##### 



SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549


FORM 10-Q

(MARK ONE)


| |  |  |                                                                                                                                                          
| |  |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------
| |  |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED
SEPTEMBER 30, 2002 OR             
|
| |  |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD
FROMTO
COMMISSION FILE NUMBER: 0-21013

XYBERNAUT CORPORATION

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)




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

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

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

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     NO

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE
PRECEDING FIVE YEARS:

Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. YES     NO

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practicable date.

|                                     |  |                                             
|------------------------------------ |  | --------------------------------------------
|Class
Common stock  $0.01 par value |  | Outstanding at November 11, 2002
112,938,254





---



##### 



INDEX

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





---



##### 



XYBERNAUT CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

|                                                 |                                                                                                                                      |                                            |         |               |            |              |           |              |            | 
|------------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------ | ------- | ------------- | ---------- | ------------ | --------- | ------------ | ---------- | 
|                                                 |                                                                                                                                      |                                            |         | September 30, |            | December 31,
|                                                 |                                                                                                                                      |                                            |         | 2002          |            | 2001        
|                                                 |                                                                                                                                      |                                            |         |               |            |             
|Current assets:                                  |                                                                                                                                      |                                            |         |               |            |              |           |             
|                                                
|                                                
|                                                
|                                                
|                                                 | Cash and cash equivalents                                                                                                            |                                            | $       | 627,139       |            |              | $         | 3,172,609    |           
|                                                
|                                                
|                                                
|                                                
|                                                 | Restricted cash                                                                                                                      |                                            |         | 500,000       |            |              |           | 500,000      |           
|                                                
|                                                
|                                                
|                                                
|                                                 | Accounts receivable, net of allowances of $273,748 and $213,434                                                                      |                                            |         | 3,040,416     |            |              |           | 3,283,828    |           
|                                                
|                                                
|                                                
|                                                
|                                                 | Inventory, net of reserves of $922,205 and $141,280                                                                                  |                                            |         | 3,390,454     |            |              |           | 4,621,019    |           
|                                                
|                                                
|                                                
|                                                
|                                                 | Prepaid and other current assets                                                                                                     |                                            |         | 1,032,567     |            |              |           | 815,619      |           
|                                                 |                                                                                                                                      |                                            |         |               |            |              |           |              |           
|                                                 |                                                                                                                                      | Total current assets                       |         |               | 8,590,576  |              |           |              | 12,393,075 | 
|                                                 |                                                                                                                                      |                                            |         |               |            |              |           |              |           
|Property, equipment and demonstration units, net |                                                                                                                                      |                                            | 818,494 |               |            |              | 1,083,411 |             
|                                                 |                                                                                                                                      |                                            |         |               |            |              |           |              |           
|Other assets:                                    |                                                                                                                                      |                                            |         |               |            |              |           |             
|                                                
|                                                
|                                                
|                                                
|                                                 | Patent costs, net of accumulated amortization of $1,443,773
and $1,115,910                                                           |                                            |         | 1,293,156     |            |              |           | 1,235,017    |           
|                                                
|                                                
|                                                
|                                                
|                                                 | Tooling costs, net of accumulated amortization of
$138,031 and $97,996, and reserves of $149,077 and $0                              |                                            |         | 956,065       |            |              |           | 1,108,869    |           
|                                                
|                                                
|                                                
|                                                
|                                                 | Other                                                                                                                                |                                            |         | 746,129       |            |              |           | 843,946      |           
|                                                 |                                                                                                                                      |                                            |         |               |            |              |           |              |           
|                                                 |                                                                                                                                      | Total other assets                         |         |               | 2,995,350  |              |           |              | 3,187,832  | 
|                                                 |                                                                                                                                      |                                            |         |               |            |              |           |              |           
|                                                 |                                                                                                                                      | Total assets                               |         | $             | 12,404,420 |              |           | $            | 16,664,318 | 
|                                                 |                                                                                                                                      |                                            |         |               |            |              |           |              |           
|Current liabilities:                             |                                                                                                                                      |                                            |         |               |            |              |           |             
|                                                
|                                                
|                                                
|                                                
|                                                 | Accounts payable                                                                                                                     |                                            | $       | 3,776,971     |            |              | $         | 4,303,078    |           
|                                                
|                                                
|                                                
|                                                
|                                                 | Accrued expenses and other                                                                                                           |                                            |         | 1,944,493     |            |              |           | 2,943,843    |           
|                                                
|                                                
|                                                
|                                                
|                                                 | Deferred revenue                                                                                                                     |                                            |         | 79,855        |            |              |           | 40,288       |           
|                                                
|                                                
|                                                
|                                                
|                                                 | Notes and loans payable                                                                                                              |                                            |         | 10,862        |            |              |           | 17,717       |           
|                                                 |                                                                                                                                      |                                            |         |               |            |              |           |              |           
|                                                 |                                                                                                                                      | Total current liabilities                  |         | $             | 5,812,181  |              |           | $            | 7,304,926  | 
|                                                 |                                                                                                                                      |                                            |         |               |            |              |           |              |           
|Commitments and contingencies                    |                                                                                                                                      |                                            |         |               |            |              |           |             
|                                                
|                                                
|                                                
|                                                
|Stockholders equity:                            |                                                                                                                                      |                                            |         |               |            |              |           |             
|                                                
|                                                
|                                                
|                                                
|                                                 | Note receivable from officer, net of reserves of $1,015,575 and $0                                                                   |                                            | $       | (57,500       | )          |              | $         | (1,026,708   | )         
|                                                
|                                                
|                                                
|                                                
|                                                 | Common stock, $0.01 par value, 200,000,000 and
80,000,000 shares authorized, 87,213,640 and 59,528,113
shares issued and outstanding |                                            |         | 872,136       |            |              |           | 595,281      |           
|                                                
|                                                
|                                                
|                                                
|                                                 | Additional paid-in capital                                                                                                           |                                            |         | 132,756,950   |            |              |           | 114,523,028  |           
|                                                
|                                                
|                                                
|                                                
|                                                 | Foreign currency translation                                                                                                         |                                            |         | 8,185         |            |              |           | (289,883     | )         
|                                                
|                                                
|                                                
|                                                
|                                                 | Accumulated deficit                                                                                                                  |                                            |         | (126,987,532  | )          |              |           | (104,442,326 | )         
|                                                 |                                                                                                                                      |                                            |         |               |            |              |           |              |           
|                                                 |                                                                                                                                      | Total stockholders equity                 |         | $             | 6,592,239  |              |           | $            | 9,359,392  | 
|                                                 |                                                                                                                                      |                                            |         |               |            |              |           |              |           
|                                                 |                                                                                                                                      | Total liabilities and stockholders equity |         | $             | 12,404,420 |              |           | $            | 16,664,318 | 
|                                                 |                                                                                                                                      |                                            |         |               |            |              |           |              |           

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





---



##### 



XYBERNAUT CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |            |             |  
|----------------------------------- | ------------------------------------------ | ----------------------------------------------------------------- | --------- | -------------------------------- | ---------- | ------------------------------- | --------- | --------- | ---------- | ---- | --------- | ---------- | ----------- | - | --------- | ---------- | ----------- | -
|                                    |                                            |                                                                   |           | Three Months Ended September 30, |            | Nine Months Ended September 30,
|                                    |                                            |                                                                   |           |                                  |            |                                
|                                    |                                            |                                                                   |           | 2002                             |            | 2001                            |           | 2002      |            | 2001
|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |     
|Revenue:                            |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |           
|                                   
|                                   
|                                   
|                                   
|                                    | Hardware                                   |                                                                   | $         | 1,553,019                        |            |                                 | $         | 1,370,559 |            |      | $         | 4,471,634  |             |   | $         | 3,221,127  |            
|                                   
|                                   
|                                   
|                                   
|                                    | Software                                   |                                                                   |           |                                 |            |                                 |           | 28,212    |            |      |           |           |             |   |           | 615,307    |            
|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |            |            
|Total product                       |                                            |                                                                   | 1,553,019 |                                  |            |                                 | 1,398,771 |           |            |      | 4,471,634 |            |             |   | 3,836,434 |           
|                                   
|                                   
|                                   
|                                   
|Consulting, licensing and other     |                                            |                                                                   | 992,308   |                                  |            |                                 | 917,642   |           |            |      | 2,897,077 |            |             |   | 2,776,764 |           
|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |            |            
|                                    |                                            | Total revenue                                                     |           |                                  | 2,545,327  |                                 |           |           | 2,316,413  |      |           |            | 7,368,711   |   |           |            | 6,613,198   |  
|                                   
|                                   
|                                   
|                                   
|Cost of sales:                      |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |           
|                                   
|                                   
|                                   
|                                   
|                                    | Hardware                                   |                                                                   |           | 1,368,415                        |            |                                 |           | 935,931   |            |      |           | 3,839,681  |             |   |           | 2,498,680  |            
|                                   
|                                   
|                                   
|                                   
|                                    | Software                                   |                                                                   |           |                                 |            |                                 |           | 3,037     |            |      |           |            |             |   |           | 345,700    |            
|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |            |            
|Total product                       |                                            |                                                                   | 1,368,415 |                                  |            |                                 | 938,968   |           |            |      | 3,839,681 |            |             |   | 2,844,380 |           
|                                   
|                                   
|                                   
|                                   
|Consulting, licensing and other     |                                            |                                                                   | 610,976   |                                  |            |                                 | 598,163   |           |            |      | 1,839,500 |            |             |   | 1,826,747 |           
|                                   
|                                   
|                                   
|                                   
|Provision for inventory and tooling |                                            |                                                                   | 359,217   |                                  |            |                                 |          |           |            |      | 413,175   |            |             |   | 1,149,020 |           
|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |            |            
|                                    |                                            | Gross income                                                      |           |                                  | 206,719    |                                 |           |           | 779,282    |      |           |            | 1,276,355   |   |           |            | 793,051     |  
|                                   
|                                   
|                                   
|                                   
|Operating expenses:                 |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |           
|                                   
|                                   
|                                   
|                                   
|                                    | Sales and marketing                        |                                                                   |           | 3,749,623                        |            |                                 |           | 4,721,158 |            |      |           | 12,641,816 |             |   |           | 11,769,041 |            
|                                   
|                                   
|                                   
|                                   
|                                    | General and administrative                 |                                                                   |           | 1,373,240                        |            |                                 |           | 1,757,036 |            |      |           | 4,649,702  |             |   |           | 5,136,352  |            
|                                   
|                                   
|                                   
|                                   
|                                    | Research and development                   |                                                                   |           | 1,602,275                        |            |                                 |           | 2,438,846 |            |      |           | 5,126,413  |             |   |           | 6,584,565  |            
|                                   
|                                   
|                                   
|                                   
|                                    | Provision for note receivable from officer |                                                                   |           | 1,015,575                        |            |                                 |           |          |            |      |           | 1,015,575  |             |   |           |           |            
|                                   
|                                   
|                                   
|                                   
|                                    | Restructuring charges                      |                                                                   |           | 361,227                          |            |                                 |           |          |            |      |           | 516,461    |             |   |           |           |            
|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |            |            
|                                    |                                            | Total operating expenses                                          |           |                                  | 8,101,940  |                                 |           |           | 8,917,040  |      |           |            | 23,949,967  |   |           |            | 23,489,958  |  
|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |            |            
|                                    |                                            | Operating loss                                                    |           |                                  | (7,895,221 | )                               |           |           | (8,137,758 | )    |           |            | (22,673,612 | ) |           |            | (22,696,907 | )
|                                   
|                                   
|                                   
|                                   
|Interest and other income, net      |                                            |                                                                   | 24,581    |                                  |            |                                 | 70,329    |           |            |      | 135,786   |            |             |   | 253,722   |           
|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |            |            
|                                    |                                            | Loss before provision for income taxes                            |           |                                  | (7,870,640 | )                               |           |           | (8,067,429 | )    |           |            | (22,537,826 | ) |           |            | (22,443,185 | )
|                                   
|                                   
|                                   
|                                   
|Provision for income taxes          |                                            |                                                                   | 2,775     |                                  |            |                                 | 5,807     |           |            |      | 7,380     |            |             |   | 20,635    |           
|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |            |            
|                                   
|                                   
|                                   
|                                   
|                                    |                                            | Net loss                                                          |           | $                                | (7,873,415 | )                               |           | $         | (8,073,236 | )    |           | $          | (22,545,206 | ) |           | $          | (22,463,820 | )
|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |            |            
|                                    |                                            | Net loss per share (basic and diluted)                            |           | $                                | (0.10      | )                               |           | $         | (0.15      | )    |           | $          | (0.33       | ) |           | $          | (0.46       | )
|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |            |            
|                                    |                                            | Weighted average number of shares
outstanding (basic and diluted) |           |                                  | 78,011,017 |                                 |           |           | 52,309,601 |      |           |            | 68,397,202  |   |           |            | 49,114,344  |  
|                                    |                                            |                                                                   |           |                                  |            |                                 |           |           |            |      |           |            |             |   |           |            |            

