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                    U. S. SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   FORM 10-KSB

[X]       ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
          EXCHANGE ACT OF 1934

          For the fiscal year ended December 31, 2001.

[_]       TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES
          EXCHANGE ACT OF 1934

          For the transition period from ____________ to ___________.

                         Commission File Number: 1-14896

                       NETWORK-1 SECURITY SOLUTIONS, INC.
                 (Name of small business issuer in its Charter)

                  DELAWARE                        11-3027591
                  --------                        ----------
        (State or other jurisdiction            (IRS Employer
             of incorporation)              Identification Number)


                       1601 TRAPELO ROAD, RESERVOIR PLACE
                          WALTHAM, MASSACHUSETTS 02451
                          ----------------------------
                    (Address of Principal Executive Offices)

                   Issuer's telephone number : (781) 522-3400

         Securities registered under Section 12(b) of the Exchange Act:

      Title of each class             Name of each exchange on which registered
      -------------------             -----------------------------------------
 Common Stock, $.01 par value                   Boston Stock Exchange

         Securities registered under Section 12(g) of the Exchange Act:

                                      None

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

     Check if there is no disclosure  of  delinquent  filers in response to Item
405 of  Regulation  S-B  contained  in  this  form,  and no  disclosure  will be
contained,  to the  best of  registrant's  knowledge,  in  definitive  proxy  or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [ ]

     The issuer's revenues for its most recent fiscal year: $1,046,000.

     The aggregate  market value of the voting stock of the  registrant  held by
non-affiliates computed by reference to the price at which the stock was sold on
March 25, 2002 was approximately $8,404,050.

     The number of shares of Common Stock  outstanding  as of March 25, 2002 was
7,677,680.

     Documents  Incorporated by Reference:  Certain portions of the Registrant's
definitive  proxy statement to be filed no later than April 30, 2002 pursuant to
Regulation 14A are  incorporated  by reference in Items 9 through 12 of Part III
of this Annual Report on Form 10-KSB.

     Transitional Small Business Disclosure Format (Check One): Yes [_] No [X]
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                                     PART I

     THIS ANNUAL REPORT ON FORM 10-KSB  CONTAINS  CERTAIN  STATEMENTS  WHICH ARE
FORWARD-LOOKING  STATEMENTS  WITHIN THE MEANING OF THE SAFE HARBOR PROVISIONS OF
SECTION 27A OF THE  SECURITIES  ACT OF 1933, AS AMENDED,  AND SECTION 21E OF THE
SECURITIES  EXCHANGE  ACT OF  1934,  AS  AMENDED.  ACTUAL  RESULTS,  EVENTS  AND
CIRCUMSTANCES  (INCLUDING FUTURE  PERFORMANCE,  RESULTS AND TRENDS) COULD DIFFER
MATERIALLY  FROM THOSE SET FORTH IN SUCH  STATEMENTS  DUE TO  VARIOUS  RISKS AND
UNCERTAINTIES,  INCLUDING  BUT NOT LIMITED TO,  THOSE  DISCUSSED  IN THE SECTION
ENTITLED "RISK FACTORS THAT MAY AFFECT FUTURE  RESULTS" IN ITEM 1 OF THIS REPORT
AS WELL AS THOSE RISKS DISCUSSED ELSEWHERE IN THIS REPORT.

ITEM 1. DESCRIPTION OF BUSINESS.

         INTRODUCTION

         Network-1 Security Solutions Inc. (the "Company") develops, markets,
licenses and supports a suite of security software products designed to prevent
unauthorized access to critical information residing on networked servers,
desktops and laptops. The Company's CyberwallPLUS family of security software
products combines the benefits of firewall and intrusion detection technology
with central management features to provide an enterprise-class layer of
security protection directly on servers, desktops, wireless and mobile computers
(the "end points"). The CyberwallPLUS family of security products compete in the
emerging "end-point" security market.

         CyberwallPLUS delivers intrusion prevention through its firewall and
intrusion detection capabilities, a unique combination of technologies that
actively detects and blocks intrusions. CyberwallPLUS interrogates incoming and
outgoing traffic on the host servers, desktops and laptops by using stateful
inspection and behavior-based intrusion detection. The packet-filtering firewall
blocks unauthorized access to any of the 65,000 ports on a computer and prevents
the computer from launching attacks of its own directed at other networked
computers. The access controls and intrusion filters enable security policy,
which is optimized to the specific computer, and dramatically increases the
machine's ability to deflect attacks or potential compromise.

          Centralized management features of CyberwallPLUS allow organizations
to flexibly deploy and manage policies enterprise-wide. In addition to training
and technical support services, the Company offers multi-year maintenance
agreements to its customers. The Company's network of solution providers in the
United States and internationally offer post-sales support services to ensure a
client's successful deployment of the Company's products.

         The Company was incorporated under the laws of the State of Delaware in
July 1990. The Company's executive offices are located at 1601 Trapelo Road,
Reservoir Place, Waltham, Massachusetts 02451 and its telephone number is
781-522-3400. The Company's Web site can be found at www.network-1.com.

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         INDUSTRY BACKGROUND

         With the advent of the Internet, the availability of broadband
technologies, and the rise in use of Web-based applications, organizations have
opened the once closed corporate network to telecommuting and mobile employees,
remote offices, customers and business partners. By leveraging the open, public
Internet, the organization is extended beyond the traditional boundaries of the
corporate network. As a result, organizations face increasing security threats
that may compromise their critical information assets.

         Traditional perimeter security solutions, such as perimeter firewalls,
can no longer effectively secure all of the network's resources. Organizations
are employing virtual private network technology (VPN) which provides a cost
effective means of transmitting confidential data over the Internet by utilizing
various encryption and authentication technologies. However, the widespread use
of VPN technology makes remote desktops and laptops a very valuable target
allowing an authenticated and encrypted path directly into the corporate
network. These VPN's, however, do not secure the end points (computers) which
are still vulnerable to compromise and which can be used in other network based
attacks. As a result, securing an organization's electronic assets has become a
critical business imperative for organizations. IDC estimates that the overall
market for security software will grow from $6.0 billion in 2001 to $14.6
billion by 2006.

         The increase in external traffic running across corporate networks has
significantly raised the potential for malicious activity from hackers and other
unauthorized users, with recreational hackers and disgruntled employees
accounting for a large percentage of security breaches. The 2001 Computer
Security Institute (CSI)/FBI study of enterprises and government agencies
reported a 36% annual growth in losses from security breaches between 1997 and
2001, with 40% of such losses attributed to theft of proprietary information.
The enormous impact of the "Nimda" and "Code Red" worms, which only targeted a
handful of Web server vulnerabilities, reveals the prevalence of vulnerabilities
to major attacks. The "Nimda" worm caused billions of dollars in damages and
infected hundreds of thousands of servers. It spread by exploiting a known
vulnerability in servers running Microsoft's Internet Information Server (IIS)
Web Software.

         Although the "Nimda" worm attacked IIS servers, simply protecting
servers is not an adequate strategy. One of the more exposed elements of the
corporate technology environment is the corporate desktop and laptop where users
load unauthorized software, leave passwords vulnerable, and fail to take
adequate precautions on their own. The problem is compounded when the
telecommuting or mobile user's laptop is infected while accessing the Internet
from their "unprotected" home, hotel or airport connection, and then accessing
the corporate network with their compromised laptop when they return to their
workplace.

         Organizations face increasing security challenges as their
organizations grow, become geographically distributed, and face increased
regulatory pressures. Outside of the corporate data center, security around
servers and PCs is less restrictive. Establishing and managing security policies
for the broad-spectrum of network nodes is a challenging task, especially for
multiple locations across Wide Area Networks (WANs). Organizations are beginning
to recognize the need to provide an additional layer of protection for servers

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and workstations storing or providing access to critical business assets that
are a potential target for hackers.

         THE NETWORK-1 SOLUTION

         The CyberwallPLUS family of security software products represents the
latest generation of our host-based security solution that integrates a powerful
range of security techniques to actively detect and block intrusions thereby
providing effective "end-point" security.

         CyberwallPLUS combines the benefits of firewall and intrusion detection
technology with central management features to provide an enterprise-class layer
of robust security protection directly on Microsoft Windows-based servers,
desktops, wireless and mobile computers. The Company's distributed intrusion
prevention software is a bi-directional layer of defense that protects the
network from the host machine, as well as protecting the host machine from the
network, regardless of whether the source of attack is inside or outside the
organization. CyberwallPLUS also protects mobile and wireless computers even
when they connect to networks outside the organization's control.

         The Company's CyberwallPLUS family of host intrusion prevention
products operates on Windows 9x, Windows NT, Windows 2000, and Windows XP
operating system platforms. The CyberwallPLUS suite of products was first
introduced in January 1999, evolving from the Company's FireWall/Plus suite of
security software products and prior practice in security consulting and
forensics. The Company's perimeter firewall product continues to be available in
IP and multi-protocol versions.

         The Company's applications address an organization's need for solutions
that improve information security in today's Internet-enabled technology
environments. Designed to reduce the total cost of ownership, the Company's
solutions deploy without difficulty, offer local or remote centralized
management features, integrate easily into existing management infrastructures,
and complement existing security investments.

         The Company's solution starts out by inhibiting intruders from even
discovering computer assets with "stealth mode", a technique that gives the
appearance that no system is present at a given IP address. Fine-grained access
control, bi-directional protection and stateful packet inspection typically
found in high-end perimeter firewalls combine with powerful intrusion detection
and prevention capabilities to add a critical second layer of defense behind
existing perimeter firewalls.

         CyberwallPLUS's centralized policy management enables detailed security
policies to be formulated, distributed, and monitored, maximizing IT security
resources. The logging features are designed to meet the requirements for legal
forensic evidence as well as timely alerts. CyberwallPLUS coexists or
interoperates easily with many other security and management components,
including virus checkers, enterprise monitoring systems, and enterprise VPNs.

