              
|                                              
|                                              
|                                               | Merger costs               |  |        | 0.0                         | %     |                           |        | 21.2 | %    |      |        | 0.0   | %   |   |        | 12.3  | %   
|                                               |                            |  |        |                             |       |                           |        |      |      |      |        |       |     |   |        |      
|Total operating expenses                       |                            |  | 394.8  | %                           |       |                           | 221.6  | %    |      |      | 339.2  | %     |     |   | 230.8  | %    
|                                               |                            |  |        |                             |       |                           |        |      |      |      |        |       |     |   |        |      
|Interest and other                             |                            |  | 4.2    | %                           |       |                           | (9.2   | %)   |      |      | 4.0    | %     |     |   | (9.3   | %)   
|                                               |                            |  |        |                             |       |                           |        |      |      |      |        |       |     |   |        |      
|Net loss                                       |                            |  | (418.2 | %)                          |       |                           | (199.9 | %)   |      |      | (334.9 | %)    |     |   | (211.2 | %)   
|                                               |                            |  |        |                             |       |                           |        |      |      |      |        |       |     |   |        |      
|Provisions for preferred stock                 |                            |  | 0.0    | %                           |       |                           | 0.1    | %    |      |      | 0.0    | %     |     |   | 0.2    | %    
|                                               |                            |  |        |                             |       |                           |        |      |      |      |        |       |     |   |        |      
|Net loss applicable to holders of common stock |                            |  | (418.2 | %)                          |       |                           | (200.0 | %)   |      |      | (334.9 | %)    |     |   | (211.4 | %)   
|                                               |                            |  |        |                             |       |                           |        |      |      |      |        |       |     |   |        |      

14



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THREE MONTHS ENDED JUNE 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 June 30, 2001 was $2,021,563
a decrease of $910,872 or 31%, compared to $2,932,435 for the quarter ended
June 30, 2000. Product revenue for the second
quarter of 2001 was $1,079,512, a decrease of $1,046,262 or 49%, compared to
$2,125,774 for the second quarter of 2000. The decrease in product revenue was
attributable to sales of the Companys hardware products, which totaled
$569,022 in the three months ended June 30, 2001, compared with $1,023,351 in
the three months ended June 30, 2000. This decrease resulted primarily from the
Companys emphasis on new and enhanced product lines, the MA V and MA TC,
which were introduced in the second quarter of 2001 and began shipping in the
third quarter of 2001. In several instances, customers have deferred purchases
until the new products are available. Additionally, the Companys current
product line, the MA IV, was sold at a larger discount in the second quarter of
2001 than in the comparable quarter in 2000 in anticipation of the new product
lines. The decrease in hardware revenue was accompanied by a decrease in
software revenue from the second quarter of 2000 to the second quarter of 2001.
The Company had a $925,000 sale of one of its software products in the second
quarter of 2000, for which a comparably sized order was not realized in the
same period in 2001. The Companys consulting, licensing and other revenue
during the second quarter of 2001 was $942,051, an increase of $135,390 or 17%,
from revenue of $806,661 in the second quarter of 2000. This increase was the
result of additional contract activity in the second quarter of 2001 compared
with the corresponding period in 2000.

COST OF SALES. The Companys cost of
sales includes the costs of components for the Mobile Assistant series,
purchased software, direct labor and related costs, amortization of tooling
costs, warranty reserves, and fulfillment and shipping costs. Total cost of
sales for the quarter ended June 30, 2001 was $2,578,641, an increase of
$552,716 or 27%, compared to $2,025,925 for the quarter ended June 30, 2000.
This increase resulted primarily from a provision for inventory and tooling
related to the MA IV product line and the increase in consulting services,
offset by a significant decrease in product cost of sales as a result of the
decrease in product sales. Overall gross margins for the second quarter of 2001
were negative 28% compared with positive 31% for 2000. Without the inventory
and tooling provision, the Companys 2001 gross margins were positive 29%. The
Companys gross margin from its product sales increased to 27% for the second
quarter of 2001 from 25% for the second quarter of 2000, resulting primarily
from high-margin software sales, offset by a decrease in hardware sale margins
as larger discounts were given to customers during the second quarter of 2001
in anticipation of upcoming new product launches. The Companys gross margin on
consulting, licensing, and other services decreased to 32% in 2001 from 45% in
2000, as the result of a number of factors, including the types of contracts in
progress, personnel costs such as salary and travel, and consulting costs.