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





---



##### 



XYBERNAUT CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
(UNAUDITED)

|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |            |             |           |  
|------------------------------------------------------------ | --------------------------------------------------------------------------- | ---------------------------------------------------------- | -------------------------------------------------------------------------------------- | -------------------------------- | -------- | ------------------------------- | ---------- | ----------- | ---------- | ----------- | --------- | -
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          | Nine Months Ended September 30,
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          | 2002                            |            | 2001       
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|Cash flows from operating activities:                        |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Net loss                                                                    |                                                            | $                                                                                      | (22,545,206                      | )        |                                 | $          | (22,463,820 | )         
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Adjustments to reconcile net loss to net cash used in
operating activities: |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Depreciation and amortization                                                          |                                  |          | 1,383,183                       |            |             |            | 1,069,330   |          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Provision for inventory and tooling                                                    |                                  |          | 413,175                         |            |             |            | 1,149,020   |          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Provision for note receivable from officer                                             |                                  |          | 1,015,575                       |            |             |            |            |          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Non-cash restructuring charges                                                         |                                  |          | 335,567                         |            |             |            |            |          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Non-cash charges for equity securities issued for services                             |                                  |          | 1,665,704                       |            |             |            | 542,916     |          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Changes in assets and liabilities:                                                     |                                  |          |                                 |            |             |            |             |          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            |                                                                                        | Inventory                        |          |                                 | 849,296    |             |            |             | 71,554    |  
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            |                                                                                        | Accounts receivable              |          |                                 | 362,758    |             |            |             | 216,316   |  
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            |                                                                                        | Prepaid and other current assets |          |                                 | (188,146   | )           |            |             | (651,659  | )
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            |                                                                                        | Other assets                     |          |                                 | (57,450    | )           |            |             | 76,732    |  
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            |                                                                                        | Accounts payable                 |          |                                 | (649,490   | )           |            |             | 1,984,567 |  
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            |                                                                                        | Accrued expenses and other       |          |                                 | (127,730   | )           |            |             | 24,461    |  
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            |                                                                                        | Restructuring liability          |          |                                 | 222,270    |             |            |             |          |  
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            |                                                                                        | Deferred revenue                 |          |                                 | 39,567     |             |            |             | (38,488   | )
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|                                                             |                                                                             |                                                            | Net cash used in operating activities                                                  |                                  | $        | (17,280,927                     | )          |             | $          | (18,019,071 | )        
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|Cash flows from investing activities:                        |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             | Note receivable from officers, net                         |                                                                                        |                                  | (24,145  | )                               |            |             | (15,976    | )          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             | Acquisition of property, equipment and demonstration
units |                                                                                        |                                  | (666,592 | )                               |            |             | (812,924   | )          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             | Acquisition of patents and trademarks                      |                                                                                        |                                  | (425,844 | )                               |            |             | (537,240   | )          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             | Decrease in restricted cash                                |                                                                                        |                                  |         |                                 |            |             | (84,343    | )          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             | Capitalization of tooling costs                            |                                                                                        |                                  |         |                                 |            |             | (1,175,653 | )          
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|                                                             |                                                                             |                                                            | Net cash used in investing activities                                                  |                                  | $        | (1,116,581                      | )          |             | $          | (2,626,136  | )        
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|Cash flows from financing activities:                        |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Proceeds from:                                                              |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Common stock offerings, net                                                            |                                  |          | 14,192,440                      |            |             |            | 13,714,939  |          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Exercise of warrants and stock options                                                 |                                  |          | 1,701,820                       |            |             |            | 1,948,691   |          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Notes and loans                                                                        |                                  |          | 250,000                         |            |             |            |            |          
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             | Payments for:                                                               |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Notes and loans                                                                        |                                  |          |                                |            |             |            | (466,668    | )        
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Capitalization of loan costs                                                           |                                  |          | (10,375                         | )          |             |            | (10,000     | )        
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|                                                             |                                                                             |                                                            | Net cash provided by financing activities                                              |                                  | $        | 16,133,885                      |            |             | $          | 15,186,962  |          
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|Effect of exchange rate changes on cash and cash equivalents |                                                                             |                                                            | (281,847                                                                               | )                                |          |                                 | (431,920   | )          
|                                                            
|                                                            
|                                                            
|                                                            
|Net decrease in cash and cash equivalents                    |                                                                             |                                                            | (2,545,470                                                                             | )                                |          |                                 | (5,890,165 | )          
|                                                            
|                                                            
|                                                            
|                                                            
|Cash and cash equivalents, beginning of period               |                                                                             |                                                            | 3,172,609                                                                              |                                  |          |                                 | 8,848,715  |            
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|                                                            
|                                                            
|                                                            
|                                                            
|Cash and cash equivalents, end of period                     |                                                                             | $                                                          | 627,139                                                                                |                                  |          | $                               | 2,958,550  |            
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|Supplemental disclosure of cash flow information:            |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Cash paid for interest                                                                 |                                  | $        | 1,966                           |            |             | $          | 5,340       |          
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|                                                             |                                                                             |                                                            | Cash paid for taxes                                                                    |                                  | $        | 22,011                          |            |             | $          | 51,298      |          
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|Supplemental disclosure of non-cash financing activities:    |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |            
|                                                            
|                                                            
|                                                            
|                                                            
|                                                             |                                                                             |                                                            | Equity securities issued for future services, recorded
as prepaid expenses when issued |                                  | $        | 1,919,498                       |            |             | $          | 507,917     |          
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|                                                             |                                                                             |                                                            | Equity securities issued for services rendered, expensed
in periods issued             |                                  | $        | 159,587                         |            |             | $          | 129,549     |          
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|                                                             |                                                                             |                                                            | Equity securities issued for settlement of
accounts payable and accrued expenses       |                                  | $        | 287,431                         |            |             | $          |            |          
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           
|                                                             |                                                                             |                                                            | Equity securities issued for settlement of
notes payable                               |                                  | $        | 250,000                         |            |             | $          |            |          
|                                                             |                                                                             |                                                            |                                                                                        |                                  |          |                                 |            |             |           

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





---



##### 



XYBERNAUT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The accompanying unaudited, condensed and consolidated financial statements of
Xybernaut Corporation (the Company) have been prepared in accordance with
accounting principles generally accepted in the United States of America (U.S.
GAAP) for interim financial information and instructions to Form 10-Q and Rule
10-01 of Regulation S-X. Accordingly, these statements do not include all of
the information and footnotes required by U.S. GAAP for complete financial
statements. In the opinion of Company management, these unaudited, condensed
and consolidated financial statements reflect all adjustments of a normal,
recurring nature necessary to present fairly the financial position of the
Company and its subsidiaries at September 30, 2002 and December 31, 2001, and
the results of their operations and cash flows for the three and nine months
ended September 30, 2002 and 2001. Results of operations for the three and nine
months ended September 30, 2002 are not necessarily indicative of results of
operations expected for the full fiscal year ending December 31, 2002. Please
refer to the Companys Annual Report on Form 10-K for the complete financial
statements.

2. THE COMPANY

The Company, a Delaware corporation, was formed in 1990 and completed its
initial public offering in 1996. The Company is engaged in the research,
development, commercialization and production of mobile, wearable computing and
communication systems, along with software and service solutions designed to
enhance productivity, improve product management, asset management and the
accuracy, timeliness and utilization of captured data. The Company offers
solutions with a software and services focus through its wholly-owned
subsidiary Xybernaut Solutions, Inc. (U.S.). The Company offers solutions with
a hardware focus through its U.S. operations and through its wholly-owned
subsidiaries Xybernaut K.K. (Japan) and Xybernaut GmbH (Germany).

The Mobile Assistant® (MA®) series is the Companys primary wearable computer
hardware product line, the current versions of which are the Mobile Assistant V
(MA V) and MA TC. The Company also developed, markets and sells the poma, a
wearable computer targeted at the light-commercial and near-consumer markets,
and the Atigo, a wireless web panel that can be used either as a stand-alone
handheld PC or as a display for an MA system, a laptop or a conventional PC.

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS

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

RESTRICTED CASH

The Companys restricted cash balance represents a cash deposit that secures a
long-term services contract.

INVENTORY

At September 30, 2002, inventory consisted primarily of wearable computer
component parts held for resale and allocated tooling costs, and is comprised
primarily of finished goods. Inventory is stated at the lower of cost or
market, with cost being determined on a first-in, first-out basis. Management
periodically assesses the need to provide for obsolescence of inventory and
adjusts the carrying value of inventory to its net realizable value when
required.

During the three months ended September 30, 2002, inventory and tooling
reserves of $841,696 and $149,077, respectively, were recorded to provide for
an estimated general decline in value of the Companys inventory. This reserve
was offset by a $631,556 reversal of poma reserve discussed below. During the
three months ended June 30, 2002, an inventory reserve of $53,958 was recorded
related to a small number of early-production models of the MA V product line
with limited hard disk capacity received by the Company. At December 31, 2001,
an inventory reserve of $141,280 was established for hard disk drives that were
purchased for the MA V product line but later replaced with higher-capacity
hard disk drives. During the first quarter of 2002, all of the hard drives were
sold in bulk at an amount approximating their net carrying value and the
reserve of $141,280 at December 31, 2001 related to these hard drives has been
fully utilized.

During the fourth quarter of 2001, a charge of $885,019 was recorded to reflect
managements estimate of losses to be incurred on the total initial production
run of the pomaproduct line. The Company elected to sell the pomasystems at
prices that are less than their initial production costs to favorably position
the pomain the price-sensitive light-commercial and near-consumer markets.
Although the pomainventory had not been





---



##### 



received by the Company as of December
31, 2001, the Company recorded the expected losses during 2001, which was
the period in which the underlying contracts were entered into. Because the
inventory had not been received by the Company as of December 31, 2001, and was
therefore not recorded as an asset, this charge was recorded as an accrued
liability, which was being reclassified to an inventory reserve as poma
inventory shipments were received during 2002. As of September 30, 2002,
$26,551 was recorded as a specific pomainventory reserve. Subsequent to
September 30, 2002, the Company entered into an agreement with the manufacturer
of the pomathrough which the Company was relieved of its obligation to
purchase additional pomaunits. Pursuant to the terms of this agreement, the
Company is required to make a payment of $80,000 during the fourth quarter of
2002 and to reduce certain of the royalty rates that are used to calculate the
licensing fees that the Company receives from the manufacturer for its sales of
the pomaor other wearable computer products. Effective September 30, 2002,
the remaining accrued liability balance, net of the $80,000 payment, was
reversed, resulting in a $631,556 reduction to the provision for inventory and
tooling charge recorded in the third quarter of 2002.

As of September 30, 2002, net of the effects of specific reserves and
write-offs, the value of the systems and components for each of the Companys
primary product lines was $1,509,312 for the MA V, $1,472,932 for the MA TC,
$348,750 for the MA IV, $28,749 for the pomaand $30,711 for the Atigo. As of
September 30, 2002, a $53,958 MA V inventory reserve, a $26,551 pomainventory
reserve and a general inventory reserve of $841,696 was recorded.

ISSUANCE OF EQUITY SECURITIES FOR SERVICES

The Company periodically issues equity securities, primarily shares of common
stock and warrants to purchase common stock, to vendors and consultants in
return for goods or services. These transactions are recorded at either the
fair value of the securities issued or at the fair value of goods received or
services performed, whichever is more reliably determined.