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STRATEGY

         The Company's goal is to become a leading provider of host security
solutions for multi-layer defense of critical business processes. Key components
of the Company's strategy include:

         EXTEND TECHNOLOGY IN HOST INTRUSION PREVENTION. The Company's
technology enables it to offer complete and cost-effective host intrusion
prevention for Windows environments. By continuing the evolution of the
Company's core technology platform, the Company expects to extend its stateful
packet inspection, intrusion detection and prevention capabilities. The Company
has expanded its development resources in 2002 to provide additional host-based
security and enterprise-scale management technologies.

         EXPAND SALES CHANNELS. The Company's sales strategy requires
establishing multiple indirect sales and marketing channels in the United States
and internationally. During the fourth quarter of 2001, the Company embarked on
an aggressive effort to extend its sales reach through indirect channels, such
as value-added resellers, system integrators, and original equipment
manufacturers (OEMs). In the U.S. this has been accomplished by establishing
relationships with leading systems integrators and consultants, including
Siemens Business Systems and CompuCom Systems, Inc. In addition, the Company
will continue its efforts to expand its sales and marketing channels in 2002,
with the addition of more partners, improved channel effectiveness via
co-marketing and joint selling programs, and further development of sales and
technical training initiatives.

         ENHANCE STRATEGIC RELATIONSHIPS FOR COMPLEMENTARY TECHNOLOGIES. As a
critical component of any organization's multi-layered security infrastructure,
intrusion prevention solutions must operate efficiently and seamlessly with
other security products. In order to increase market awareness and distribution,
as well as ensure co-existence that delivers customer benefits, the Company will
increase its efforts to cultivate technology, marketing and sales synergies with
vendors of complementary technologies - including VPNs, anti-virus solutions,
file integrity applications, and more.

         EXPAND STRATEGIC RELATIONSHIPS WITH KEY INFRASTRUCTURE PROVIDERS.
Effective security architecture is inextricably linked to the clear
identification of the infrastructure to be protected and the relevant threats -
requiring close partnerships with infrastructure vendors to develop optimized
security solutions. In addition to extending the Company's relationships with
leading vendors of systems, software and networking infrastructure, the Company
will attempt to establish relationships with emerging infrastructure technology
vendors. The Company's marketing strategy includes targeting emerging
application segments where security is becoming more important. In October 2001
the Company signed a ten (10) year Licensing and Distribution Agreement which
established a co-development, marketing and distribution sales relationship with
FalconStor Software, Inc. ("FalconStor") (Nasdaq; FALC), a storage networking
company, to develop versions of CyberwallPLUS that are optimized for
FalconStor's IPStor storage management suite.

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         CONTINUE INTERNATIONAL EXPANSION. In late 2001 the Company expanded its
marketing efforts beyond the United States to Europe and Asia. The Company has
recently expanded its sales force with the objective of gaining broad
international market acceptance of the Company's security solutions.
Internationally, the Company will attempt to execute a systematic program to
recruit and grow its business with local channel partners.

         LEVERAGE KEY REFERENCE ACCOUNTS IN SELECTED VERTICAL MARKETS. The
Company has targeted its marketing and direct sales efforts at organizations
within several key vertical markets where security is the utmost priority due to
new consumer privacy regulations, sensitivity of data residing on
remote-accessed networks, and a high percentage of mobile/remote workers. The
positive references garnered from this installed customer base offers the
Company an opportunity to expand our market penetration within those critical
industries. In addition, these reference accounts will serve as references for
other like-sized, security sensitive organizations.

PRODUCTS AND SERVICES

         The Company maintains two classes of CyberwallPLUS products - host
intrusion prevention solutions and network and perimeter firewall solutions -
each with a corresponding central manager module.

         HOST INTRUSION PREVENTION. The Company's host solutions control access
to desktops, laptops, and servers. The Company released three revisions of
CyberwallPLUS host products, culminating with the release of version 7.2 in
February 2002. The product suite includes:

                  CYBERWALLPLUS FOR DESKTOPS AND LAPTOPS. CYBERWALLPLUS-WS runs
         on Windows 9x, Windows NT/2000, and Windows XP client systems and
         provides a necessary complement to mail-only antivirus scanners. The
         packet-filtering firewall blocks unauthorized access to any of the
         65,000 ports on the end point (computer), and prevents that computer
         from launching any attacks of its own directed at other network
         resources. The combination of firewall and intrusion detection
         technology is comparable to robust perimeter security technology, but
         optimized for an end point computer. CYBERWALLPLUS-WS also ensures that
         a computer operates in stealth mode, making it invisible to scanning
         programs typically used by hackers to locate computers on the network.
         In addition, at the option of the network administrator,
         CYBERWALLPLUS-WS can be operated in silent mode so that the computer
         user does not have access to the product and thus can not make any
         changes to its configuration.

                  CYBERWALLPLUS FOR SERVERS. The CYBERWALLPLUS-SV server edition
         is intended for all Microsoft application, database, or infrastructure
         servers to provide a layer of local self-defense against unauthorized
         access. Remote access to public servers such as Web servers, Microsoft
         Exchange Server mail servers, or even Intranet and database servers
         creates vulnerability in an organization's protection scheme. The
         access controls and intrusion filters enable security policy which is
         optimized to the specific server, and dramatically increases its
         ability to deflect attacks or compromise.

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                  CYBERWALLPLUS CENTRAL MANAGER. CYBERWALLPLUS-CM, a management
         application enabling control and monitoring of multiple CyberwallPLUS
         installations, responds to an organization's need to easily and
         centrally manage and maintain the Company's solution distributed across
         the corporate network. Complementing existing management environments,
         CyberwallPLUS offers local, remote, and centralized management; policy
         deployment and management; logging and reporting to existing management
         systems; and centralized license deployment and license inventory
         capabilities.

         NETWORK AND PERIMETER FIREWALLS. The Company also offers a set of
network and perimeter firewalls to complete a layered network defense strategy.
The Company released two revisions of CyberwallPLUS firewall products,
culminating with the release of version 6.2 in July 2001. The product suite
includes:

                  CYBERWALLPLUS INTERNET PROTOCOL. Designed to protect a
         computer network from Internet attacks and intrusions, CYBERWALLPLUS-IP
         installs as either a transparent bridge or router on the network
         perimeter. CYBERWALLPLUS-IP, an ICSA (International Computer Security
         Association) certified product, thwarts malicious attacks originating
         on either side of the network through its advanced firewall and active
         intrusion detection/prevention capabilities. The network security
         software runs on Windows NT/2000 systems configured with two Ethernet
         interfaces and features an advanced packet filter engine that provides
         fine-grained network access controls, sophisticated intrusion detection
         and prevention algorithms, and detailed traffic audit logs.

                  CYBERWALLPLUS MULTI-PROTOCOL. Ideally suited for internal
         network security, CYBERWALLPLUS-MP is a high-speed local area network
         (LAN) segment firewall controlling access between internal networks. It
         operates as a two-port Ethernet bridge and supports hundreds of IP and
         non-IP protocols. It provides network administrators with the network
         access controls and intrusion detection tools needed to secure
         multi-protocol Ethernet LANs from outside attacks.

Network-1's solutions contain the following features or attributes:

         ADVANCED PACKET FILTERING SYSTEM. CyberwallPLUS provides both inbound
and outbound packet filtering; passing traffic based on network access rules.
These rules restrict packet flow, protecting the network and the systems
connected to the network from unnecessary and potentially malicious traffic.

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         STATEFUL PACKET INSPECTION AND DYNAMIC PORT ALLOCATION. CyberwallPLUS
examines packets to determine whether or not to pass the packet based on the
state of the connection. Should the state of the connection be other than
anticipated, CyberwallPLUS will not pass the packet to the destination because
the packet is not considered stateful. Stateful inspection is also necessary for
dynamic port allocation. With dynamic port allocation, certain protocols may
request the one-time opening of a subsidiary connection on additional ports that
are opened and closed when the application requires them, yet blocked when not
in use. Through Stealth mode operation, CyberwallPLUS will not respond to
requests on blocked ports, thus making it more difficult for attackers to
"fingerprint" or detect the computer for attack, rather than responding to an
unauthorized query with a "connection not allowed" message which would reveal
the existence of the computer on the network.

         SILENT MODE. Silent mode allows the CyberwallPLUS product to operate
without the local user interface present. In enterprise deployments, this gives
central administrators control over configuration, policy, and monitoring of
host systems without involving or disturbing the end user.

         CENTRALIZED MANAGEMENT. Enterprise environments benefit from
CyberwallPLUS's scalable creation of groups of individual hosts and the
distribution of policies and licenses across a large number of machines.
Multiple industry standard logging formats are supported to enhance the
integration of CyberwallPLUS with existing enterprise management systems.

         CUSTOMIZED SECURITY POLICIES. Security policies may be customized for
individual departments, and individual systems and personnel within the network.
In addition, CyberwallPLUS allows the creation and tailoring of templates to
support custom applications, protocols, and non-standard port configurations.

         EASE OF USE. CyberwallPLUS was designed to be easily installed,
configured and managed by a network or system manager with minimal security
skills through an intuitive user interface. To facilitate implementation,
CyberwallPLUS comes pre-programmed with a wide variety of frequently used
default security policies (templates) which require the customer to simply
select one of the rule sets and save the selection.

         The Company's solutions are licensed on a per-machine basis, with
licenses for individual systems, or license packs with volume price breaks for
multiple systems, as well as site licenses, where applicable. The Company adds
to the completeness of its solution by offering professional training,
multi-year product maintenance agreements, and 5/10 technical support plans.
Deployment services are offered through the Company's worldwide network of
channel partners.