SALES AND MARKETING EXPENSES. Sales and
marketing expenses for the quarter ended June 30, 2001 were $4,155,875, an
increase of $1,297,584 or 45%, from the comparable 2000 quarter. This increase
is a result of increased marketing activity and employee headcount related to
the introduction of the new product lines. Included in these amounts were
non-cash expenses of $233,913 and $168,009 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 were generally constant
between the second quarter of 2001 and 2000. This consistency 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 June 30,
2001 were $2,439,479, an increase of $819,724, or 51%, compared to $1,619,755
for the corresponding period in 2000. This is primarily the result of
expenditures in the second quarter of 2001 related to the final design and
development of the MA V and MA TC product lines. During the comparable
period

15



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of 2000, although product development costs related to the new products had
begun, substantial expenditures had not been made.

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. Interest and
other income for the quarter ended June 30, 2001 was $92,379, an increase of
$350,894, or 136%, compared to interest and other expense of $258,515 for the
corresponding period in 2000. This increase was primarily the result of
interest expense on loans and the amortization of note discount for the second
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
$8,839 for a tax provision for the three months ended June 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 June 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 quarter ended June 30, 2001, the amount of dividends
accrued was $0, a decrease of $2,308, 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 quarter ended June 30, 2001 was
$8,453,995, an increase of $2,589,675, or 44%, compared to $5,864,320 for the
corresponding period in 2000.

SIX MONTHS ENDED JUNE 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 six months ended June 30, 2001 was $4,296,785,
a decrease of $740,122 or 15%, compared to $5,036,907 for the six months ended
June 30, 2000. Product revenue for the first six months of 2001 was $2,437,663,
a decrease of $1,178,635 or 33%, compared to $3,616,298 for the first six
months of 2000. The decrease in product revenue was attributable to sales of
the Companys hardware and software products, which decreased $669,442 or 27%
and $518,111 or 47%, respectively. The decrease in hardware sales resulted
primarily from the Companys emphasis on new and enhanced product lines, the MA
V and MA TC, which were introduced in the second quarter of 2001 and began
shipping in the third quarter of 2001. Additionally, the Companys current
product line, the MA IV, was sold at a larger discount in the first six months
of 2001 than in the comparable period in 2000 in anticipation of the new
product lines. The decrease in software sales was the result of a $925,000 sale
of one of the Companys software products in the first six months of 2000. The
Companys consulting, licensing and other revenue during the first six months
of 2001 was $1,859,122, an increase of $447,431 or 32%, from revenue of
$1,411,691 in the first six months of 2000. This increase was the result of
additional contract activity in the first six months of 2001 compared with the
corresponding period in 2000.

COST OF SALES. The Companys cost of
sales includes the costs of components for the Mobile Assistant series,
purchased software, direct labor and related costs, amortization of tooling
costs, warranty reserves, and fulfillment and shipping costs. Total cost of
sales for the six months ended June 30, 2001 was $4,283,016, an

16



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increase of $700,563 or 20%, compared to $3,582,453 for the first six months
ended June 30, 2000. This increase resulted primarily from a provision for
inventory and tooling related to the MA IV product line and the increase in
consulting services provided, offset by a decrease in product cost of sales
corresponding to the decrease in such sales. Overall gross margins for the
first six months of 2001 and 2000 are 0% and 29%, respectively. Without the
inventory and tooling provision, the Companys 2001 gross margin was 27%. The
Companys gross margin from its product sales decreased to 22% for the first
six months of 2001 from 26% for the first six months of 2000, resulting
primarily from lower margins on hardware sales as larger discounts were given
to customers in anticipation of upcoming new product launches. The Companys
gross margin on consulting, license and other revenue remained consistent from
2000 to 2001.

SALES AND MARKETING EXPENSES. Sales and
marketing expenses for the six months ended June 30, 2001 were $7,256,249, an
increase of $1,297,054 or 22%, compared to the six months ended June 30, 2000
quarter. The majority of these costs related to the continued sales and
marketing efforts for the Companys hardware products. Included in these
amounts were non-cash expenses of $422,424 and $884,681 for outside marketing
services funded through the issuance of the Companys equity securities during
the 2001 and 2000 periods, respectively.

GENERAL AND ADMINISTRATIVE
EXPENSES. General and administrative expenses for the six months ended June
30, 2001 were $3,032,039, an increase of $196,544, or 7%, compared to
$2,835,495, 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 six months ended June
30, 2001 were $4,284,630, an increase of $2,075,047, or 94%, compared to
$2,209,583 for the corresponding period in 2000. This is primarily the result
of increased expenditures in the six months of 2001 related to the introduction
of the MA V and MA TC product lines. During the comparable period of 2000,
although development on the Companys next product lines had begun, significant
product development costs had not yet been incurred.