RESTRUCTURING

The Company recorded restructuring charges in accordance with Emerging Issues
Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (including Certain
Costs Incurred in a Restructuring), and Staff Accounting Bulleting (SAB) No.
100, Restructuring and Impairment Charges. During April 2002, management
adopted a restructuring plan which established the plan of termination, the
benefits available to terminated employees and communicated these benefits to
the terminated employees. The employee severance costs and outplacement
services according to this plan were recorded as restructuring charges of
$155,234 during the second quarter of 2002. During the third quarter of 2002,
management established and implemented additional termination plans and
communicated the benefits to the terminated employees. The employee severance
costs and outplacement services according to these plans were recorded as
restructuring charges of $137,922 during the third quarter of 2002. In
addition a plan was implemented to reduce office space by moving employees of a
subsidiary of the Company to headquarters and preparing the subsidiarys
building for sublease. The present value of the future cash flows of the
office space rent for the life of the contract less an estimate that the
building can be subleased at 50% rent for a total $223,305 was recorded as
restructuring charges in the third quarter. Of these charges $404,199 was or
will be paid in cash and $112,262 was paid by the issuance of equity securities
during the second and third quarters of 2002. At September 30, 2002, the
remaining unpaid balance of $222,270 is included in accrued expenses.
Management expects to establish and implement additional restructuring plans
during the fourth quarter of 2002 and also possibly into 2003.

RECLASSIFICATIONS

Certain 2001 balances and disclosures have been reclassified to conform to 2002
presentation.

4. LIQUIDITY AND OPERATIONS

The Company has recorded net losses since its inception, including during the
periods presented in this Form 10-Q. These losses are primarily attributable to
the operating expenses incurred by the Company to design, develop, sell and
market its wearable computer products and to provide general and administrative
support for these activities. During these periods, the Companys revenues and
gross margins have not been sufficient to fund these operating activities. As a
result, the Company has consistently recorded negative cash flows from
operating activities and net losses and had an accumulated deficit of
$126,987,532 at September 30, 2002.

The combination of the Companys operating losses and its working capital
requirements has severely impacted the Companys financial position and
liquidity. At September 30, 2002, the Company had unrestricted cash on hand of
$627,139 and accounts payable, accrued expenses and short term notes totaling
$5,732,326. During 2002, 2001 and 2000, the Company funded its operating and
investing activities through its financing activities, which consist primarily
of private placements of common stock, warrant and stock option exercises and
borrowings.

During 2002, management has taken steps that it believes are necessary to
improve the Companys operations and raise additional capital, both of which
are needed to enhance its ability to meet its cash flow needs through December
31, 2002 and thereafter.

During the period from March through November 2002, the Company has performed
ongoing reviews of its operations and has developed a program to significantly
reduce the Companys operating expenses. The Company began implementation of
these cost cutting programs in April 2002 and has continued to execute these
reductions through the date of this filing.





---



##### 



Assuming there are no significant changes to the Companys business plan,
management has targeted savings of approximately 50% from
annualized fourth quarter 2001 levels once these steps are fully implemented.
Managements target is to reach an operating expense level of approximately
$5,000,000 per quarter, beginning with the fourth quarter of 2002. Future
significant fluctuations may still occur as a result of the Companys research
and development activities, which will vary depending on the Companys wearable
computer product development cycle during any given period. As indicated in
the chart below, through the third quarter of 2002, the Company has reduced its
net operating expenses by 41% from annualized fourth quarter 2001 levels.

|                       |  |               |            |                   |  |               |     |   |  |  |     |  
|---------------------- |  | ------------- | ---------- | ----------------- |  | ------------- | --- | - |  |  | --- | -
|                       |  | Operating     |            | % Change from     |  |               |     |  
|                       |  | Expenses, Net |            | Fourth Quarter of |  | % Change from
|                       |  | (1)           |            | 2001              |  | Prior Quarter
|Fourth Quarter of 2001 |  | $             | 10,114,109 |                   |  |               |    |   |  |  |    |  
|                      
|                      
|                      
|                      
|First Quarter of 2002  |  | $             | 8,745,553  |                   |  |               | -14 | % |  |  | -14 | %
|                      
|                      
|                      
|                      
|Second Quarter of 2002 |  | $             | 6,947,240  |                   |  |               | -31 | % |  |  | -21 | %
|                      
|                      
|                      
|                      
|Third Quarter of 2002  |  | $             | 5,995,627  |                   |  |               | -41 | % |  |  | -14 | %



| |  |  | (1) Operating Expenses, Net represents total operating expenses as
adjusted for restructuring charges recorded in accordance with U.S. GAAP
and certain other non-recurring transactions that do not meet the criteria
for recordation as restructuring charges. The operating expense balances
for the fourth quarter of 2001 and the first quarter of 2002 presented
herein are unadjusted. The balance for the second quarter of 2002
represents total operating expenses less: $155,234 in restructuring
charges. The balance for the third quarter of 2002 represents total
operating expenses less: $361,227 in restructuring charges; a $729,511
non-cash charge recorded as a sales and marketing expense related to the
cancellation of an agreement for marketing services and certain retail
space at the Waldorf Astoria Hotel in New York City; and a $1,015,575
charge for a reserve recorded against a note receivable due from an
executive officer of the Company.
| |  |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The key cash saving initiatives that have been, and will continue to be,
implemented are listed below:



| |  | Worldwide headcount will have been reduced by 45% from approximately 145 full-time employees to
approximately 80 full-time employees.                                                                                                                                                         
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | The Companys worldwide engineering and product functions have been consolidated.                                                                                                                                                                                                             
| 
| |  | Operations in Asia were significantly reduced, especially related to direct sales, marketing
and product efforts. Future Asian operations will focus primarily on channel sales, potential
business combinations and business development.                                                    
| 
| |  | Operations in Europe were significantly reduced, especially related to direct sales and
marketing efforts. Future European operations will focus primarily on channel sales, sales and
marketing relationships with strategic partners, business development and research and
development.    
| 
| |  | Participation in trade shows has been reduced.                                                                                                                                                                                                                                                
| 
| |  | An agreement was reached with the manufacturer of the pomaproduct line through which the
Company eliminated its obligation to purchase additional systems.                                                                                                                                    
| 
| |  | An agreement with a vendor to provide the Company with marketing services and certain retail
space at the Waldorf Astoria Hotel in New York City was canceled.                                                                                                                                
| 
| |  | [Insert discussion of patent portfolio reduction]                                                                                                                                                                                                                                             
| 
| |  | Agreements with certain consultants, vendors and partners have been, and will continue to be,
cancelled or renegotiated in order to minimize cash expenditures through the issuance of the
Companys equity securities, the renegotiation of terms and a reduction or elimination of
services.
| 
| |  | Other various reductions in discretionary costs have been, and will continue to be, implemented.                                                                                                                                                                                              

Subsequent to these changes, management believes that the Companys staffing
and resources will be sufficient to carry out its business plan for the
foreseeable future.

In addition to the cost cutting initiatives detailed above, management
continues to review all aspects of the Companys operations and may take
additional actions to reduce operating expenses further.

Even when the above cost cutting initiatives are fully implemented, the Company
will still be required to obtain outside financing to supplement the Companys
cash position. Potential sources of additional financing include private equity
offerings, strategic investments and various forms of debt financing. Due in
large part to the Companys current stock price and the depressed general
capital markets, the equity financings that the Company has completed in recent
quarters have been of a smaller size when compared to those transacted in
previous periods. The Companys management believes that the combination of
cash on hand, cash flows from operations and outside funding will provide
sufficient liquidity to meet the Companys ongoing cash requirements. This is
based both on the Companys historical ability to raise capital and on debt and
equity financings currently available to the Company. However, there can be no
assurance that the Company can or will obtain sufficient funds from operations
or from additional financings on terms acceptable to the Company.

During the nine months ended September 2002, the Company raised $16,144,260 in
cash through sales of its common stock to institutional investors, through
warrant and stock option exercises and through borrowings that were repaid
through the issuance of common stock.

Subsequent to September 30, 2002, the Company raised approximately $5,250,000
in additional funds through warrant exercises and sales of its common stock to
institutional investors.





---



##### 



5. BORROWINGS

In December 2001, the Company entered into a revolving credit facility with IBM
Global Finance (the IBM Revolver). The IBM Revolver provides for up to
$3,000,000 in borrowings based on the Companys base of eligible U.S.
receivables and inventory. Interest on the facility accrues at the prime rate
plus 2.0% per annum. The borrowing is secured by the Companys U.S. assets,
excluding patents and intellectual property. The IBM Revolver includes
customary financial covenants and other restrictions, including the requirement
that the Company obtain a $1,000,000 irrevocable letter of credit (the Letter
of Credit) to secure this facility. The Company believes that it will have to
post cash collateral in an equal amount to obtain the Letter of Credit. At
September 30, 2002, the Company had not made any borrowings under the IBM
Revolver and the Company does not anticipate drawing down on the IBM Revolver
during 2002.

During June 2002, the Company received $250,000 in cash from an investor that
was recorded by the Company as a note payable. This note bears interest at 6.0%
per annum and is due on or before September 30, 2003. At the Companys option,
this note can be repaid through a cash payment, the issuance of 500,000 shares
of common stock or the cashless exercise of 500,000 of the investors existing
warrants at a reduced price of $0.50 per share. [Insert language related to
repayment through stock]

6. STOCKHOLDERS EQUITY

During August 2002, the Company received gross proceeds of $2,000,000 through a
private placement of 5,714,286 shares of its common stock to certain investors.
The shares were sold at $0.35 per share, representing an approximate 11%
discount to the closing price of the shares for the 20 trading days immediately
preceding the closing. In connection with this private placement, the Company
issued to the investors callable warrants to purchase 5,714,286 shares of
common stock at an exercise price of $0.70 per share and callable warrants to
purchase 5,714,286 shares of common stock at an exercise price of $1.50 per
share.

The Company has issued equity securities to certain employees, consultants and
companies for services provided to, or goods received, by the Company. These
securities include shares of common stock and warrants and options to purchase
shares of common stock. These transactions were individually valued based upon
the fair value of the securities issued or the services or goods provided,
whichever was more reliably measured. For the nine months ended September 30,
2002, the Company recorded expenses related to the issuance of equity
securities for services rendered of $159,587, recorded $287,431 related to the
settlement of accounts payable and accrued liabilities, $250,000 related to the
settlement of notes payable and recorded prepaid assets for future services or
goods to be provided of $1,919,498. Of these prepaid expenses, $729,511 was
written off due to the Companys various cost cutting initiatives. The
remaining prepaid expenses have been, or will continue to be amortized into
operating expenses or inventory during 2002 and 2003 pursuant to the terms of
the underlying agreements. For the nine months ended September 30, 2001, the
Company recorded expenses for services rendered of $129,549 and recorded
prepaid assets for future services to be provided of $507,917. These prepaid
expenses were and will continue to be amortized into operating expenses during
2001 and 2002 over the remaining lives of the underlying agreements. The
Company recorded total expenses associated with these services, including
expenses resulting from equity securities issued in both the current and prior
periods, of $406,782 and $112,240 for the three months ended September 30, 2002
and 2001, respectively, and $1,048,455 and $591,665 for the nine months ended
September 30, 2002 and 2001, respectively. Included in prepaid and other
assets at September 30, 2002 and December 31, 2001 are equity securities issued
for payment of future services of $215,048 and $253,958, respectively.

The Company issues warrants to purchase shares of its common stock, primarily
in connection with the Companys financings and borrowings. During the nine
months ended September 30, 2002, the Company received gross proceeds of
$1,698,773 and issued 7,579,198 shares of its common stock through the exercise
of certain of these warrants. To induce certain of the investors to exercise
warrants, the Company reduced the exercise price of 6,034,837 of these warrants
from a weighted average price of $1.48 per share to $0.15 per share. At
September 30, 2002, the Company had warrants outstanding to purchase 14,109,465
shares of its common stock at prices that range from $0.70 to $18.00 per share,
with a weighted average of $2.12 per share.