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SALES, MARKETING AND DISTRIBUTION

         The Company's objective is to develop a channel-centric sales strategy.
In the U.S., the Company directly markets its products through a field sales
organization supported by inside sales representatives. The Company also
indirectly markets its products through regional value-added resellers (VARs)
who offer complementary technologies, including specialized government
resellers, and national integrators who have a focus or practice in security.
Internationally, the Company's network of regional/country resellers or
distributors provides sales interface with prospective customers.

         DIRECT SALES. The Company`s direct marketing efforts target medium and
large-scale Microsoft Windows-centric enterprises with a large percentage of
mobile or remote employees in financial services, healthcare, higher education,
and government agencies or suppliers. The Company's sales professionals qualify,
develop and pursue leads based on a variety of marketing awareness and lead
generation programs, including event marketing, online advertising, and direct
mail, as well as downloaded product trials from its corporate Web site. The
first objective of the field sales staff is to develop end user opportunities
through a combination of on-site and remote interactions with the prospect. The
second objective of the field sales staff is to recruit, cultivate and support
indirect channel partners. The Company's domestic sales staff is mainly located
at corporate headquarters in Waltham, Massachusetts, with the exception of field
sales personnel in the western United States.

         The Company intends to continue to aggressively expand its
international operations to address the rapid global adoption of distributed
computing environments. Many foreign countries do not have laws recognizing
network intrusion or misuse as a crime or the resources to enforce such laws if
they do exist. As a consequence, the Company believes that organizations in such
countries will have greater need for effective security solutions. The Company
plans to expand in those regions where businesses, governments and other
institutional users are using distributed networks and the Internet for their
mission-critical needs. In the first quarter of 2002, the Company established
its Asia Pacific operations which are headquartered in Shanghai, China. These
operations will provide product development, sales, marketing and customer
support in the Asia Pacific region.

         INDIRECT SALES. The Company currently has relationships with 19
national, regional and local resellers and systems integrators. In addition, the
Company currently has relationships with 17 international system integrators,
VARs, resellers and distributors including, among others, the following
countries: Japan, United Kingdom, Italy, Germany, Finland, Norway, Canada,
Singapore, Russia, Argentina, Peru, Dominican Republic, Antigua, Australia,
Switzerland and Saudi Arabia. The Company's agreements with resellers generally
grant the right to market the Company's products in specified territories on a
non-exclusive basis, are terminable on short notice and do not prohibit the
reseller from selling products that are competitive with the Company's products.
The Company has signed reseller agreements with several leading VARs and
integrators, most notably Siemens Business Services, Inc. and CompuCom Systems,
Inc.

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Channel partners may be classified as:

         SYSTEM INTEGRATORS. System integrators add significant value to mutual
customers by providing outsourced IT management services for deploying, managing
and maintaining security infrastructure technology. The Company will continue to
attempt to expand the breadth and depth of existing relationships, while also
making efforts to sign new system integrators to assist the Company in vertical
or geographical expansion.

         REGIONAL VARS. The regional and/or vertical focus of the Company's VARs
is important for the Company's continued presence in small and medium-sized
enterprises as well as the government sector in the U.S. Internationally, VARs
have provided the backbone of the Company's sales and marketing presence in the
local markets. The Company will continue to pursue these relationships in 2002.

         OEMS. The Company has established several OEM relationships with
vendors who market, sell and support the Company's solutions. The Company's
CyberwallPLUS products are currently bundled with NEC's Fault Tolerant Server.
Furthermore, FalconStor intends to offer the Company's technology solutions with
its storage management product suite in the first half of 2002.

         ISV/CO-MARKETING PARTNERS. The Company continues to seek partnerships
with companies whose technologies are complementary. In addition to sales and
marketing initiatives, the Company also may work on technical integration of its
products to provide seamless co-existence or other benefits to mutual customers.

FALCONSTOR LICENSE AND DISTRIBUTION AGREEMENT

         Simultaneously with the closing of the Company's October 2001 private
offering of $6,765,000 of securities (See "Management's Discussion and Analysis
or Plan of Operation" at page 24 hereof), the Company entered into a ten (10)
year License and Distribution Agreement with FalconStor, pursuant to which
FalconStor has the right to distribute the Company's product offerings in its
indirect and OEM channels. As part of the Agreement, FalconStor paid the Company
a non-refundable advance of $500,000 against future royalty payments (See
"Management's Discussion and Analysis or Plan of Operations" at page 24).

MARKETING

         The Company's marketing mission is two-fold - create awareness of the
Company's product offerings with the Company's target audience through
broad-reach communications programs, and generate leads for sales and channel
partners through direct marketing efforts. The Company has engaged in print and
online advertising promotions, and maintains an active public relations program.
Through these vehicles, the Company attempts to reach the widest-range audience
to educate and promote its security solutions. The Company's targeted marketing
programs, such as event sponsorships and exhibitions, direct mail (paper and
email), and online advertising allow the Company to customize its messages to
the specific market segments and/or buyers of its products, and are most
effective in not only informing prospects about its products features and
benefits, but also generating the most qualified leads for channel partners. The
Company

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also pursues co-marketing activities with strategic and indirect channel
partners. The Company plans to devote additional resources to marketing its
corporate and product brands in 2002.

CUSTOMERS

         The Company's customers represent a wide range of industries and
institutions, both commercial and government, which consider networked-data
resources to be among the most important assets within their organizations. As
of December 31, 2001 the Company had licensed one or more of its products to 530
customers. New customers during 2001 include: The National Institute of Health,
Pennsylvania Supreme Court, University of Washington, The Fuji Bank, Ltd.,
Bristol Meyers Squibb, and Bank of Finland. During the year ended December 31,
2001 revenue from the University of Washington and Pacific InfoTech (China) Ltd.
accounted for 15% and 14% of the Company's revenues, respectively.

         During the years ended December 31, 2001 and 2000, revenue from
international customers (licenses and service to foreign end users and
international distributors) accounted for 21% and 11% of our revenues,
respectively.

         Strategic Alliances

         The Company continues to actively seek strategic alliances to offer
complementary benefits to its mutual customers and prospective customers while
expanding the sales and marketing reach of its solutions. The Company has
focused on two classes of strategic alliances:

                  INFRASTRUCTURE VENDORS. The Company's co-marketing and
         distribution relationships focus on generating revenue by being the
         preferred vendor for securing the partner's infrastructure. In 2001 the
         Company established such relationships with NEC (fault tolerant
         servers) and FalconStor (storage networking).

                  SECURITY SOLUTIONS VENDORS. The co-marketing and technology
         integration relationships the Company has secured ensures technology
         compatibility and extends the reach of its CyberwallPLUS solutions.
         These partners include authentication, public key encryption (PKI),
         VPN, and security management solution vendors.

         In addition, the Company remains actively involved with industry
standards organizations, including ICSA (International Computer Security
Association), IETF (Internet Engineering Task Force), and ASP (Application
Service Provider) Industry Consortium.

COMPETITION

         The market for host intrusion prevention solutions is characterized by
intense competition and rapidly changing business conditions, customer
requirements and technologies. The Company expects competition to continue to
increase both from existing competitors and emerging companies. Management
believes that the Company's ability to compete depends on many factors both
within and beyond its control, including:

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o    the effectiveness, performance, reliability, features, price, and
     ease-of-use of the Company's CyberwallPLUS product line as compared with
     the product offerings of competitors;

o    the Company's ability to attract and retain key strategic relationships
     with indirect channel partners and technology partners;

o    the Company's ability to expand its domestic and international sales
     operations; and

o    the timing and market acceptance of new solutions and enhancements to
     existing solutions developed by the Company and its competitors.

EXISTING COMPETITION

         The Company views its competition in several classes as follows:

                  HOST INTRUSION PREVENTION FOR SERVER SYSTEMS RUNNING MICROSOFT
         WINDOWS NT/2000. The Company's principal competitors include operating
         system (OS) intercept vendors Entercept Security Technologies and
         Okena, Inc.; and host intrusion detection system (IDS) vendors Internet
         Security Systems, Inc., Enterasys Networks, Inc., Symantec Corporation
         and NFR Security, Inc. Since there is a wide array of server operating
         systems, as well as the types of threats (operating system,
         application, network, file, etc.) that can exist, no one solution is
         used independently. However, Management believes that the Company's
         solution is differentiated by its longevity in the server protection
         arena, and its unique technology approach to server security.

                  HOST INTRUSION PREVENTION FOR ENTERPRISE DESKTOPS/LAPTOPS
         RUNNING MICROSOFT WINDOWS 9X, WINDOWS NT/2000, OR WINDOWS XP. The
         Company competes primarily with personal firewall vendors, such as
         Internet Security Systems, Inc. (NetworkICE acquisition), Symantec
         Corporation, Zone Labs, Inc., InfoExpress, Inc. and Sygate
         Technologies, Inc. VPN/Firewall vendors, such as Check Point Software
         Technologies Ltd. and InfoExpress, Inc.; and Host IDS vendors, such as
         Internet Security Systems, Inc.

                  NETWORK AND PERIMETER FIREWALL PRODUCTS. The Company's primary
         source of competition is Check Point Software Technologies Ltd.,
         Symantec Corporation, SonicWall, Inc., and WatchGuard Technologies,
         Inc.

                  FUTURE COMPETITION. The Company may face competition in the
         future from new market entrants or established security infrastructure
         companies who have not previously entered the market for host intrusion
         prevention solutions.