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 six months ended June 30, 2001 was $183,393, an increase of $612,742,
or 143%, compared to other expense of $429,349 for the corresponding period in
2000. This increase was primarily the result of interest expense on loans and
the amortization of note discount for the first six months of 2000 for which no
similar loan and notes were outstanding for the corresponding period in 2001.
The Companys primary source of other income relates to interest earned on the
Companys cash balances.

PROVISION FOR TAXES. The Company accrued
$14,828 for a tax provision for the six months ended June 30, 2001 related to
the operations of its foreign subsidiaries. The Companys U.S. operations had a
net loss for the six months ended June 30, 2001 and, therefore, no provision
for U.S. income taxes is required.

17



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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
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 June30, 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 six months ended June 30, 2001
was $14,390,584, an increase of $3,742,729, or 35%, compared to $10,647,855 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 $100,000,000
through its various financings from its inception through June 30, 2001. In
addition, as described further below, the Company raised an additional
$4,000,000 through a private placement in July 2001.

The Companys significant financing
activities for the six months ended June 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

18



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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. These shares were sold at a
weighted average price of $1.95, representing an approximate 13% discount to
the closing bid price of the shares on the days preceding the finalization of
negotiations between the Company and the 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.

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 six months ended June 30, 2001 and
the year ended December 31, 2000, the Company received gross proceeds of
$52,285 and $1,547,011, respectively, and issued 33,738 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
$479,425 and $1,312,630 during the six months ended June 30, 2001 and the year
ended December 31, 2000, respectively. At June 30, 2001, an additional
$380,938 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 six months ended June 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 June 30, 2001, the
Company had warrants outstanding to purchase 4,899,893 shares of its common
stock at prices that range from $2.00 to $18.00 per share, with a weighted
average of $4.68 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. The Company has received a proposal from IBM
Finance to obtain a revolving credit facility on more favorable terms and
conditions secured by the Companys inventory and accounts receivable balances,
but there can be no assurance that this facility will be finalized.

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.

At June 30, 2001, the Company had
commitments to purchase inventory, tooling and engineering services from its
suppliers and partners related to the MA V, MA TC, WIA and other product
lines. While the timing and amount of certain of these shipments and services
may be adjusted, the total amount scheduled to be paid between July and
December 2001 is estimated at approximately $8,000,000, of which
approximately

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$6,000,000 is committed to the purchase of inventory. Pursuant to these and
other formal and informal agreements, the Company has commitments of a similar
nature for 2002 and potentially beyond.

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 June 30, 2001, the Company had an
accumulated deficit of approximately $86,600,000. The achievement of
profitability is primarily dependent upon the continued development and
commercial acceptance of the Companys products, the successful management of
the business and managements ability to strategically focus the Company. There
can be no assurance as to whether or when profitable operations will occur. In
addition, the Company is experiencing negative cash flow from operations and it
is expected that it will continue to experience negative cash flows through
2001 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. In July 2001, the
Company raised $4,000,000 through a private placement of its common stock. 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 has received a proposal from IBM Finance
to obtain an expanded revolving credit facility based on the Companys
inventory and accounts receivable balances, 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

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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.

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 June 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 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 six months ended June 30, 2001, the Companys operations
in Europe comprised 19.3% and 19.1% of its total revenue and 11.9% and 11.5% of
its net loss compared to 16.5% and 17.1% of its total revenue and 4.7% and 6.8%
of its net loss in the same periods for 2000. For the three months and six
months ended June 30, 2001, the Companys operations in Asia comprised 1.2% and
4.8% of its total revenue and 14.3% and 9.9% of its net loss compared to 5.9%
and 13.4% of its total revenue and 4.9% and 4.2% of its net loss in the same
periods for 2000. At June 30, 2001, the Companys assets in Europe and Asia
comprised 9.6% and 3.7% of its total assets, compared to 5.3% and 24.1% of its
total assets at June 30, 2000. According to published sources, the average
fluctuation of the European Euro during the three and six months ended June 30
2001 was 1.3% and 4.7%; the average fluctuation of the German Deutsche Mark
during the same periods in 2000 was 7.4% and 4.5%. The average fluctuation of
the Japanese Yen during the three months and six months ended June 30, 2001 was
2.2% and 5.4% compared to 4.2% and 4.4% 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 six months ended, June
30, 2001 and 2000 or financial position at June 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

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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 two quarters of
fiscal year 2001 was 8.83% and 8.17%, respectively and the average prime
interest rate during the first two quarters of fiscal year 2000 was 8.67% and
8.92%, respectively, or a prime interest rate change compared to the rate at
the beginning of the fiscal year of 1.00% and 2.50% in 2001 and 0.25% and
1.00% 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 June 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 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 June 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. NEWMAN                                                                          
|                                                                                              
|By: 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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