7. SEGMENT AND ENTERPRISE WIDE REPORTING

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

Revenues by geographical destination as a percentage of total revenues for the
three and nine months ended September 30, 2002 and 2001 are as follows:





---



##### 



|                            |  |                    |    |                   |  |      |    |      |  |  |    |   |  |  |    |  
|--------------------------- |  | ------------------ | -- | ----------------- |  | ---- | -- | ---- |  |  | -- | - |  |  | -- | -
|                            |  | Three Months Ended |    | Nine Months Ended
|                            |  | September 30,      |    | September 30,    
|                            |  |                    |    |                  
|                            |  | 2002               |    | 2001              |  | 2002 |    | 2001
|                            |  |                    |    |                   |  |      |    |     
|United States               |  |                    | 87 | %                 |  |      | 70 | %    |  |  | 82 | % |  |  | 74 | %
|                           
|                           
|                           
|                           
|Europe, principally Germany |  |                    | 11 | %                 |  |      | 26 | %    |  |  | 14 | % |  |  | 22 | %
|                           
|                           
|                           
|                           
|Asia, principally Japan     |  |                    | 2  | %                 |  |      | 4  | %    |  |  | 4  | % |  |  | 4  | %

Operations in various geographical areas are summarized as follows:

|               |                     |  |                    |           |                   |  |      |            |      |  |   |            |  |  |   |            | 
|-------------- | ------------------- |  | ------------------ | --------- | ----------------- |  | ---- | ---------- | ---- |  | - | ---------- |  |  | - | ---------- | 
|               |                     |  | As of and for the  |           | As of and for the
|               |                     |  | Three Months Ended |           | Nine Months Ended
|               |                     |  | September 30,      |           | September 30,    
|               |                     |  |                    |           |                  
|               |                     |  | 2002               |           | 2001              |  | 2002 |            | 2001
|               |                     |  |                    |           |                   |  |      |            |     
|North America: |                     |  |                    |           |                   |  |      |            |      |  |   |            |  |  |   |           
|              
|              
|              
|              
|               | Total revenue       |  | $                  | 2,222,243 |                   |  | $    | 1,633,169  |      |  | $ | 6,058,331  |  |  | $ | 4,904,611  | 
|              
|              
|              
|              
|               | Net loss            |  |                    | 6,051,551 |                   |  |      | 7,060,456  |      |  |   | 18,627,169 |  |  |   | 18,369,884 | 
|              
|              
|              
|              
|               | Identifiable assets |  |                    | 9,863,977 |                   |  |      | 11,969,142 |      |  |   | 9,863,977  |  |  |   | 11,969,142 | 
|              
|              
|              
|              
|Europe (1):    |                     |  |                    |           |                   |  |      |            |      |  |   |            |  |  |   |           
|              
|              
|              
|              
|               | Total Revenue       |  | $                  | 273,452   |                   |  | $    | 601,505    |      |  | $ | 988,276    |  |  | $ | 1,420,580  | 
|              
|              
|              
|              
|               | Net loss            |  |                    | 1,737,318 |                   |  |      | 729,406    |      |  |   | 3,613,630  |  |  |   | 2,387,636  | 
|              
|              
|              
|              
|               | Identifiable assets |  |                    | 2,124,806 |                   |  |      | 2,592,073  |      |  |   | 2,124,806  |  |  |   | 2,592,073  | 
|              
|              
|              
|              
|Asia:          |                     |  |                    |           |                   |  |      |            |      |  |   |            |  |  |   |           
|              
|              
|              
|              
|               | Total revenue       |  | $                  | 49,632    |                   |  | $    | 81,739     |      |  | $ | 322,104    |  |  | $ | 288,007    | 
|              
|              
|              
|              
|               | Net loss            |  |                    | 84,546    |                   |  |      | 283,374    |      |  |   | 304,407    |  |  |   | 1,706,300  | 
|              
|              
|              
|              
|               | Identifiable assets |  |                    | 415,637   |                   |  |      | 691,264    |      |  |   | 415,637    |  |  |   | 691,264    | 

(1)  Included in the Companys operations in Europe are expenses related to
research and development activities conducted by a branch of the Company
operating in Germany. These expenses were $639,051 and $343,604 for the three
months ended September 30, 2002 and 2001, respectively, and $1,387,757 and
$1,197,383 for the nine months ended September 30, 2002 and 2001, respectively.
Also included in the net loss and identifiable assets balances is a $490,773
inventory and tooling reserve recorded during the three months ended September
30, 2002.

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

|                                     |  |                    |    |                   |  |      |    |      |  |  |    |   |  |  |    |  
|------------------------------------ |  | ------------------ | -- | ----------------- |  | ---- | -- | ---- |  |  | -- | - |  |  | -- | -
|                                     |  | As of and for the  |    | As of and for the
|                                     |  | Three Months Ended |    | Nine Months Ended
|                                     |  | September 30,      |    | September 30,    
|                                     |  |                    |    |                  
|                                     |  | 2002               |    | 2001              |  | 2002 |    | 2001
|                                     |  |                    |    |                   |  |      |    |     
|Revenue:                             |  |                    |    |                   |  |      |    |      |  |  |    |   |  |  |    |  
|                                    
|                                    
|                                    
|                                    
|Number of Customers                  |  |                    | 1  |                   |  |      | 3  |      |  |  | 1  |   |  |  | 3  |  
|                                    
|                                    
|                                    
|                                    
|Percent of Total Revenue             |  |                    | 19 | %                 |  |      | 48 | %    |  |  | 10 | % |  |  | 39 | %
|                                    
|                                    
|                                    
|                                    
|Accounts Receivable:                 |  |                    |    |                   |  |      |    |      |  |  |    |   |  |  |    |  
|                                    
|                                    
|                                    
|                                    
|Number of Customers                  |  |                    | 2  |                   |  |      | 2  |      |  |  | 2  |   |  |  | 2  |  
|                                    
|                                    
|                                    
|                                    
|Percent of Total Accounts Receivable |  |                    | 45 | %                 |  |      | 56 | %    |  |  | 45 | % |  |  | 56 | %

For the three months ended September 30, 2002, revenue from IBM comprised
greater than 10% of total revenue. For the nine months ended September 30,
2002, revenue from the State of Tennessee Department of Transportation (DOT)
comprised greater than 10% of total revenue. As of September 30, 2002, the
following customers accounts receivable balance each comprised greater than
10% of total accounts receivable: the State of Tennessee DOT and IBM.

For the three months ended September 30, 2001, revenue from the following
customers each comprised greater than 10% of total revenue: Federal





---



##### 



Express,
the State of Tennessee DOT and Europart Consulting GmbH & Co. For the nine
months ended September 30, 2001, revenue from the following customers each
comprised greater than 10% of total revenue: Naval Undersea Warfare Center, the
State of Tennessee DOT and Europart Consulting GmbH & Co. As of September 30,
2001, the following customers accounts receivable balance comprised greater
than 10% of total accounts receivable: Europart Consulting GmbH & Co and the
State of Tennessee DOT.

8. TRANSACTIONS WITH RELATED AND CERTAIN OTHER PARTIES

Between November 2000 and February 2001, the Company loaned $940,188, net of
repayments, to the Companys President, Chief Executive Officer and Chairman of
the Board of Directors. The proceeds were used to prevent a forced sale of a
portion of this officers personal common stock holdings of the Company that
secured a margin loan from an investment bank. The loan to this officer was
made pursuant to a promissory note that is secured by shares of the officers
personal common stock holdings of the Company (the Promissory Note). On
December 31, 2001, the Companys Board of Directors increased the number of
shares securing the loan from 200,000 shares to 250,000 shares, extended the
maturity date from December 31, 2001 to December 31, 2002 and reduced the
interest rate from 8.0% to 6.0%, reflective of a general decline in interest
rates over this period. The outstanding principal and interest owed to the
Company under the Promissory Note totaled $1,073,075 and $1,026,708 at
September 30, 2002 and December 31, 2001, respectively. If the value of the
pledged shares is not sufficient to repay the outstanding balance of the note
at maturity or upon acceleration, the Company would have recourse to other
assets of the officer. The Company does not believe that the officers other
assets would be sufficient to repay the loan in full. This loan has been
recorded as a contra-equity account for all periods presented in this Form 10-Q
to reflect the likelihood that the loan will be repaid with the collateralized
shares or proceeds from the sale of such shares. At September 30, 2002, the
Company recorded a $1,015,575 reserve to reduce the net carrying value of the
Promissory Note to the value of the collateralized shares based on the closing
market price of the Companys common stock on September 30, 2002. In recording
this reserve, the Company has not waived it rights under the Promissory Note.
The Companys Board of Directors is currently considering modifications to
selected terms and conditions of this loan, including adding to the Companys
collateral position. Any such modifications will be governed by applicable
rules and regulations, including the provisions of the Sarbanes-Oxley Act.

The Company has contracted with IBM to design, develop and manufacture certain
components of the MA V product line, including the computer portion and two
versions of flat panel displays. The Company has also entered into an agreement
with IBM under which IBM purchases MA V, Atigo and other products from the
Company and markets and sells the systems worldwide to its own customers.
During the three and nine months ended September 30, 2002, the Company was
billed $7,440 and $2,214,978, respectively, by IBM related to design and
development services and inventory purchases. During the same periods in 2001,
the Company was billed $516,765 and $3,060,455, respectively, by IBM related to
design and development services and inventory purchases. During the three and
nine months ended September 30, 2002, the Company recorded revenues of $471,939
and $531,529, respectively, related to sales of MA V products to IBM. During
the three and nine months ended September 30, 2001, the Company recorded
revenues of $12,152 related to sales of MA V products to IBM. The Companys
management believes that the agreements and contracts underlying both the
design, development and manufacture of the MA V product line and the sale of MA
V products to IBM contain arms-length terms and conditions.

Certain of the end-users of the Companys wearable computer products are
universities and other not-for-profit agencies (collectively, the
End-Users) that purchase these products from a Value Added Reseller (the
VAR) of Xybernaut GmbH. The Company also contracts with certain of the
End-Users to provide research and development and sales and marketing services
to the Company. The research and development services provided to the Company
include activities such as hardware and software development, product testing
and evaluation. The sales and marketing services include activities such as
Company participation in and sponsorship of industry trade shows, the
preparation of competitive market analysis, and the use of the End-Users as
named reference accounts. During the three and nine months ended September 30,
2002, the Company recorded revenues of approximately $225,390 and $713,642,
respectively, related to sales to this VAR. During the three and nine months
ended September 30, 2001, the Company recorded revenues of approximately
$446,068 and $1,064,616, respectively, related to sales to this VAR. During the
three and nine months ended September 30, 2002, the Company recorded total
research and development and sales and marketing expenses of approximately
$664,171 and $1,247,161, respectively, related to services performed by the
End-Users. During the three and nine months ended September 30, 2001, the
Company recorded total research and development and sales and marketing
expenses of approximately $88,291 and $487,376, respectively, related to
services performed by the End-Users. The Companys management believes that the
agreements and contracts underlying both the sale of the products and the
performance of the services contain arms-length terms and conditions.

9. SUBSEQUENT EVENTS

In October 2002, the Company entered into an agreement with the manufacturer of
the pomathrough which the Company was relieved of its obligation to purchase
additional pomaunits. Pursuant to the terms of this agreement, the Company is
required to make a payment of $80,000 during the fourth quarter of 2002 and to
reduce certain of the royalty rates that are used to calculate the licensing
fees that the Company receives from the manufacturer for sales of the pomaor
other wearable computer products. Effective September 30, 2002, the accrued
liability balance originally recorded based on managements estimate of losses
to be incurred on shipments of the poma, net of the $80,000 payment, was
reversed, resulting in a $631,556 reduction to the provision for inventory and
tooling charge recorded in the third quarter of 2002.

Subsequent to September 30, 2002, the Company received gross proceeds of
approximately $[5,250,000] through exercises of previously issued warrants and
through private placements of its common stock to institutional investors. The
Company issued [25,654,762] shares of its common stock and issued callable
warrants to purchase an additional [21,250,000] shares of its common stock at
$1.50 related to these financings.





---



##### 



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

OVERVIEW

Xybernaut Corporation, a Delaware corporation (the Company), was formed in
1990 and completed its initial public offering (IPO) in 1996. The Company is
engaged in the research, development, commercialization and production of
mobile, wearable computing and communications systems, along with software and
service solutions designed to enhance productivity, improve product management,
asset management and the accuracy, timeliness and utilization of captured data.
The Company offers solutions with a software and services focus through its
wholly-owned subsidiary Xybernaut Solutions, Inc. (U.S.) (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 consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries: XSI (Virginia, U.S.), Xybernaut Development
Corporation (Virginia, U.S.), Xybernaut K.K. (Yokohama, Japan) and Xybernaut
GmbH (Boeblingen, Germany). All significant intercompany accounts and
transactions have been eliminated in the consolidation.

The Mobile Assistant® (MA®) series is the Companys primary wearable computer
hardware product line, the current versions of which are the Mobile Assistant V
(MA V) and MA TC. Since its commercial introduction in 1995, the Company has
realized revenue of over $19,000,000 on sales of approximately 3,900 units of
the MA series. The Company also developed, markets and sells the poma, a
wearable computer targeted at the light-commercial and near-consumer markets,
and the Atigo, a wireless web panel that can be used either as a stand-alone
handheld PC or as a display for an MA system, a laptop or a conventional PC.
The Company derives its revenues from sales of its wearable computers, software
products, consulting services and licensing of its intellectual property.