         Most of the Company's current and potential competitors have longer
operating histories, greater name recognition, larger installed customer bases
and possess substantially greater financial, technical, marketing and other
competitive resources than the Company. As a result, the Company's competitors
may be able to adapt more quickly to new or emerging technologies or attacks,
changes in customer requirements and devote greater resources to the promotion
and sale of their products than the Company. While the

                                       12
<PAGE>

Company believes that its CyberwallPLUS products do not compete against
manufacturers of other categories of security products (such as encryption and
authentication products), potential customers may perceive the products of such
other companies as substitutes for the Company's products. In addition, certain
of the Company's competitors may determine for strategic reasons to consolidate,
to substantially lower the price of their network security products or to bundle
their products with other products, such as hardware or other enterprise
software products. Accordingly, it is possible that new competitors and
alliances among competitors may emerge and rapidly acquire significant market
share. The Company's current and potential competitors may develop products that
may be more effective than the Company's current or future products, or the
Company's products may be rendered obsolete or less marketable by evolving
technologies or changing consumer demands, or the Company may otherwise be
unable to compete successfully. Increased competition for firewall and
CyberwallPLUS products may result in price reductions, reduced gross margins and
may adversely effect the Company's ability to gain market share, any of which
would adversely effect the Company's business, operating results and financial
condition.

PRODUCT RESEARCH AND DEVELOPMENT

         The security software market is dynamic, characterized by rapid changes
in technology and customer requirements, new product introductions and
enhancements, and emerging industry standards. The Company devotes significant
time and resources to analyzing and responding to changes in the industry, such
as changes in operating systems, application software, security standards and
networking software. In addition, the Company continuously monitors evolving
customer requirements because it believes that a customer-driven development
strategy will enable the Company to continue to broaden its products and feature
sets. The Company's research and development department is responsible for the
design, development and release of the Company's products, and is focused on the
continuous evolution of the Company's products. Organized into development,
quality assurance, and documentation disciplines, the research and development
team works closely with sales, marketing, and customer support in order to
better understand market needs and user requirements.

         A full time development team located at the Company's Waltham,
Massachusetts headquarters has the primary responsibility for product
development and technology direction, which is augmented by staff located at the
Company's Shanghai, China operations center. Consultants are sometimes retained
to address specific areas of expertise on a limited basis.

         During the years ended December 31, 2001 and 2000, the Company's total
product development costs, including the costs capitalized after technological
feasibility has been reached, were $2,522,000, and $1,808,000, respectively.

CUSTOMER SERVICE AND SUPPORT

         One-year maintenance subscriptions are typically sold with software
licenses, and optional multi-year maintenance subscriptions are available
thereafter. The Company provides customer technical support as a component of
its annual maintenance subscriptions, which includes phone, email, and Web-based
support. The Company's telephone and email support services are available Monday
through Friday between the

                                       13
<PAGE>

hours of 8am and 6pm eastern standard time in the United States. The Company's
corporate Web site contains a wealth of support information, such as frequently
asked questions, configuration documents and service pack download. Support
services provide installation and configuration assistance, as well as product
troubleshooting for the term of the maintenance agreement. Additionally,
fee-based on-site, Web-based, or regional training programs are also available.

PROPRIETARY RIGHTS

         The Company's success is substantially dependent on its proprietary
technologies. The Company does not hold any patents and relies on copyright and
trade secret laws, non-disclosure agreements with employees, consultants,
distributors and customers, including "shrink wrap" license agreements that are
not signed by the customer, and technical measures to protect the ideas,
concepts and documentation of the Company's proprietary technologies and
know-how. Such methods may not afford complete protection, and there can be no
assurance that third-parties will not independently develop substantially
equivalent or superior technologies or obtain access to the Company's
technologies, ideas, concepts and documentation. In addition, confidentiality
agreements between the Company and its employees, distributors or customers may
not provide meaningful protection for the Company's proprietary information in
the event of any unauthorized use or disclosure. Any inability to protect the
Company's proprietary technologies could have a material adverse effect on the
Company. Furthermore, the Company may be subject to additional risk as it enters
into transactions in countries where intellectual property laws are not well
developed or are poorly enforced. Legal protection of the Company's rights may
be ineffective in such countries.

         On June 19, 2001, the Company was issued a U.S. trademark registration
(reg. no. 2,462,262) for the mark CyberwallPLUS for computer products. Although
we are not aware of any challenges to our rights to use this trademark, there
can be no assurance that the use of this mark would be upheld if challenged.

         Although the Company believes that its technologies and products have
been developed independently and do not infringe upon the proprietary rights of
others, there can be no assurance that the Company's technologies and products
do not infringe and that third parties will not assert infringement claims
against the Company in the future. The Company is not aware of any patent
infringement charge or any violation of other proprietary rights claimed by any
third party relating to the Company or its products.

         As the number of security products being offered continues to increase,
the functionality of such products may further overlap, which could result in
increased infringement claims by software developers, including infringement
claims against the Company with respect to future products. The Company may not
be able to modify its products or obtain a license in a timely manner, upon
acceptable terms and conditions. In addition, the Company may not have the
financial or other resources necessary to defend a patent infringement or other
proprietary rights infringement action. Failure to do any of the foregoing could
have a material adverse effect on the Company, including possibly requiring it
to cease marketing its products.

                                       14
<PAGE>

EMPLOYEES

         As of March 25, 2002, the Company had 39 full time employees. None of
the Company's employees are represented by a labor union or are subject to a
collective bargaining agreement. The Company has not experienced any work
stoppages and considers its relationships with its employees to be good.

          Competition with respect to the recruitment of highly qualified
personnel in the software industry is intense and many of the Company's
competitors have significantly greater resources than the Company. The Company's
ability to attract and assimilate new personnel will be critical to the
Company's performance and there can be no assurance that the Company will be
successful in attracting or retaining the personnel it requires to enhance its
products, develop new products and conduct its operations successfully.

RISK FACTORS THAT MAY AFFECT FUTURE RESULTS

          The Company operates in a rapidly changing and highly competitive
environment that involves a number of risks, some of which are beyond the
Company's control. The following discussion highlights the most material of the
risks.

         WE HAVE A HISTORY OF LOSSES AND IF WE DO NOT ACHIEVE PROFITABILITY, WE
MAY NOT BE ABLE TO CONTINUE OUR BUSINESS IN THE FUTURE.

         We have incurred substantial operating losses since our inception,
which has resulted in an accumulated deficit of $34,517,000 as of December 31,
2001. For the years ended December 31, 2001 and 2000, we incurred net losses of
$5,872,000 and $4,789,000, respectively. Since December 31, 2001, we have
continued to incur substantial operating losses. We have financed our operations
primarily through the sales of equity and convertible debt securities as well as
the sale of our professional services business in February 2000. Our expense
levels are high and our revenues are difficult to predict. We anticipate
incurring additional losses until we increase our client base and revenues. We
may never achieve or sustain significant revenues or profitability. If we are
unable to achieve increased revenues, we will continue to have losses and may
not be able to continue our operations.

         WE COULD BE REQUIRED TO CUT BACK OR STOP OPERATIONS IF WE ARE UNABLE TO
RAISE OR OBTAIN NEEDED FUNDING.

          We anticipate, based on our currently proposed plans and assumptions
(including the timetable of, costs and expenses associated with, and success of,
our marketing efforts), that our current cash position and projected revenues
from operations, will more likely than not be sufficient to satisfy our
operations and capital requirements through December 31, 2002. There can be no
assurance, however, that such funds will not be expended prior thereto due to
unanticipated changes in economic conditions or other unforeseen circumstances.
In the event our plans change, or our assumptions change or prove to be
inaccurate (due to unanticipated expenses, difficulties, delays or otherwise),
or our projected revenues otherwise prove to be insufficient to fund our working
capital

                                       15
<PAGE>

requirements, we could be required to seek additional financing sooner than
currently anticipated. We have no current arrangements with respect to any
additional financing. Consequently, there can be no assurance that any
additional financing will be available to us when needed, on commercially
reasonable terms or at all. Any inability to obtain additional financing when
needed would have a material adverse effect on our operations, requiring us to
curtail and possibly cease operations.

         WE HAVE NOT ACHIEVED SUBSTANTIAL REVENUE FROM SOFTWARE SALES.

          We have had only limited sales of our products. Our total revenues for
software licenses for the years ended December 31, 2001 and 2000 were $809,000
and $978,000, respectively.

         OUR REVENUES DEPEND ON SALES OF OUR CYBERWALLPLUS PRODUCTS AND WE ARE
UNCERTAIN WHETHER THERE WILL BE BROAD MARKET ACCEPTANCE OF THESE PRODUCTS.

          Our revenue growth for the foreseeable future is dependent upon
increased sales of our CYBERWALLPLUS family of software products. Since the
introduction of our CYBERWALLPLUS suite of products in January 1999 through
December 31, 2001, license revenue from our CyberwallPLUS products was only
$1,977,000. Our future financial performance will depend upon the successful
introduction and customer acceptance of our CyberwallPLUS products as well as
the development of new and enhanced versions of this product. Revenue from
products such as CYBERWALLPLUS depend on a number of factors, including the
influence of market competition, technological changes in the network security
market, our ability to design, develop and introduce enhancements on a timely
basis and our ability to successfully establish and maintain distribution
channels. If we fail to achieve broad market acceptance of our CYBERWALLPLUS
products, it would have a material adverse effect on our business, operating
results and financial condition.

         WE NEED TO ATTRACT AND RETAIN HIGHLY QUALIFIED TECHNICAL, SALES,
MARKETING, DEVELOPMENT AND MANAGEMENT PERSONNEL.

         Our success depends on our ability to attract, train and retain highly
qualified technical, sales, marketing, development and management personnel.
There is considerable and often intense competition for the services of such
personnel. We may not be able either to retain our existing personnel or acquire
additional qualified personnel as and when needed. If we are unable to hire and
retain such personnel, our business, operating results and financial condition
could be materially adversely affected.

CONTROL BY BARRY RUBENSTEIN, WHEATLEY AFFILIATES AND FALCONSTOR SOFTWARE, INC.