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

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

The Company believes that sales of its wearable computers will rely to a great
extent on the availability of wireless broadband services that can take
advantage of the processing power and display capabilities of the Companys
hardware products. Wireless LANs are now well established
in the commercial markets for providing broadband capabilities in limited-range
applications such as warehouses, factory floors, flightline operations and the
like. However, wide-range wireless access, commonly referred to as 2.5G or 3G,
is not established at this time but is expected in the near future. The Company
believes that the consumer markets will require such wireless broadband access
to fully develop.

RESULTS OF OPERATIONS

The following table sets forth certain consolidated financial data as a
percentage of revenues for the three and nine months ended September 30, 2002
and 2001.





---



##### 



|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |  |  |        |       | 
|----------------------------------- | ------------------------------------------ |  | ------------------ | ----- | ----------------- |  | ------ | ----- | ---- |  | ------ | ----- |  |  | ------ | ----- | 
|                                    |                                            |  | Three Months Ended |       | Nine Months Ended
|                                    |                                            |  | September 30,      |       | September 30,    
|                                    |                                            |  |                    |       |                  
|                                    |                                            |  | 2002               |       | 2001              |  | 2002   |       | 2001
|                                    |                                            |  |                    |       |                   |  |        |       |     
|Revenue                             |                                            |  | 100.0              | %     |                   |  | 100.0  | %     |      |  | 100.0  | %     |  |  | 100.0  | %    
|                                   
|                                   
|                                   
|                                   
|Cost of sales                       |                                            |  | 77.8               |       |                   |  | 66.4   |       |      |  | 77.1   |       |  |  | 70.6   |      
|                                   
|                                   
|                                   
|                                   
|Provision for inventory and tooling |                                            |  | 14.1               |       |                   |  | 0.0    |       |      |  | 5.6    |       |  |  | 17.4   |      
|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |  |  |        |      
|                                    | Gross income / (loss)                      |  |                    | 8.1   |                   |  |        | 33.6  |      |  |        | 17.3  |  |  |        | 12.0  | 
|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |  |  |        |      
|Operating expenses:                 |                                            |  |                    |       |                   |  |        |       |      |  |        |       |  |  |        |      
|                                   
|                                   
|                                   
|                                   
|                                    | Sales & marketing                          |  |                    | 147.3 |                   |  |        | 203.8 |      |  |        | 171.6 |  |  |        | 178.0 | 
|                                   
|                                   
|                                   
|                                   
|                                    | General & administrative                   |  |                    | 54.0  |                   |  |        | 75.9  |      |  |        | 63.1  |  |  |        | 77.7  | 
|                                   
|                                   
|                                   
|                                   
|                                    | Research & development                     |  |                    | 62.9  |                   |  |        | 105.3 |      |  |        | 69.6  |  |  |        | 99.6  | 
|                                   
|                                   
|                                   
|                                   
|                                    | Provision for note receivable from officer |  |                    | 39.9  |                   |  |        | 0.0   |      |  |        | 13.8  |  |  |        | 0.0   | 
|                                   
|                                   
|                                   
|                                   
|                                    | Restructuring charges                      |  |                    | 14.2  |                   |  |        | 0.0   |      |  |        | 7.0   |  |  |        | 0.0   | 
|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |  |  |        |      
|Total operating expenses            |                                            |  | 318.3              |       |                   |  | 385.0  |       |      |  | 325.0  |       |  |  | 355.2  |      
|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |  |  |        |      
|Interest and other                  |                                            |  | 0.9                |       |                   |  | 2.8    |       |      |  | 1.7    |       |  |  | 3.5    |      
|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |  |  |        |      
|Net loss                            |                                            |  | (309.3             | %)    |                   |  | (348.5 | %)    |      |  | (306.0 | %)    |  |  | (339.7 | %)   
|                                    |                                            |  |                    |       |                   |  |        |       |      |  |        |       |  |  |        |      

THREE MONTHS ENDED SEPTEMBER 30, 2002 AND SEPTEMBER 30, 2001

REVENUE. The Company derives its revenue from product sales of its wearable
computers and components, product sales of software and consulting services.
Total revenue for the three months ended September 30, 2002 was $2,545,327, an
increase of $228,914, or 10%, compared to $2,316,413 for the three months ended
September 30, 2001. Sales from the Companys wearable computers increased
$182,460, or 13%, to $1,553,019 for the three months ended September 30, 2002
compared to $1,370,559 for the same period in 2001. Hardware revenues from U.S.
operations increased $574,246 in the third quarter of 2002 compared with the
same period in 2001 due primarily to sales of MA V and MA TC systems as well as
a large sale of Atigo systems, which was introduced in the third quarter of
2002. This increase in U.S. hardware sales was offset by a $359,679 decrease in
European hardware sales in the third quarter of 2002 compared with the same
period in 2001, due primarily to a decrease in orders from a large European
customer. Hardware revenues from Asia, consisting primarily of MA V systems,
decreased slightly by $32,107 in the third quarter of 2002 compared with the
same period in 2001. Offsetting this overall increase in wearable computer
sales was a decrease in software product revenue from $28,212 for the three
months ended September 30, 2001 to $0 for the same period in 2002. Revenue from
software products generally consists of a few large transactions that occur
throughout the year that are unrelated to the Companys hardware products.
Therefore, it is not uncommon to have significant fluctuations in software
revenue from quarter to quarter. The Companys consulting, licensing and other
revenue for the three months ended September 30, 2002 was $992,308, an increase
of $74,666, or 8%, from revenue of $917,642 for the three months ended
September 30, 2001.

COST OF SALES. The Companys cost of sales includes the costs of components for
the Companys wearable computer product lines, purchased software, direct labor
and materials, amortization of tooling costs, warranty costs, fulfillment and
shipping costs, and inventory and tooling reserves. Total cost of sales for the
three months ended September 30, 2002 was $2,338,608, an increase of $801,477,
or 52%, compared to $1,537,131 for the three months ended September 30, 2001.
This increase relates largely to the $990,773 general reserve recorded by
management to cover estimated valuation issues in its various inventory
components offset by a $631,556 decrease in the pomaaccrual,
resulting in a net increase in the provision of $359,217. There was no such
provision recorded in the same period of 2001. The cost of sales related to the
Companys hardware products increased by $432,484, or 46%, from the three
months ended September 30, 2002 compared to the same period in 2001. This
increase in hardware product cost of sales is significantly greater than the
13% increase in hardware product sales. Margins on sales of the MA V and TC
were higher in the 2001 period than in the 2002 period, since both the MA V and
MA TC product lines were introduced in 2001 and margins are typically highest
following a products commercial launch. Partially offsetting the above
factors which negatively affected hardware margins, the Company began shipping
the Atigo product line in the third quarter of 2002, which resulted in a
positive effect on margins. Consulting, licensing and other cost of sales
increased approximately $12,813, or 2%, which is approximately consistent with
the 8% increase in consulting, license and other revenue.

SALES AND MARKETING EXPENSES. Sales and marketing expenses for the three months
ended September 30, 2002 were $3,749,623, a decrease of $971,535, or 21%,
compared to $4,721,158, for the corresponding period in 2001. As a result of
the cost saving measures undertaken in the second and third quarters of 2002,
sales and marketing expenses in the third quarter of 2002 relating to salaries
and benefits, consulting, promotional items and recruiting expenses decreased
approximately $872,000, $214,000, $132,000 and $339,000, respectively, compared
to the same period in 2001. For the three months ending September 30, 2002,
$117,618 of severance and outplacement expenses relating to sales and marketing
employees were classified as restructuring charges. This decrease is offset by
an increase of $105,142 related to non-cash marketing expenses for outside
services funded through the issuance of the Companys equity securities for the
three months ended September 30, 2002 of $189,322 compared to $84,180 during
the same period in 2001. Included in sales and marketing expenses during the
third quarter is a $729,511 non-cash, non-recurring charge related to the
cancellation of an agreement for marketing services and certain retail space at
the Waldorf Astoria





---



##### 



Hotel in New York City.

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses for
the three months ended September 30, 2002 were $1,373,240, a decrease of
$383,796, or 22%, compared to $1,757,036 for the same period in 2001. As a
result of the cost saving measures undertaken in the second and third quarters
of 2002, general and administrative expenses in the third quarter of 2002
relating to salaries and benefits, and consulting decreased approximately
$110,000 and $209,000, respectively, compared to the same period in 2001.

RESEARCH AND DEVELOPMENT EXPENSES. The Companys research and development
expenses consist primarily of personnel costs, the purchase of test equipment
and payments to consultants and other third-parties which provide research and
development services for general wearable technology. Research and development
expenses for the three months ended September 30, 2002 were $1,602,275, a
decrease of $836,571 or 34%, compared to $2,438,846 for the corresponding
period in 2001. This decrease resulted largely from a $704,000 decline in
expenditures to third parties and consultants for design and development of the
Companys mobile/wearable product lines. Expenditures during the 2001 period
related to the MA V and MA TC product lines while expenditures during the 2002
period related to the Atigo product line. In addition, the research and
development expenses of the Companys Asian operations decreased by $131,000
from the three months ended September 30, 2001 to 2002 due to cost saving
measures undertaken in the second and third quarters of 2002.

PROVISION FOR NOTES RECEIVABLE FROM OFFICER. At September 30, 2002, the
Company recorded a $1,015,575 reserve to reduce the net carrying value of a
promissory note due from an executive officer of the Company. The reserve was
calculated based on the value of the shares of common stock that collateralize
this note on September 30, 2002. No comparable expenses were recorded during
the same period in 2001.

RESTRUCTURING COSTS. Restructuring costs were $361,227 for the third quarter of
2002. These expenses relate to the Companys cost cutting efforts being
undertaken during 2002, for which no comparable expenses were recorded during
2001. These expenses consist of severance extended to terminated employees and
a reduction of facilities.

INTEREST AND OTHER, NET. Net interest and other income for the three months
ended September 30, 2002 was $24,581, a decrease of $45,748, or 65%, compared
to interest and other income of $70,329 for the same period in 2001. This
decrease resulted primarily from a decrease in interest income earned from the
Companys cash balances from the second quarter in 2002 compared to the second
quarter of 2001.

PROVISION FOR INCOME TAXES. The provision for income taxes for the three months
ended September 30, 2002 was $2,775, a decrease of $3,032, compared to the
income tax provision of $5,807 for the three months ended September 30, 2001.
These amounts relate to the operations of the Companys foreign subsidiaries.
The Companys U.S. operations had a net loss during these periods and,
therefore, no provision for U.S. income taxes was made.

NET LOSS. As a result of the factors described above, the net loss for the
three months ended September 30, 2002 was $7,873,415, a decrease of $199,821 or
2%, compared to $8,073,236 for the three months ended September 30, 2001.

NINE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001

REVENUE. The Company derives its revenue from product sales of its wearable
computers and components, software, and from consulting services. Total revenue
for the nine months ended September 30, 2002 was $7,368,711, an increase of
$755,513 or 11%, compared to $6,613,198 for the nine months ended September 30,
2001. Product revenue for the first nine months of 2002 was $4,471,634, an
increase of $635,200 or 17%, compared to $3,836,434 for the first nine months
of 2001. The increase in product revenue was attributable to sales of the
Companys wearable computer and components products, which increased
$1,250,507, or 39%. The increase 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 late in 2001. Additional hardware product revenue resulted from
sales of two new product lines introduced in 2002, the pomaand the Atigo.
Hardware revenues from U.S. operations increased $1,715,631, or 113%, in the
first nine months of 2002 compared to the same period in 2001. Hardware
revenues from Asian operations increased by $32,846, or 11%, in the first nine
months of 2002 compared to the same period in 2001. Offsetting the increases in
U.S. and Asian hardware revenues was a decrease of $497,970 in European
hardware revenue, due primarily to a decrease in orders from a large European
customer. Further offsetting this increase in wearable computer hardware sales
was a decrease in software product revenue from $615,307 for the nine months
ended September 30, 2001 to $0 for the same period in 2002. Revenues from
software products generally consist of a few large transactions unrelated to
our hardware products that occur throughout the year. Therefore, it is not
uncommon for the Company to have significant fluctuations in software revenue
from quarter to quarter. The Companys consulting, licensing and other revenue
remained consistent between the first nine months of 2002 and 2001 at
$2,897,077 and $2,776,764, respectively, representing a 4% increase, as the
number of ongoing consulting contracts remained relatively consistent between
the first nine months of 2002 and 2001.

COST OF SALES. The Companys cost of sales include the costs of components for
the Companys wearable computer product lines, purchased software, direct labor
and materials, amortization of tooling costs, warranty costs, fulfillment and
shipping costs, and inventory and tooling reserves. Total cost of sales for the
nine months ended September 30, 2002 was $6,092,356 an increase of $272,209 or
5%, compared to $5,820,147 for the first nine months ended September 30, 2001.
The cost of sales related to the Companys hardware products increased
$1,341,001, or 54%, compared to $2,498,680 for the nine months ended September
30, 2001. This increase in hardware product cost of sales is significantly
greater than the 39% increase in hardware product sales. This fluctuation was
caused by several factors. First, total warranty costs for the nine months
ended September 30, 2002 increased $285,902 compared to the same period in 2001
due to certain charges for product replacement related to previous quarters
sales of the MA V to two of the Companys customers. The Company believes that
the warranty





---



##### 



expenses specific to these customers were non-recurring in nature
and does not anticipate that it will continue to record similar warranty
expenses in the future. In addition, margins on sales of the MA V and TC were
higher in the 2001 period than in the 2002 period, since both the MA V and MA
TC product lines were introduced in 2001 and margins are typically highest
following a products commercial launch. Partially offsetting the above
factors which negatively affected hardware margins, the Company began shipping
the Atigo product line in the third quarter of 2002, which resulted in a
positive effect on margins. As a result of these activities, gross margins from
hardware sales for the first nine months of 2002 were 14%, compared to 22% for
2001. Software cost of sales decreased from $345,700 for the nine months ended
September 30, 2001 to $0 for the same period in 2002 as the Company did not
have software sales in 2002. The decrease in high-margin software sales impacts
negatively on the Companys gross margin from product sales which decreased to
14% for the first nine months of 2002 from 26% for the same period in 2002.
Cost of sales of consulting, licensing and other revenue remained relatively
consistent with an increase of less than 1%, which is relatively consistent
with the 4% increase in consulting, license and other revenue. The Company
recognized inventory and tooling provisions of $413,175 and $1,149,020 in the
first nine months of 2002 and 2001, respectively, related to a general reserve
recorded primarily for the MA V and MA TC products and the write-off of MA IV
inventory, respectively. Total gross margins, including the provisions for
inventory and tooling, were 17% and 12% for the nine months ended September 30,
2002 and 2001, respectively.

SALES AND MARKETING EXPENSES. Sales and marketing expenses for the nine months
ended September 30, 2002 were $12,641,816, an increase of $872,775, or 7%,
compared to $11,769,041 for the same period in 2001. Included in sales and
marketing expenses for the nine months ended September 30, 2002 is a $729,511
non-cash charge related to the cancellation of an agreement for marketing
services and certain retail space at the Waldorf Astoria Hotel in New York
City. Non-cash expenses for outside marketing services funded through the
issuance of the Companys equity securities were $590,865 and $217,893 for the
first nine months of 2002 and 2001, respectively. General expenditures for
sales and marketing expenses of the European and Asian operations increased
$153,000 from 2001 to 2002. These increases are offset by a decrease of
approximately $345,000 in recruiting costs for sales and marketing staff as a
result of the cost saving measures undertaken in the second and third quarters
of 2002. For the three months ending September 30, 2002, $231,643 of severance
and outplacement expenses relating to sales and marketing employees were
classified as restructuring charges.

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses for
the nine months ended September 30, 2002 were $4,649,702, a decrease of
$486,650, or 9%, compared to $5,136,352, for the corresponding period in 2001.
As a result of the cost saving measures undertaken in the second and third
quarters of 2002, general and administrative expenses for the nine months ended
September 30, 2002 relating to salaries and benefits, travel and consulting
decreased approximately $181,000, $106,000 and $229,000, respectively, compared
to the same period in 2001.

RESEARCH AND DEVELOPMENT EXPENSES. The Companys research and development
expenses consist primarily of personnel costs, the purchase of test equipment
and payments to consultants and other third-parties which provide research and
development services for general wearable technology. Research and development
expenses for the nine months ended September 30, 2002 were $5,126,413, a
decrease of $1,458,152, or 22%, compared to $6,584,565 for the corresponding
period in 2001. This decrease resulted largely from a $1,579,000 decline in
expenditures to third parties and consultants for design and development of the
Companys mobile/wearable product lines. Expenditures during the 2001 period
related to the MA V and MA TC product lines while expenditures during the 2002
period related to the Atigo product line. In addition, the research and
development expenses of the Companys Asian operations decreased by $460,000
from the nine months ended September 30, 2001 to 2002 due to cost saving
measures undertaken in the second and third quarters of 2002.

PROVISION FOR NOTES RECEIVABLE FROM OFFICER. At September 30, 2002, the
Company recorded a $1,015,575 reserve to reduce the net carrying value of a
promissory note due from an executive officer of the Company. The reserve was
calculated based on the value of the shares of common stock that collateralize
this note on September 30, 2002. No comparable expenses were recorded during
the same period in 2001.

RESTRUCTURING COSTS. Restructuring costs were $516,461 for 2002. These expenses
relate to the Companys cost cutting efforts undertaken in the second and third
quarter of 2002, for which no comparable expenses were recorded during the same
periods in 2001. These expenses consist of severance extended to terminated
employees and facilities and reduction of facilities.

INTEREST AND OTHER, NET. Other income for the nine months ended September 30,
2002 was $135,786, a decrease of $117,936 or 46%, compared to $253,722 for the
corresponding period in 2001. This decrease resulted primarily from a decrease
in interest income earned from the Companys cash balances from the first half
of 2002 compared to the first half of 2001.

PROVISION FOR TAXES. The Company accrued $7,380 for a tax provision for the
nine months ended September 30, 2002 related to the operations of its foreign
subsidiaries. The Companys U.S. operations had a net loss for the nine months
ended September 30, 2002 and, therefore, no provision for U.S. income taxes is
required.

NET LOSS. As a result of the factors described above, the net loss for the nine
months ended September 30, 2002 was $22,545,206, an decrease of $81,386, or
less than 1%, compared to $22,463,820 for the corresponding period in 2001.

OTHER OPERATING ACTIVITIES

For the nine months ended September 30, 2002, the Companys operating
activities used cash of $17,263,334 as a result of its net loss of $22,545,206,
net working capital requirements of $451,075 and non-cash expenses of
$4,830,797. The Companys investing activities used cash of $1,116,581. These
activities were funded through
the Companys financing activities which
provided cash of $16,133,885, principally through





---



##### 



the private placement of
common stock. As a result, the Companys cash balance decreased from $3,172,609
at December 31, 2001 to $627,139 at September 30, 2002.

For the nine months ended September 30, 2001, the Companys operating
activities used cash of $18,019,071 as a result of its net loss of $22,463,820,
offset by proceeds from working capital and non-cash expenses of $1,683,483 and
$2,761,266, respectively. The Companys investing activities used cash of
$2,626,136. These activities were funded through the Companys financing
activities which provided cash of $15,186,962, principally through the private
placement of common stock. As a result, the Companys cash balance decreased
from $8,848,715 at December 31, 2000 to $2,958,550 at September 30, 2001.

For hardware product sales, the Company generally provides a one-year warranty
on its parts and a six-month warranty on labor. The Companys suppliers for the
significant components of the MA series, including the computing unit, flat
panel and head mounted displays, and batteries, provide the Company with
similar warranties. A provision for estimated future warranty costs is recorded
at the time of shipment as a component of cost of sales. The provision is an
estimate of internal costs to be incurred for such sales above and beyond the
warranty offered to the Company by its suppliers. The trend in the computer
hardware industry is to provide extended warranties for up to two years beyond
the one-year base warranty. In certain circumstances, the Company recently
began offering such an additional two-year warranty period to its customers.
The Company is negotiating with its suppliers to offer similar warranties to
the Company to back up the extended warranties offered to the Companys
customers. In the event that the Company is not able to obtain such warranties
from its suppliers, the Company may incur warranty expenses in the future that
are significantly greater than those incurred in the past. The Company recorded
warranty expense, net of warranty coverage from suppliers, of $42,001 and
$366,965 during the three and nine months ended September 30, 2002,
respectively, and $9,170 and $81,063 during the three and nine months ended
September 30, 2001, respectively. The Company had a warranty reserve of $83,823
and $86,915 at September 30, 2002 and December 31, 2001, respectively.

The Companys consolidated financial statements contain a provision for income
tax expense related to its operations outside the United States. Subject to
realization, the Company has generated net operating losses in the U.S. that
can be used to offset taxable operating income in the future. The Companys
future operations, if profitable, will be subject to income tax expense not
previously incurred by the Company. At December 31, 2001, the Company had
approximately $94,000,000 and $3,800,000 of net operating loss carryforwards
for U.S. federal and foreign income tax purposes, respectively. The U.S. losses
will begin to expire in 2010 and the losses from foreign operations do not
expire. The use of the U.S. carryforwards may be limited in any one year under
Internal Revenue Code Section 382 if significant ownership changes occur.

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

TRANSACTIONS WITH RELATED AND CERTAIN OTHER PARTIES

Between November 2000 and February 2001, the Company loaned $940,188, net of
repayments, to the Companys President, Chief Executive Officer and Chairman of
the Board of Directors. The proceeds were used to prevent a forced sale of a
portion of this officers personal common stock holdings of the Company that
secured a margin loan from an investment bank. The loan was made pursuant to a
promissory note that is secured by shares of the officers personal common
stock holdings of the Company (the Promissory Note). On December 31, 2001,
the Companys Board of Directors increased the number of shares securing the
loan from 200,000 shares to 250,000 shares, extended the maturity date from
December 31, 2001 to December 31, 2002 and reduced the interest rate from 8.0%
to 6.0%, reflective of a general decline in interest rates over this period.
The outstanding principal and interest owed to the Company under the Promissory
Note totaled $1,073,075 and $1,026,708 at September 30, 2002 and December 31,
2001, respectively. If the value of the pledged shares is not sufficient to
repay the outstanding balance of the note at maturity or upon acceleration, the
Company would have recourse to other assets of the officer. The Company does
not believer that the officers other assets would be sufficient to repay the
loan in full. This loan has been recorded as a contra-equity account for all
periods presented in this Form 10-Q to reflect the likelihood that the loan
will be repaid with the collateralized shares or proceeds from the sale of such
shares. At September 30, 2002, the Company recorded a $1,015,575 reserve to
reduce the net carrying value of
the Promissory Note to the value of the collateralized shares based on the
closing market price of the Companys common stock on September 30, 2002. In
recording this reserve, the Company has not waived it rights under the
Promissory Note. The Companys Board of Directors is currently considering
modifications to selected terms and conditions of this loan, including adding
to the Companys collateral position. Any such modifications will be governed
by applicable rules and regulations, including the provisions of the
Sarbanes-Oxley Act.

The Company has contracted with IBM to design, develop and manufacture certain
components of the MA V product line, including the computer portion and two
versions of flat panel displays (the Engineering and Inventory Agreement).
The Company has also entered into an agreement with IBM under which IBM
purchases MA V and other products from the Company and markets and sells the
systems worldwide to its own customers (the Sales and Marketing Agreement).
During the three and nine months ended September 30, 2002, the Company was
billed $7,440 and $2,214,978, respectively, by IBM related to design and
development services and inventory purchases. During the same periods in 2001,
the Company was billed $516,765 and $3,060,455, respectively, by IBM related to
design and development services and inventory purchases. During the three and
nine months ended September 30, 2002, the Company recorded revenues of $471,939
and $529,728, respectively, related to sales of MA V products and Atigo to IBM.
During the same periods in 2001, the Company recorded revenues of $12,152
related to sales of MA V products to IBM. Before selecting IBM as its partner
for the Engineering and Inventory Agreement, the Company reviewed IBMs
proposal to provide such services, which included discussion of the estimated
costs to be incurred, IBMs track-record of bringing new technologies to
market, IBMs reputation for quality and other customary evaluations. The Sales
and Marketing Agreement was reached with similar terms and conditions provided
to other volume resellers of the Companys products. As a result, the Companys
management believes that the Engineering





---



##### 



and Inventory Agreement and the Sales
and Marketing Agreement contain arms-length terms and conditions.

One of the Companys resellers is an entity that is owned by the son of a Vice
President of the Company, who is also a member of the Board of Directors of the
Company. During the three and nine months ended September 30, 2002, the Company
recorded sales of $13,068 and $42,500 to this reseller and the products related
to these revenues were subsequently sold to a third party end-user under
arms-length terms and conditions. There were no sales to this customer during
the same periods in 2001. The sales were transacted with similar terms and
conditions provided to other resellers of the Companys products. As a result,
the Companys management believes that these sales transactions contain
arms-length terms and conditions.