         Barry Rubenstein, Wheatley Partners II, L.P. and other affiliated and
related entities and parties (the "Wheatley Parties") currently own 32% of our
outstanding voting stock (exclusive of any securities owned by FalconStor). In
addition, FalconStor currently owns 15.9% of our outstanding voting stock. Barry
Rubenstein owns 15.5% of the outstanding voting securities of FalconStor and
other Wheatley affiliates own an additional 6.1% of the

                                       16
<PAGE>

outstanding voting securities of FalconStor. Accordingly, Barry Rubenstein and
the Wheatley Parties together with FalconStor currently own 47.9% of our
outstanding voting securities (and beneficially own options and warrants to
purchase an additional 28.2% of our outstanding voting securities) and as a
result of their aggregate holdings would have the ability to control the outcome
of all matters submitted to a vote of our stockholders including the election of
directors, amendments to our Certificate of Incorporation and approval of
mergers and a sale of substantially all of our assets. Such consolidation of
voting power could also have the effect of delaying, deterring or preventing a
change in control of our company that might be beneficial to other stockholders.

         WE REQUIRE THE CONSENT OF THE HOLDERS OF SERIES E PREFERRED STOCK FOR
CERTAIN CORPORATE ACTION.

         In connection with our private offering of Series E Preferred Stock and
warrants completed in October 2001, we agreed that so long as the holders of the
outstanding shares of Series E Preferred Stock own at least 10% of our
outstanding voting stock, we will not take certain actions without the consent
of Wheatley Partners II, L.P., the designee of the holders of Series E Preferred
Stock and one of our principal stockholders. Such actions requiring the consent
of Wheatley Partners II, L.P. include, among others, (i) issuing securities
other than securities to be issued under our stock option plan, (ii) incurring
debt in excess of $250,000, (iii) entering into a merger, acquisition or sale of
substantially all of our assets and (iv) taking any action to amend our
Certificate of Incorporation or By-laws that could in any way adversely affect
the rights of the holders of the Series E Preferred Stock. Accordingly, the
holders of Series E Preferred Stock may not consent to certain actions that we
may consider to be in our best interest and the best interest of the holders of
Common Stock. For more information regarding the rights and preferences of the
Series E Preferred Stock, see our Current Report on Form 8-K filed with the SEC
on October 12, 2001.

         WORLD INSTABILITY - TERRORISM.

         The terrorist attacks on September 11, 2001 in the United States and
the declaration of war by the United States against terrorism has created
significant instability and uncertainty in the world which may continue to have
a material adverse effect on world financial markets, including financial
markets in the United States. In addition, such adverse political events may
have an adverse impact on economic conditions in the United States. Unfavorable
economic conditions in the United States may have an adverse effect on our
financial operations including, but not limited to, our ability to expand the
market for our products, obtain necessary financing, enter into strategic
relationships and effectively compete in the network security market.

         OUR INABILITY TO ENTER INTO STRATEGIC RELATIONSHIPS WITH INDIRECT
CHANNEL PARTNERS COULD HAVE A MATERIAL ADVERSE EFFECT ON US.

         As part of our sales and marketing efforts, we are seeking to develop
strategic relationships with indirect channel partners, such as original
equipment manufacturers and resellers. We have limited financial, personnel and
other resources to undertake extensive marketing activities ourselves.
Therefore, our prospects will depend on our ability to

                                       17
<PAGE>

develop and maintain strategic marketing relationships with indirect channel
partners and their ability to market and distribute our products. If we are
unable to enter into and maintain such arrangements or if such arrangements do
not result in the successful commercialization of our products, then this could
have a material adverse effect on our business, operating results and financial
condition.

         WE MAY NOT BE ABLE TO SUCCESSFULLY COMPETE IN THE NETWORK SECURITY
MARKET.

         The network security market is characterized by intense competition and
rapidly changing business conditions, customer requirements and technologies.
The principal competitive factors affecting the market for network security
products include security effectiveness, scope of product offerings, name
recognition, product features, distribution channels, price, ease of use and
customer service and support. Most of our current and potential competitors have
longer operating histories, greater name recognition, larger installed customer
bases and possess substantially greater financial, technical and marketing and
other competitive resources than us. As a result, our competitors may be able to
adapt more quickly to new or emerging technologies and changes in customer
requirements or to devote greater resources to the promotion and sale of their
products than we may. In addition, certain of our competitors may determine for
strategic reasons to consolidate, to substantially lower the price of their
network security products or to bundle their products with other products, such
as hardware or other enterprise software products. Our current and potential
competitors may develop products that may be more effective than our current or
future products or that render our products obsolete or less marketable.
Increased competition for network security products may result in price
reductions and reduced gross margins and may adversely effect our ability to
gain market share, any of which would adversely affect the Company's business,
operating results and financial condition.

         WE MAY NOT BE ABLE TO ADEQUATELY PROTECT OUR PROPRIETARY TECHNOLOGY,
WHICH COULD RESULT IN LOWER REVENUES AND/OR PROFITS.

         We do not hold any patents and rely on copyright and trade secret laws,
non-disclosure agreements and contractual provisions to protect our proprietary
technology. These methods afford only limited protection. Despite the
precautions we take, unauthorized parties may attempt to copy or otherwise
obtain and use our proprietary technologies, ideas, know-how and other
proprietary information without authorization or may independently develop
technologies similar or superior to our technologies. Policing unauthorized use
of our products may be difficult and costly. Also, the laws of some foreign
countries do not protect our proprietary rights as much as the laws of the
United States. We are unable to predict whether our means of protecting our
proprietary rights will be adequate.

         We believe that our technologies have been developed independent of
others. Nevertheless, third parties may assert infringement claims against us
and our technologies may be determined to infringe on the intellectual property
rights of others. We could become liable for damages, be required to modify our
technologies or obtain a license if our technologies are determined to infringe
upon the intellectual property rights of others.

                                       18
<PAGE>

We may not be able to modify our technologies or obtain a license in a timely
manner, if required, or have the financial or other resources necessary to
defend an infringement action. We would be materially adversely effected if we
fail to do any of the foregoing.

         WE CAN BE EXPOSED TO NUMEROUS POTENTIAL LIABILITY CLAIMS FOR DAMAGES
AND, IF OUR INSURANCE DOESN'T ADEQUATELY COVER LOSSES, THIS COULD HAVE A
MATERIAL ADVERSE EFFECT ON US.

         Since our products are used to prevent unauthorized access to and
attacks on critical enterprise information, we may be exposed to potential
liability claims for damage caused as a result of an actual or alleged failure
of an installed product. We cannot assure you that the provisions in our
standard license agreements designed to limit our exposure will be enforceable.
Our personnel often gain access to confidential and proprietary client
information. Any unauthorized use or disclosure of such information could result
in a claim for substantial damages. We can give no assurances that our insurance
policies will be sufficient to cover potential claims or that adequate levels of
coverage will be available in the future at a reasonable cost.

         POSSIBLE DELISTING OF OUR SECURITIES FROM NASDAQ; RISKS RELATING TO
LOW-PRICED STOCKS.

         Our common stock is listed on The Nasdaq Stock Market's SmallCap Market
under the symbol "NSSI." In order for our common stock to continue to be listed
on Nasdaq, however, we must comply with certain maintenance standards. In the
event of a delisting, an investor could find it more difficult to dispose of or
to obtain accurate quotations as to the market value of our common stock.

         In addition, if our common stock were to become delisted from trading
on Nasdaq and the trading price of our common stock were to then be below $5.00
per share, our common stock could be considered a penny stock. SEC regulations
generally define a penny stock to be an equity security that is not listed on
Nasdaq or a national securities exchange and that has a market value of less
than $5.00 per share, subject to certain exceptions. The SEC regulations would
require broker-dealers to deliver to a purchaser of our common stock a
disclosure schedule explaining the penny stock market and the risks associated
with it. Various sales practice requirements are also imposed on broker-dealers
who sell penny stocks to persons other than established customers and accredited
investors (generally institutions). Broker-dealers must also provide the
customer with current bid and offer quotations for the penny stock, the
compensation of the broker-dealer and monthly account statements disclosing
recent price information for the penny stock held in the customer's account. If
our common stock is no longer traded on Nasdaq and becomes subject to the
regulations applicable to penny stocks, investors may find it more difficult to
obtain timely and accurate quotes and execute trades in our common stock.

         FAVORABLE LICENSE AND DISTRIBUTION AGREEMENT RECEIVED BY FALCONSTOR
SOFTWARE, INC.

         On October 2, 2001, we entered into a License and Distribution
Agreement with FalconStor pursuant to which FalconStor has the right to
distribute, on a non-exclusive basis, our product offerings in its indirect and
OEM channels. Simultaneously and

                                       19
<PAGE>

conditioned upon entering into the License and Distribution Agreement,
FalconStor invested $2,300,000 in our private offering of $6,765,000 of
preferred stock and warrants. (See "Management's Discussion and Analysis or Plan
of Operation" at page 24). FalconStor currently owns 15.9% of our outstanding
voting stock (27.4% assuming the exercise of currently exercisable warrants to
purchase 2,169,870 shares of common stock). FalconStor, as the largest investor
in the private offering, was able to negotiate terms (and may receive additional
benefits in the future) with respect to the License and Distribution Agreement
which would likely have not been available to other licensees and distributors
who were not simultaneously making a significant investment in our securities.

         OUR OPERATING RESULTS MAY FLUCTUATE QUARTERLY AND IF THEY WERE BELOW
THE EXPECTATIONS OF INVESTORS AND ANALYSTS, THE PRICE OF OUR STOCK WOULD LIKELY
BE ADVERSELY EFFECTED.