Certain of the end-users of the Companys wearable computer products are
universities and other not-for-profit entities (collectively, the End-Users)
that purchase these products from a Value Added Reseller (the VAR) of
Xybernaut GmbH. The Company also contracts with certain of the End-Users to
provide research and development and sales and marketing services to the
Company. The research and development services provided to the Company include
activities such as hardware and software development, product testing and
evaluation. The sales and marketing services include activities such as Company
participation in and sponsorship of industry trade shows, the preparation of
competitive market analysis, and the use of the End-Users as named reference
accounts. During the three and nine months ended September 30, 2002, the
Company recorded revenues of approximately $14,492 and $488,252, respectively,
related to sales to this VAR. During the three and nine months ended September
30, 2001, the Company recorded revenues of approximately $287,300 and $618,548,
respectively, related to sales to this VAR. During the three and nine months
ended September 30, 2002, the Company recorded total research and development
and sales and marketing expenses of approximately $383,915 and $582,990,
respectively, related to services performed by the End-Users. During the three
and nine months ended September 30, 2001, the Company recorded total research
and development and sales and marketing expenses of approximately $239,089 and
$399,085, respectively, related to services performed by the End-Users. The
Company compares the cost of the projects performed by the End-Users against
the cost it would likely incur if it were to obtain these services from
entities other than the End-Users. Management also evaluates the cost if the
Company performed these services in-house, including expenses that would be
incurred for salary and benefits, training, travel, supplies and equipment, and
overhead. As a result, the Companys management believes that the agreements
and contracts underlying both the sale of the products and the performance of
the services contain arms-length terms and conditions.

LIQUIDITY AND CAPITAL RESOURCES

From its inception until the completion of 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s
financing and borrowing activities for 2002 and 2001 are provided below.

COMMON STOCK

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

On July 31, 2001, the Company received gross proceeds of $4,000,000 through a
private placement of 1,324,503 shares of its common stock. In connection with
this private placement, the Company issued callable warrants to purchase
331,126 shares of its common stock at an exercise price of $4.53 per share. The
Company also paid $120,000 in cash and issued callable warrants to purchase
39,735 shares of common stock with the same terms to a financial advisor.

On November 15, 2001, the Company received gross proceeds of $9,250,000 through
the private placement of 5,441,175 shares of its common
stock. In connection with this private placement, the Company issued callable
warrants to purchase 1,360,294 shares of its common stock at an exercise price
of $2.55 per share. The Company also paid $266,131 in cash and issued callable
warrants to purchase 61,765 shares of common stock with the same terms to a
financial advisor and a finder.

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

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

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





---



##### 



The Company issues warrants to purchase shares of its common stock, primarily
in connection with the Companys financings and borrowings. The Company
received gross proceeds of $1,698,773 and $3,773,405 through the issuance of
7,579,198 and 1,881,470 shares of its common stock during the nine months ended
September 30, 2002 and the fiscal year ended December 31, 2001, respectively,
through the exercise of certain of these warrants. To induce certain of the
investors to exercise the warrants during the nine months ended September 30,
2002, the Company reduced the exercise price of 6,034,837 of these warrants
from a weighted average of $[     ] per share to $0.15 per share. At September
30, 2002, the Company had warrants outstanding to purchase 14,109,465 shares of
its common stock at prices that range from $0.70 to $18.00 per share, with a
weighted average of $1.95 per share.

BORROWINGS

In December 2001, the Company entered into a revolving credit facility with IBM
Global Finance (the IBM Revolver).The IBM Revolver provides for up to
$3,000,000 in borrowings based on the Companys base of eligible U.S.
receivables and inventory. Interest on the facility accrues at the prime rate
plus 2.0% per annum. The borrowing is secured by the Companys U.S. assets,
excluding patents and intellectual property. The IBM Revolver includes
customary financial covenants and other restrictions, including the requirement
that the Company obtain a $1,000,000 irrevocable letter of credit (the Letter
of Credit) to secure this facility. The Company believes that it will have to
post cash collateral in an equal amount to obtain the Letter of Credit. At
September 30, 2002, the Company had not made any borrowings under the IBM
Revolver and the Company does not anticipate drawing down on the IBM Revolver
during 2002.

During June 2002, the Company received $250,000 in cash from an investor that
was recorded by the Company as a note payable. This note bears interest at 6.0%
per annum and is due on or before September 30, 2003. At the Companys option,
this note can be repaid through a cash payment, the issuance of 500,000 shares
of common stock or the cashless exercise of 500,000 of the investors existing
warrants at a reduced price of $0.50 per share. [Update for repayment through
stock].

COMMITMENTS

Inventory.At September 30, 2002, the Company had commitments to purchase
inventory, tooling and engineering and other services from its suppliers and
manufacturers related to its current and future hardware product lines. The
Company expects that it will enter into similar inventory and engineering
commitments in the future as it designs, develops and procures future wearable
computer product lines.

The current contract with IBM requires the Company to purchase up to 24,000
computing units (the MA V CPUs). Changes in available technology and current
negotiations with IBM are such that the Company believes that the contract will
be modified and that this obligation will be significantly reduced and/or
transferred to future generations of products or services. However, there can
be no assurance that the Company will be successful in renegotiating this
commitment. Under the current contract, the MA V CPUs are scheduled for
purchase over a 15 month period following final acceptance by the Company,
which acceptance is determined by a number of criteria, including receipt of
comprehensive product documentation and other defined deliverables. All
criteria for acceptance had not been met at the time of this filing, [but the
Company expects that all criteria may be met during 2002]. The Company may
cancel its purchase commitment following product acceptance by paying a
cancellation fee in an amount not to exceed approximately $4,000,000, which
amount decreases in proportion to the number of MA V CPUs purchased over the
contract period.

In October 2002, the Company entered into an agreement with the manufacturer of
the pomathrough which the Company was relieved of its obligation to purchase
additional pomaunits. Pursuant to the terms of this agreement, the Company is
required to make a payment of $80,000 during the fourth quarter of 2002 and to
reduce certain of the royalty rates that are used to calculate the licensing
fees that the Company receives from the manufacturer for sales of the pomaor
other wearable computer products.

The Company has commitments to purchase computing units, flat panel and head
mounted displays, miscellaneous computing components as well as engineering and
other services from its various vendors, including IBM, related to the MA V, MA
TC, poma(pursuant to the October
2002 agreement discussed above), Atigo and future product lines. The Company
believes that the timing and amount of many of these shipments, services and
payments may be adjusted through the payment of cancellation fees, contract
negotiations or the satisfaction of obligations through the issuance of the
Companys equity securities. However, there can be no assurance that the
Company can successfully modify these contracts or commitments. Excluding the
potential impact of contract negotiations, the Company had approximately
$7,000,000 in inventory liabilities and commitments at September 30, 2002. The
Company estimates that it will make additional payments of $[2,000,000] between
October 2002 and December 2002 in order to execute its business plan for the
remainder of 2002. If the current contracts between the Company and its
suppliers were completed in full, the Company would be obligated to make
approximately $[39,000,000] in payments during 2003 related primarily to the
IBM MAV CPU contract. However, the Company believes that these contracts will
be modified such that this obligation will be significantly reduced and/or
transferred to future generations of products or services.

Operating Leases and Other.The Company leases operating facilities and
equipment under operating leases expiring on various dates through 2006. Future
minimum payments under noncancelable operating leases at September 30, 2002
are:





---



##### 



|                         |  |   |           | 
|------------------------ |  | - | --------- | 
|YEAR ENDING DECEMBER 31, |  |   |           | 
|                         |  |   |           | 
|2002                     |  | $ | 189,082   | 
|                        
|                        
|                        
|                        
|2003                     |  |   | 609,222   | 
|                        
|                        
|                        
|                        
|2004                     |  |   | 176,727   | 
|                        
|                        
|                        
|                        
|2005                     |  |   | 156,566   | 
|                        
|                        
|                        
|                        
|2006                     |  |   | 160,528   | 
|                         |  |   |           | 
|                         |  | $ | 1,292,125 | 
|                         |  |   |           | 

OTHER LIQUIDITY AND CAPITAL RESOURCES DISCLOSURES

Certain government contracts of XSI require that five to twenty percent of
direct labor reimbursements per contract be withheld from payments remitted to
the Company until such time as the contract is completed and a final accounting
and approval has been made. Since the amounts billed will not be collected
within one year of the date of the financial statements, the balance is
included in long-term other assets. Retainage at September 30, 2002 and
December 31, 2001 was $366,397 and $316,839, respectively.

The Company recognizes revenue from fixed price long-term service contracts
based on the percentage of completion method by calculating the ratio of costs
incurred over total estimated costs to complete. Revenue in excess of billings
on service contracts is recorded as unbilled receivables. At September 30, 2002
and December 31, 2001, unbilled receivables of $1,052,381 and $365,763,
respectively, were included in trade accounts receivable. The Company believes
that these unbilled receivables will be billed and collected in the first half
of 2003.

The Company has recorded net losses since its inception, including during the
periods presented in this Form 10-Q. These losses are primarily attributable to
the operating expenses incurred by the Company to design, develop, sell and
market its wearable computer products and to provide general and administrative
support for these operating activities. During these periods, the Companys
revenues and gross margins have not been sufficient to fund these operating
activities. As a result, the Company has consistently recorded negative cash
flows from operating activities and net losses and had an accumulated deficit
of $126,987,532 at September 30, 2002.

The combination of the Companys operating losses and its working capital
requirements has severely impacted the Companys financial position and
liquidity. At September 30, 2002, the Company had unrestricted cash on hand of
$627,139 and accounts payable, accrued expenses and short term notes totaling
$5,732,326. Certain of these liabilities are past their stated terms of
payment, including those owed to vendors that provide services and inventory
which are required by the Company to execute its business plan. In general,
any company that does not pay its suppliers in a timely manner is at risk of
being forced into an involuntary bankruptcy proceeding instituted by creditors,
which may provide for the liquidation of assets or the reorganization of assets
and debts. The Company generally believes that it has a reasonably good
relationship with most of its vendors and creditors. However certain of its
vendors have filed legal actions to recover overdue accounts payables and
ceased providing services and products to the Company. There can be no
assurances that other vendors will not pursue similar actions.

[During 2002, 2001 and 2000, the Company funded its operating and investing
activities through its financing activities, which consist primarily of private
placements of common stock, warrant and stock option exercises and borrowings.]

The eventual achievement of profitability is primarily dependent upon the
continued development and commercial acceptance of the Companys products and
services, the successful management of the business, the ability to profitably
sell the Companys wearable computer products and services, and managements
ability to reduce operating expenses relative to the growth in revenues and
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 flows from operations and it is expected that it will continue to
experience negative cash flows through 2002 and [most if not all of] 2003.

The Company anticipates that its working capital requirements and operating
expenses, excluding the impact of the restructuring and cost reduction programs
discussed below, will increase as the Company expands production of its current
wearable computer product lines, develops new models, 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.

During 2002, management has taken steps that it believes are necessary to
improve the Companys operations and raise additional capital, both of which
are needed to enhance its ability to meet its cash flow needs through December
31, 2002 and thereafter.

During the period from March through November 2002, the Company has performed
ongoing reviews of its operations and has developed a program to significantly
reduce the Companys operating expenses. The Company began implementation of
these cost cutting programs in April 2002 and has continued to execute these
reductions through the date of this filing.