         We anticipate significant quarterly fluctuations in our operations in
the future, since our results are dependent on the volume and timing of orders,
which are difficult to predict. Customers' purchasing patterns and budgeting
cycles, as well as the introduction of new products, may also cause our
operating results to fluctuate. Therefore, comparing quarterly operating results
may not be meaningful and should not be relied on. Also, our operating results
may be below analysts' and investors' expectations in some future quarters,
which would likely have a material adverse effect on the price of our common
stock.

         THE SIGNIFICANT NUMBER OF OPTIONS, WARRANTS AND CONVERTIBLE SECURITIES
OUTSTANDING MAY ADVERSELY AFFECT THE MARKET PRICE FOR OUR COMMON STOCK.

          As of March 25, 2002, there are outstanding (i) options and warrants
to purchase an aggregate of 12,681,964 shares of our common stock at exercise
prices ranging from $.70 to $10.125, (ii) 3,032,951 shares of convertible
preferred stock which are convertible at any time into 5,995,272 shares of our
common stock and (iii) 1,570,776 additional shares of our common stock which may
be issued in the future under our stock option plan. To the extent that
outstanding options and warrants are exercised or preferred stock is converted,
your percentage ownership will be diluted and any sales in the public market of
the common stock underlying such options, warrants or convertible debt may
adversely affect prevailing market prices for our common stock.

         WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED
STOCK, WHICH MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.

         As of March 25, 2002, our Board of Directors has the authority, without
further action by the stockholders, to issue 10,000,000 shares of preferred
stock (of which only 231,054 shares of Series D Preferred Stock are outstanding
and 2,801,897 shares of Series E Preferred Stock are outstanding) on such terms
and with such rights, preferences and designations as our Board of Directors may
determine. Such terms may include restricting dividends on our common stock,
dilution of the voting power of our common stock or impairing the liquidation
rights of the holders of our common stock. Issuance of such preferred stock,
depending on the rights, preferences and designations thereof, may

                                       20
<PAGE>

have the effect of delaying, deterring or preventing a change in control. In
addition, certain "anti-takeover" provisions in Delaware law may restrict the
ability of our stockholders to authorize a merger, business combination or
change of control.

ITEM 2. DESCRIPTION OF PROPERTY

         The Company currently subleases approximately 9,000 square feet of
office space in Waltham, Massachusetts, for its principal executive offices and
1,700 square feet of office space in Manchester, New Hampshire as a satellite
development office. In addition, the Company leases approximately 2,200 square
feet of office space in Shanghai, China as its Asia-Pacific operations office.
On February 14, 2002 the Company agreed to a one (1) year extension of the lease
for its executive offices which requires the Company to make payments of
approximately $21,000 per month for the period ending February 2003. The lease
for the satellite development office in Manchester, New Hampshire expires
February 28, 2004 and requires the Company to make payments of approximately
$2,100 per month during the term of the lease. The Company's lease for its
office in in Shanghai, China expires January 31, 2003 and requires the Company
to make payments of approximately $2,400 per month.

ITEM 3. LEGAL PROCEEDINGS

        None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

         On November 27, 2001, the 2001 Annual Meeting of Stockholders of the
Company (the "Annual Meeting") was held. At the Annual Meeting, the stockholders
voted on the following proposals:

         1. Election of Directors-- Each of Murray P. Fish, Corey M. Horowitz,
Emanuel R. Pearlman, Jonathan Mark and Harry B. Schessel were re-elected as
directors of the Company and each of the nominees received votes of 12,023,695
(For) and 8,107 (Withheld Authority).

         2. Amendment to the Company's Certificate of Incorporation to increase
(i) the number of authorized shares of Common Stock, $.01 per value per share,
from 25,000,000 shares to 50,000,000 shares and (ii) the number of authorized
shares of Preferred Stock, $.01 par value per share, from 5,000,000 shares to
10,000,000 shares. This proposal was adopted by the following stockholder vote:
8,826,640 shares were voted in favor, 25,000 shares were voted against and 2,000
shares abstained from voting.

         3. Amendment to the Company's Amended and Restated 1996 Stock Option
Plan to increase the number of shares of Common Stock available for issuance
thereunder by 1,465,000 shares to an aggregate of 4,000,000 shares. This
proposal was adopted by the following stockholder vote: 8,707,349 shares were
voted in favor, 143,298 shares were voted against and 2,000 shares abstained
from voting.

                                       21
<PAGE>

         4. Ratification of Accountants -- Richard A. Eisner & Company, LLP was
ratified as independent auditors of the Company for the year ended December 31,
2001. This proposal was adopted by the following stockholder vote: 12,028,702 in
favor, 1600 shares were voted against and 1500 shares abstained from voting.

                                     PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

         MARKET INFORMATION. The Company's Common Stock has traded since
November 12, 1998 on the NASDAQ SmallCap Market under the symbol "NSSI." The
following table sets forth, for the periods indicated, the range of the high and
low closing bid prices for the Common Stock as reported on NASDAQ. Such prices
reflect inter-dealer quotations, without retail mark-up, mark-down or commission
and may not necessarily represent actual transactions.

YEAR ENDED DECEMBER 31, 2001              HIGH                  LOW
                                          ----                  ---

Fourth Quarter                            $   2.26              $   1.10
Third Quarter                             $   1.40              $   0.43
Second Quarter                            $   2.16              $   0.91
First Quarter                             $   4.375             $   1.34375


YEAR ENDED DECEMBER 31, 2000              HIGH                  LOW
                                          ----                  ---

Fourth Quarter                            $   5.25              $   2.00
Third Quarter                             $   8.8125            $   4.00
Second Quarter                            $  12.8125            $   2.6872
First Quarter                             $  23.875             $   8.125

         On March 25, 2002, the last sale price for the Common Stock as reported
on NASDAQ was $1.31 per share. The number of record holders of the Company's
Common Stock was 72 as of March 22, 2002. The Company believes that there are in
excess of 1,700 beneficial owners of its Common Stock.

         DIVIDEND POLICY. The Company has never declared or paid any cash
dividends on its Common Stock and does not intend to declare or pay cash or
other dividends in the foreseeable future. The Board of Directors currently
expects to retain any future earnings, if any, for use in the operation and
expansion of its business. The declaration and payment of any future dividends
will be at the discretion of the Board of Directors and will depend upon a
variety of factors, including future earnings, if any, operations, capital
requirements, the general financial condition of the Company, the preferences of
any series of Preferred Stock, the general business conditions and future
contractual restrictions on payment of dividends, if any.

                                       22
<PAGE>

         RECENT ISSUANCES OF UNREGISTERED SECURITIES. On October 2, 2001 the
Company completed a $6.765 million private offering consisting of 3,191,037
shares of Series E Preferred Stock and Warrants to purchase up to 6,882,074 of
Common Stock pursuant to a Securities Purchase Agreement with fifty (50)
investors. The purchase price for the shares of Series E Preferred Stock was
$2.12 per share (equal to two (2) times the average closing price of the
Company's Common Stock as reported on the Nasdaq Small Cap Market for the five
(5) trading days prior to two (2) trading days before the closing). The Warrants
issued in the private offering consisted of two (2) year warrants exercisable at
$1.27 per share and an additional five (5) year warrant issued to FalconStor
which is also exercisable at a $1.27 per share. Each share of Series E Preferred
Stock is convertible into two (2) shares of Common Stock, subject to adjustment.
As the largest investor in the offering, FalconStor received an additional
warrant to purchase 500,000 shares of Common Stock at an exercise price of $1.27
per share. The shares of Series E Preferred Stock and Warrants were issued in
reliance upon Section 4(2) of the Securities Act of 1933, as amended.

         On October 8, 2001, the Company issued to CMH Capital Management Corp.
("CMH") five (5) year warrants to purchase 250,000 shares of Common Stock at an
exercise price of $1.48 per share, in consideration for consulting services
rendered to the Company by CMH.

ITEM 6.   MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION


         THE FOLLOWING DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION
WITH THE COMPANY'S FINANCIAL STATEMENTS, INCLUDING THE NOTES THERETO, INCLUDED
ELSEWHERE IN THIS FORM 10-KSB. EXCEPT FOR THE HISTORICAL INFORMATION CONTAINED
HEREIN, THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS
AND UNCERTAINTIES, INCLUDING, BUT NOT LIMITED TO, THOSE DISCUSSED IN THE SECTION
ABOVE ENTITLED "RISK FACTORS WHICH MAY AFFECT FUTURE RESULTS" IN ITEM 1 OF THIS
REPORT AS WELL AS THOSE RISKS DISCUSSED IN THIS SECTION AND ELSEWHERE IN THIS
REPORT. BECAUSE SUCH STATEMENTS INVOLVE RISKS AND UNCERTAINTIES, ACTUAL RESULTS
MAY DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED BY SUCH FORWARD-LOOKING
STATEMENTS.

         OVERVIEW

         The Company develops, markets, licenses and supports a suite of
security software products designed to prevent unauthorized access to critical
information residing on networked servers, desktops and laptops. In January
1999, the Company introduced its CyberwallPLUS family of network security
products. The Company has made only limited sales of its CyberwallPLUS product,
upon which an evaluation of its prospects and future performance can be made.
Such prospects must be considered in light of the risks, expenses and
difficulties frequently encountered in the introduction of new products and the
shift from research and product development to commercialization of products
based

                                       23
<PAGE>

on rapidly changing technologies in a highly specialized and emerging market.
The Company will be required to raise additional financing to fund its
operations, significantly expand its product and development capabilities,
introduce new products, introduce enhanced features to existing products, expand
its in-house sales force, establish and maintain distribution channels through
third-party vendors, increase marketing expenditures and attract additional
qualified personnel. In addition, the Company must adapt to the demands of an
emerging and rapidly changing computer network security market, intense
competition and rapidly changing technology and industry standards. The Company
may not be able to successfully address such risks, and the failure to do so
would have a material adverse effect on the Company's business, results of
operations and financial condition.

         To date, the Company has incurred significant losses and, at December
31, 2001, had an accumulated deficit of $34,517,000. In addition, since December
31, 2001, the Company has continued to incur significant operating losses. The
Company expects to incur substantial operating expenses in the future to support
its product development activities, as well as continue to expand its domestic
and international sales activities and marketing capabilities. Management
believes it currently has cash to fund its operations through December 31, 2002
(or earlier if the Company does not achieve certain revenue assumptions) (See
"Liquidity and Capital Resources" on page 27 hereof).

         On October 2, 2001, the Company completed a $6.765 million private
offering of Series E Preferred Stock and warrants pursuant to a Securities
Purchase Agreement with investors (the "Financing"). In accordance with the
Securities Purchase Agreement, an aggregate of 3,191,037 shares of Series E
Preferred Stock were sold to investors at a price of $2.12 per share together
with warrants to purchase 6,882,074 shares of Common Stock at an exercise price
of $1.27 per share. Each share of Series E Preferred Stock is convertible into
two (2) shares of Common Stock, subject to adjustment. As the largest investor
($2,300,000) in the Financing, FalconStor, a storage networking infrastructure
software company, received an additional warrant to purchase 500,000 shares of
the Company's Common Stock (the "Additional Warrant"). The shares underlying the
Series E Preferred Stock and the warrants (including the Additional Warrant)
issued in the Financing were registered pursuant to a Form S-3 Registration
Statement which was declared effective by the SEC on February 12, 2002.
Simultaneously with the closing of the Financing, the Company and FalconStor
entered into a ten year Distribution and License Agreement pursuant to which
FalconStor has the right to distribute the Company's product offerings in its
indirect and OEM channels. As part of the Distribution and License Agreement,
FalconStor paid the Company a non-refundable advance of $500,000 against future
royalty payments of which, in accordance with accounting principles generally
accepted in the United States of America, $350,000 has been accounted for as the
purchase price of the Additional Warrant and this resulted in total proceeds
allocated to the Financing of $7,115,000.

         During the period October 2001 through March 2002, the Company hired
fifteen (15) employees, including a new Chief Executive Officer and President
(see below), a Senior Vice President of Marketing and Business Development, a
Vice President of Channel Development and a Vice President and General Manager -
Asia Pacific. The aggregate annual salaries for the fifteen (15) new employees
is $904,300.

                                       24
<PAGE>

         On March 11, 2002, the Company hired Richard Kosinski as Chief
Executive Officer and President pursuant to a two (2) year Employment Agreement
in which Mr. Kosinski receives an annual base salary of $200,000 per year and is
eligible to receive bonus compensation of up to $150,000 per year. In addition,
Mr. Kosinski was issued options to purchase 1,200,000 shares of the Company's
Common Stock, at an exercise price of $1.65 per share, which vest over a four
(4) year period.

         The Company's software products have not yet achieved market
acceptance. The future success of the Company is largely dependent upon market
acceptance of its CyberwallPLUS family of software products. While the Company
believes that its family of software products offer advantages over competing
products for network security, license revenue from network security software
products since the introduction of FireWall/Plus (June 1995), a predecessor
product line, through December 31, 2001 has only been $4,709,000, including a
non-refundable pre-paid royalty of $500,000 in 1997. From January 1999 through
December 31, 2001, license revenue from CyberwallPLUS has only been $1,977,000.
CyberwallPLUS may not achieve significant market acceptance. Revenue from such
commercial products depends on a number of factors, including the influence of
market competition, technological changes in the network security market, the
Company's ability to design, develop and introduce enhancements on a timely
basis, and the ability of the Company to successfully establish and maintain
distribution channels. The failure of CyberwallPLUS to achieve significant
market acceptance as a result of competition, technological change or other
factors, would have a material adverse effect on the Company's business,
operating results and financial condition.

         The Company has committed significant product and development resources
to its CyberwallPLUS family of products. The Company's anticipated levels of
expenditures for product development are based on its plans for product
enhancements and new product development. The Company capitalizes and amortizes
software development costs in accordance with Statement of Financial Accounting
Standards No. 86. These costs consist of salaries, consulting fees and
applicable overhead.

RESULTS OF OPERATIONS

YEAR ENDED DECEMBER 31, 2001 COMPARED TO YEAR ENDED DECEMBER 31, 2000.

          Revenues decreased by $101,000 or 9%, from $1,147,000 for the year
ended December 31, 2000 ("2000") to $1,046,000 for the year ended December 31,
2001 ("2001"). License revenues decreased by $169,000 or 17%, from $978,000 for
2000 to $809,000 for 2001, primarily due to the reduction in sales and marketing
expenditures as a result of the overhead reduction effectuated to preserve
capital pending the Company securing financing in October 2001, the overall
industry business decline as well as from the tragic events of September 11,
2001 which disrupted the normal business environment during the fourth quarter
of 2001. Service revenues from maintenance and training increased by $68,000 or
40% from $169,000 in 2000 to $237,000 in 2001. The Company's revenues from
customers in the United States represented 89% of its revenues in 2000 and 79%
of its revenues in 2001.

                                       25
<PAGE>

         Cost of revenues increased $127,000 or 26%, from $480,000 for 2000 to
$607,000 for 2001, representing 42% and 58% of revenues, respectively. The
increase in cost of revenues was primarily due to increased amortization of
software development costs in 2001.

         Cost of licenses decreased $38,000 or 56%, from $68,000 for 2000 to
$30,000 for 2001, representing 7% and 4% of license revenues, respectively. The
decrease in the cost of licenses resulted primarily from lower media and
documentation costs.

         Amortization of software development costs increased by $130,000 or
53%, from $247,000 for 2000 to $377,000 for 2001, representing 25% and 47% of
license revenues, respectively. The increase in amortization of software
development costs in 2001 was due to a higher average asset base in 2001.

         Cost of services increased by $35,000 or 21%, from $165,000 for 2000 to
$200,000 for 2001, representing 98% and 84% of service revenues, respectively.
The decrease in cost of services as a percentage of service revenues was due
primarily to additional service revenues.

         The gross profit decreased by $228,000 or 34%, from $667,000 for 2000
to $439,000 for 2001, representing 58% and 42% of revenues, respectively. The
decrease in gross profit was primarily due to decreased revenue of $101,000 and
a $130,000 increase in amortization of capitalized software development costs.

         Product development expenses increased by $773,000 or 54%, from
$1,436,000 for 2000 to $2,209,000 for 2001, representing 125% and 211% of
revenues, respectively. The increase in product development costs was due
primarily to increased use of outside consultants. The use of outside
consultants was reinstituted during 2001 to accelerate product development
schedules. During 2000 and 2001, the Company capitalized $372,000 and $313,000,
respectively, of additional software development costs associated with the
development and enhancement of its CyberwallPLUS family of products.

         Sales and marketing expenses decreased by $169,000 or 6%, from
$2,820,000 for 2000 to $2,651,000 for 2001, representing 246% and 253% of
revenues, respectively. The Company had been expanding its sales and marketing
departments but in order to preserve capital pending completion of the October
2001 financing and due to the overall general business decline, the Company
materially reduced its headcount between April 2001 and July 2001. The decrease
in sales and marketing expenses were due primarily to decreases of $223,000 in
advertising expense and $103,000 in marketing collateral printing which was
offset by increases of $158,000 in total marketing and sales personnel costs
incurred prior to the personnel reductions. The increase in sales and marketing
expenses as a percentage of sales was due to the decrease in the Company's
revenues.

         General and administrative expenses increased by $441,000 or 24%, from
$1,827,000 for 2000 to $2,268,000 for 2001, representing 159% and 217% of
revenues for 2000 and 2001, respectively. The increase in general and
administrative expenses in dollar amount was due primarily to an increase of
$436,000 related to recognition of compensation expense related to warrants
issued to the Company's Chairman of the Board of Directors for services rendered
after the Company's President and Chief Executive Officer resigned in June 2001

                                       26
<PAGE>

and an increase of $108,000 in professional services which was partially offset
by decreases in investor relations expenses of $81,000. The increase in general
and administrative expense as a percent of revenue was due primarily to the
increase in general and administrative expenses and the decrease in the
Company's revenues.

          Interest expense (net of interest income of $324,000) for 2000 was
$1,258,000, compared with net interest income of $103,000 for 2001. The decrease
in interest expense was due primarily to the fact that the Company completed a
Series D Preferred Stock, warrant and note financing on December 22, 1999 which
resulted in interest charges in 2000 of $1,582,000 including an interest charge
of $1,500,000 upon shareholder approval in April 2000 related to the excess of
the market value of the common stock (on the closing date of the December 1999
financing) issuable upon conversion of the preferred stock and exercise of the
warrants issuable upon conversion of the notes.

         Gain from discontinued operations was $1,885,000 in 2000 compared with
a gain on the sale of discontinued operations of $714,000 in 2001. The
discontinued operations was sold on February 9, 2000 to Exodus Communications.
The gain from discontinued operations in 2001 was attributed to the contingent
payments and related contingent expenses pertaining to the sale received or paid
in 2001.

         No provision for or benefit from federal, state or foreign income taxes
was recorded for 2000 or 2001 because the Company incurred net operating losses
for each year and fully reserved its deferred tax assets as their future
realization could not be determined.

         As a result of the foregoing, the net loss increased by $1,083,000 or
23%, from $4,789,000 for 2000 to $5,872,000 for 2001.