Assuming there are no significant changes to the Companys business plan,
management has targeted savings of approximately 50% from annualized fourth
quarter 2001 levels once these steps are fully implemented. Managements target
is to reach an operating expense level of approximately $5,000,000 per quarter,
beginning with the fourth quarter of 2002. Future significant fluctuations may
still occur as a result of the





---



##### 



Companys research and development activities,
which will vary depending on the Companys wearable computer product
development cycle during any given period. As indicated in the chart below,
through the third quarter of 2002, the Company has reduced its net operating
expenses by 41% from annualized fourth quarter 2001 levels.

|                       |  |               |            |                   |  |               |     |   |  |  |     |  
|---------------------- |  | ------------- | ---------- | ----------------- |  | ------------- | --- | - |  |  | --- | -
|                       |  | Operating     |            | % Change from     |  |               |     |  
|                       |  | Expenses, Net |            | Fourth Quarter of |  | % Change from
|                       |  | (1)           |            | 2001              |  | Prior Quarter
|Fourth Quarter of 2001 |  | $             | 10,114,109 |                   |  |               |    |   |  |  |    |  
|                      
|                      
|                      
|                      
|First Quarter of 2002  |  | $             | 8,745,553  |                   |  |               | -14 | % |  |  | -14 | %
|                      
|                      
|                      
|                      
|Second Quarter of 2002 |  | $             | 6,947,240  |                   |  |               | -31 | % |  |  | -21 | %
|                      
|                      
|                      
|                      
|Third Quarter of 2002  |  | $             | 5,995,627  |                   |  |               | -41 | % |  |  | -14 | %



| |  | (1) Operating Expenses, Net represents total operating expenses as
adjusted for restructuring charges recorded in accordance with U.S. GAAP
and certain other non-recurring transactions that do not meet the criteria
for recordation as restructuring charges. The operating expenses balances
for the fourth quarter of 2001 and the first quarter of 2002 presented
herein are unadjusted. The balance for the second quarter of 2002
represents total operating expenses less $155,234 in restructuring
charges. The balance for the third quarter of 2002 represents total
operating expenses less $361,227 in restructuring charges, a $729,511
non-cash charge recorded as a sales and marketing expense related to the
cancellation of an agreement for marketing services and certain retail
space at the Waldorf Astoria Hotel in New York City and a $1,015,575
charge recorded for a reserve recorded against a note receivable due from
an executive officer of the Company.
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Subsequent to these changes, management believes that the Companys staffing
and resources will be sufficient to carry out its business plan for the
foreseeable future.

In addition to the cost cutting initiatives detailed above, management
continues to review all aspects of the Companys operations and may take
additional actions to reduce operating expenses further.

Even if the above cost cutting initiatives are fully implemented, the Company
will still be required to obtain outside financing to supplement the Companys
cash position. Potential sources of additional financing include private equity
offerings, strategic investments and various forms of debt financing. If
additional funds are raised through the issuance of equity securities, the
percentage of ownership of current stockholders of the Company will be reduced
and if additional funds are raised at current prices for the Companys stock,
such dilution could be significant. If additional funds are raised through
borrowings, the Company will be subject to interest charges and principal
repayments, will likely be required to comply with financial covenants or other
restrictions, and will likely have to collateralize such borrowings with its
assets, which could be taken by the lender in the event of default.

During the nine period from January 1, 2002 through the date of this filing,
the Company has raised approximately $21,400,000 in cash through sales of its
common stock to institutional investors, through warrant and stock option
exercises and through borrowings that were repaid through the issuance of
common stock. Due in large part to the Companys current stock price and the
depressed general capital markets, the equity financings that the Company has
completed in recent quarters have been smaller than those transacted in
previous periods. As a result of the Companys financings and other
activities, 27,685,527 shares of common stock were issued during the first nine
months of 2002. This represents a 47% increase in the number of shares as
compared to that outstanding as of December 31, 2001. The equity markets,
especially for small capitalization technology stocks, have remained depressed,
and the U.S. and world economies have generally been in a decline or recession.
If a sustained decline in the general equity markets, the price of the
Companys common stock, or the U.S. or world
economy were to occur, the Company could face difficulties in its ability to
raise additional capital. Additionally, the Company has historically made
several private placements of its common stock per year, primarily to a limited
number of institutional investors who specialize in making similar types of
investments. If these institutional investors were to choose to not participate
in future private placements, the Company could face difficulties in its
ability to raise additional capital.

On July 22, 2002, the Company received notice from Nasdaq that the Companys
common stock had closed below $1 per share for 30 consecutive trading days.
Effective October 29, 2002, the Company was granted a transfer to the Nasdaq
SmallCap Market and provided until January 21, 2003 for the stock price to
close above $1 for ten consecutive trading days. If the Company does not meet
this stock price requirement, it can extend the date before which it must
demonstrate compliance until July [21], 2003 if it is in compliance with
various other Nasdaq listing requirements. The Company is currently in
compliance with all such requirements and management anticipates it will remain
in compliance in the future. However, there can be no assurances that the
Company will be able to remain in compliance in the future. Prior to the
delisting of the Companys common stock, the Company can appeal Nasdaq for an
extension or for other remedies. If necessary, management intends to fully
exercise all of its rights to maintain its listing.

Because of the transfer to the SmallCap Market, the Company may face reductions
in holdings by institutional holders whose charters may not allow investment in
NASDAQ companies that do not trade on the National Market. Further, if the
Company is unable to remain on the SmallCap Market, it may be forced to trade
on the Over the Counter Bulletin Board or Pink Sheets markets, which could
significantly reduce the liquidity in the stock and interest of potential
investors in purchasing the stock.

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





---



##### 



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

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

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is exposed to market risk related to changes in foreign currency
exchange rates and changes in interest rates. The Company does not hold
investments or use derivative financial instruments for speculative or trading
purposes. All of the potential changes noted below are based on sensitivity
analyses performed on the Companys financial position at September 30, 2002.
Actual results may differ materially.

FOREIGN CURRENCY EXCHANGE RISK

The majority of the Companys revenue, expense, and capital purchasing
activities are transacted in U.S. dollars. However, as a result of the
Companys international manufacturing, research and development, sales and
marketing, inventory procurement, and other activities, the Company enters into
transactions denominated in other currencies, primarily the Japanese Yen and
the European Euro or in which the U.S. Dollar equivalent is determined by the
values of such currencies. Prior to the adoption of the Euro, the Company also
regularly entered into transactions denominated in the German Deutsche Mark. As
of January 1, 2001, Xybernaut GmbH converted its functional currency from the
Deutsche Mark to the Euro. The effect of this conversion was an increase of
$151,123 on beginning accumulated deficit, which is included in the foreign
currency translation balance. Historically, the Company has not realized
significant gains or losses in transactions denominated in, or determined by,
foreign currencies. To date, the Company has not entered into foreign exchange
forward or option contracts to hedge its exposure to future movements in
foreign exchange rates because the Companys management believes that the
potential impact of these movements does not justify the costs of entering into
such contracts or the use of capital to collateralize these contracts. In the
future, the Company may enter into foreign exchange forward and option
contracts to hedge transactions denominated in a foreign currency if management
determines that the levels of international sales or operations justify the use
of such contracts. For the three and nine months ended September 30, 2002, the
Companys operations in Europe comprised 10.7% and 13.4% of its total revenue
and 22.1% and 16.0% of its net loss, respectively compared to 26.0% and 21.5%
of its total revenue and 9.0% and 10.6% of its net loss, respectively in the
same periods for 2001. For the three and nine months ended September 30, 2002,
the Companys operations in Asia comprised 1.9% and 4.4% of its total revenue
and 1.1% and 1.4% of its net loss, respectively compared to 3.5% and 4.4% of
its total revenue and 3.5% and 7.6% of its net loss, respectively in the same
periods for 2001. At September 30, 2002, the Companys assets in Europe and
Asia comprised 17.1% and 3.4% of its total assets, respectively compared to
17.0% and 4.5% of its total assets at September 30, 2001, respectively.
According to published sources, the average fluctuation of the European Euro
during the three and nine months ended September 30, 2002 and 2001 was -.04%
and 3.7%, respectively compared to 4.9% and -5.0% for the same periods in 2001,
respectively. The average fluctuation of the Japanese Yen for the three and
nine months ended September 30, 2002 was 0.5% and 3.7%, respectively compared
to 2.6% and -5.7% for the same periods in 2001, respectively. Management
believes that these fluctuations did not have a material impact on the
Companys results of operations or financial position for 2002 and 2001.

INTEREST RATE SENSITIVITY

As discussed in the Liquidity and Capital Resources section, the Company has
established a revolving credit facility that provides for up to
$3,000,000 in borrowings and is also exploring various other financing
alternatives, including debt financings. If additional funds are raised through
borrowings, the Company will be subject to additional interest charges.
Interest rate increases may materially increase the Companys interest expense,
hinder the Companys ability to borrow additional funds or have a negative
effect on the ability of the Companys customers to purchase its products. To
date, the Company has not entered into interest rate forward or option
contracts to hedge its exposure to future movements in interest rates because
the Companys management believes that the potential impact of these movements
does not justify the costs of entering into such contracts or the use of
capital to collateralize these contracts. As the Companys exposure to interest
rate fluctuations becomes more significant, it may enter into interest rate
forward and option contracts to hedge against such fluctuations. According to
published sources, the average prime interest rate during the first three
quarters of fiscal year 2002 was 4.75% for each period, compared to 8.83%,
8.17% and 7.67% average prime interest rate during the same periods in 2001,
respectively. For 2002 and 2001, the prime interest rate fluctuation from
January 1 to September 30 of each year was 0% and -3.0%, respectively.
Management believes that these fluctuations did not have a material impact on
the Companys results of operations or financial position for 2002 and 2001.

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 ended June 30, 2002. As of
January 1, 2001, Xybernaut GmbH converted its functional currency from the
Deutsche Mark to the Euro. The effect of this conversion on beginning
accumulated deficit was an increase of $151,123, which is included in the
foreign currency translation balance. Issues that were addressed by the Company
as a result of the introduction of the Euro include the conversion of
information technology systems, reassessment of foreign currency exchange risk,
negotiation and amendment of existing agreements and contracts, and processing
of tax and accounting records. At September 30, 2002, 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.

ITEM 4. CONTROLS AND PROCEDURES

Within the 90 days prior to the date of this report, the Company carried out an
evaluation, under the supervision and with the participation of the Companys
management, including the Companys Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of the Companys
disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based
upon that evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that the design of the Companys disclosure controls and procedures
is effective. However, with respect to the operation of such controls and
procedures, the evaluation determined that in some instances, certain of the
Companys established procedures related to contract execution were not
followed in a timely manner. Subsequent to the evaluation, the established
procedures were applied to these transactions and the Chief Executive Officer
and Chief Financial Officer concluded that the financial statements,
Managements Discussion and Analysis and other information contained in this
report is full and accurate. Management is currently evaluating corrective
action to improve the operation of the Companys disclosure controls and
procedures. There were no significant changes in the Companys internal
controls or in other factors that could significantly affect these controls
subsequent to the date of their evaluation.

PART II  OTHER INFORMATION

ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS

During August 2002, the Company received gross proceeds of $2,000,000 through a
private placement of 5,714,286 shares of its common stock to certain investors.
The shares were sold at $0.35 per share, representing an approximate 11%
discount to the closing price of the shares for the 20 trading days immediately
preceding the closing. In connection with this private placement, the Company
issued to the investors callable warrants to purchase 5,714,286 shares of
common stock at an exercise price of $0.70 per share and callable warrants to
purchase 5,714,286 shares of common stock at an exercise price of $1.50 per
share. The net proceeds of the placement were used for working capital of the
Company. The private placement was exempt from registration pursuant to Section
4(2) of the Securities Act of 1933 and Rule 506 promulgated thereunder.

ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K

A) EXHIBITS

None.

B) REPORTS ON FORM 8-K

None.





---



##### 



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/ THOMAS D. DAVIS                                                                            |  | 
| |  |                                                                                                |  | 
| |  | By: Thomas D. Davis
Senior Vice President and Chief Financial
Officer                          |  | 





---



##### 



Certification pursuant to [Section 906] of the Sarbanes-Oxley Act of 2002

I, Edward G. Newman and Thomas D. Davis, certify that:

1.     I have reviewed this quarterly report on Form 10-Q of Xybernaut Corporation;

2.     Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;

3.     Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4.     The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrants disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the Evaluation Date); and

c) presented in this quarterly report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;

5.     The registrants other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the
equivalent function):

a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrants ability to record, process,
summarize and report financial data and have identified for the registrants
auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrants internal controls;
and

6.     The registrants other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

November 14, 2002

| |  |                                                                                                |  | 
| |  | ---------------------------------------------------------------------------------------------- |  | 
| |  | XYBERNAUT CORPORATION                                                                          |  | 
|
|
|
|
| |  |                                                                                                |  | 
|
|
|
|
| |  | /s/ EDWARD G. NEWMAN                                                                           |  | 
| |  |                                                                                                |  | 
| |  | By: Edward G. Newman
President, Chief Executive Officer and
Chairman of the Board of Directors |  | 
|
|
|
|
| |  |                                                                                                |  | 
|
|
|
|
| |  | /s/ THOMAS D. DAVIS                                                                            |  | 
| |  |                                                                                                |  | 
| |  | By: Thomas D. Davis
Senior Vice President and Chief Financial
Officer                          |  |