LIQUIDITY AND CAPITAL RESOURCES

         The Company's capital requirements have been and will continue to be
significant and its cash requirements continue to exceed its cash flow from
operations. At December 31, 2001, the Company had $7,121,000 of cash and cash
equivalents and working capital of $5,971,000. In October 2001, the Company
completed a private offering of $6,765,000 of securities (see description
below). The Company has financed its operations primarily through sales of
equity and debt securities, as well as the sale of its professional services
group. Net cash used in operating activities was $4,343,000 during 2000 and
$4,947,000 during 2001, respectively. Net cash used in operating activities for
2001 was primarily attributable to a net loss from continuing operations of
$6,586,000 which was partially offset by non-cash expenses including a charge
related to the issuance of options and warrants for services rendered of
$545,000 and depreciation and amortization of $525,000.

         Cash provided by investing activities was $733,000 resulting primarily
from $1,003,000 of net proceeds received in 2001 related to the sale of the
Company's professional services group in February 2000, less capitalized
software costs of $313,000. The Company does not currently have a line of credit
from a commercial bank or other institution.

                                       27
<PAGE>

         On October 2, 2001, the Company completed a $6.765 million private
offering of Series E Preferred Stock and warrants pursuant to a Securities
Purchase Agreement with investors (the "Financing"). In accordance with the
Securities Purchase Agreement, an aggregate of 3,191,037 shares of Series E
Preferred Stock were sold to investors at a price of $2.12 per share together
with warrants to purchase 6,882,074 shares of Common Stock at an exercise price
of $1.27 per share. Each share of Series E Preferred Stock is convertible into
two (2) shares of Common Stock, subject to adjustment. Simultaneously with the
closing of the Financing, the Company and FalconStor entered into a ten year
License and Distribution Agreement pursuant to which FalconStor has the right to
distribute the Company's product offerings in its indirect and OEM channels. As
part of the Agreement, FalconStor paid the Company a non-refundable advance of
$500,000 against future royalty payments of which, in accordance with accounting
principles generally accepted in the United States of America, $350,000 has been
accounted for as the purchase price of the additional warrant to purchase
500,000 shares of Common Stock issued to FalconStor as the largest investor in
the Financing. This resulted in total proceeds allocated to the private offering
of $7,115,000.

         The Company anticipates, based on currently proposed plans and
assumptions (including the timetable of, costs and expenses associated with, and
success of, its marketing efforts), that its current cash balance of
approximately $6,053,000 as of February 28, 2002 together with certain revenue
assumptions from operations, will be sufficient to satisfy the Company's
operations and capital requirements through at least December 31, 2002. There
can be no assurance, however, that such funds will not be expended prior
thereto. In the event the Company's plans change, or its assumptions change, or
prove to be inaccurate (due to unanticipated expenses, difficulties, delays or
otherwise) or projected revenues otherwise prove to be insufficient to fund the
Company's working capital requirements, the Company may have insufficient funds
to support its operations prior to December 31, 2002 and will be required to
seek additional financing sooner than currently anticipated. The Company does
not have any current arrangements with respect to any additional financing.
Consequently, there can be no assurance that any additional financing will be
available to the Company when needed, on commercially reasonable terms or at
all. The inability of the Company to obtain additional financing would have a
material adverse effect on the Company, requiring it to curtail and possibly
cease its operations. In addition, any additional equity financing may involve
substantial dilution to the interests of the Company's then existing
stockholders.

FLUCTUATIONS IN OPERATING RESULTS

         The Company anticipates significant quarterly fluctuations in its
operating results in the future. The Company generally ships orders for
commercial products as they are received and, as a result, does not have any
material backlog. As a result, quarterly revenue and operating results depend on
the volume and timing of orders received during the quarter, which are difficult
to forecast. Operating results may fluctuate on a quarterly basis due to factors
such as the demand for the Company's products, purchasing patterns and budgeting
cycles of customers, the introduction of new products and product enhancements
by the Company or its competitors, market acceptance of new products introduced
by the Company or its competitors and the size, timing, cancellation or delay of
customer orders, including cancellation or delay in anticipation of new product
introduction or enhancement. Therefore, comparisons of quarterly operating
results may not be

                                       28
<PAGE>

meaningful and should not be relied upon, nor will they necessarily reflect the
Company's future performance. Because of the foregoing factors, it is likely
that in some future quarters the Company's operating results will be below the
expectations of public market analysts and investors. In such event, the price
of the Common Stock would likely be materially adversely affected.

         The sales cycle for the Company's products can be lengthy and generally
commences at the time a prospective customer demonstrates an interest in
licensing a CyberwallPLUS solution, typically includes a 28-day free evaluation
period and ends upon execution of a purchase order by the customer. The length
of the sales cycle varies depending on the type and sophistication of the
customer and the complexity of the operating system.

ITEM 7. FINANCIAL STATEMENTS

        The financial statements required hereby are located on pages F-1
        through F-20 which follow Part III.

ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE.

        None.

ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS, AND CONTROL PERSONS;
        COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT.

        The information required by this item is incorporated by reference from
        the Company's definitive proxy statement to be filed not later than
        April 30, 2002 pursuant to Regulation 14A of the General Rules and
        Regulations under the Securities Exchange Act of 1934 ("Regulation
        14A").

ITEM 10. EXECUTIVE COMPENSATION

        The information required by this item is incorporated by reference from
        the Company's definitive proxy statement to be filed not later than
        April 30, 2002 pursuant to Regulation 14A.

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

        The information required by this item is incorporated by reference from
        the Company's definitive proxy statement to be filed not later than
        April 30, 2002 pursuant to Regulation 14A.

                                       29
<PAGE>

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

        The information required by this item is incorporated by reference from
        the Company's definitive proxy statement to be filed not later than
        April 30, 2002 pursuant to Regulation 14A.

ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K

(a)      Exhibits

    NO.                              DESCRIPTION

    3.1           Certificate of Incorporation, as amended. Previously filed as
                  Exhibit 3.1 to the Company's Registration Statement on Form
                  SB-2 (Registration No. 333-59617), declared effective by the
                  SEC on November 12,1998 (the "1998 Registration Statement"),
                  and incorporated herein by reference.

    3.1.1         Certificate of Amendment to the Certificate of Incorporation
                  dated November 27, 2001. Previously filed as Exhibit 3.1.1 to
                  the Company's Registration Statement on Form S-3 (Registration
                  No. 333-81344) declared effective by the SEC on February 12,
                  2002, and incorporated herein by reference (the "February 2002
                  Form S-3")

    3.2           Certificate of Designations of Series D Preferred Stock.
                  Previously filed as Exhibit 3.1 to the Company's current
                  report on Form 8-K filed January 5, 2000 and incorporated
                  herein by reference.

    3.3           Certificate of Designations of Series E Preferred Stock.
                  Previously filed as Exhibit 3.1 to the Company's current
                  report on Form 8-K filed October 12, 2001 (the "October 2001
                  Form 8-K") and incorporated herein by reference.

    3.4           By-laws, as amended. Previously filed as Exhibit 3.2 to the
                  1998 Registration Statement and incorporated herein by
                  reference.

    4.1           Form of Common Stock certificate. Previously filed as Exhibit
                  4.1 to the 1998 Registration Statement and incorporated herein
                  by reference.

    10.1          Securities Purchase Agreement, dated as of October 2, 2001,
                  between the Company and the investors listed therein.
                  Previously filed as Exhibit 10.21 to the October 2001 Form 8-K
                  and incorporated herein by reference.

    10.2          Form of Warrant, dated October 2, 2001, issued by the Company
                  to the holder listed thereon. Previously filed as Exhibit B to
                  Exhibit 10.21 to the October 2001 Form 8-K and incorporated
                  herein by reference.

    10.3          Financial Advisory and Investment Banking Agreement, dated
                  December 1, 2001, by and between EarlyBirdCapital, Inc. and
                  the Company. Previously filed as Exhibit 10.3 to the October
                  2002 Form S-3 and incorporated by reference herein.

                                       30
<PAGE>

    10.4          Agreement dated, January 29, 2002, between the Company and CMH
                  Capital Management Corp. relating to extension of the
                  consulting agreement. Previously filed as Exhibit 10.4 to the
                  October 2002 Form S-3 and incorporated by reference herein.

    10.5          Employment Agreement, dated June 29, 2001, between the Company
                  and Murray P. Fish. Previously filed as Exhibit 10.19 to the
                  Company's 10-QSB for the quarterly period ended June 30, 2002.

    10.6          Employment Agreement, dated March 4, 2002, between the Company
                  and Richard Kosinski. Previously filed as Exhibit 10.6 to the
                  Company's current report on Form 8-K filed March 25, 2002 and
                  incorporated herein by reference.

    10.7**        License and Distribution Agreement between the Company and
                  FalconStor Software, Inc. Previously filed as Exhibit 10.21 to
                  October 2001 Form 8-K and incorporated herein by reference.

    23.1*         Consent of Richard A. Eisner & Company, LLP, independent
                  certified public accountants.


     *   Filed herewith.
    **   Confidentiality treatment has been granted for certain provisions.

(b) Reports on Form 8-K

         On October 12, 2001, the Company filed a current report on Form 8-K
with respect to the completion of its $6.765 million private offering of Series
E Preferred Stock and Warrants.


                                       31
<PAGE>

                                   SIGNATURES

         In accordance with the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized, in the City of
Waltham, Commonwealth of Massachusetts, on the 1st day of April 2002.

         NETWORK-1 SECURITY SOLUTIONS, INC.


         By  /s/ Richard Kosinski
            -------------------------------------
            Richard Kosinski
            President and Chief Executive Officer

         In accordance with the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant caused this report to be signed
on its behalf by the following persons in the capacities and on the dates
indicated:

NAME                            TITLE                             DATE
----                            -----                             ----

/s/ Richard Kosinski            President, Chief Executive        April 1, 2002
------------------------------  Officer and Director
Richard Kosinski                (principal executive officer)


/s/ Murray P. Fish              Chief Financial Officer,          April 1, 2002
------------------------------  Secretary and Director
Murray P. Fish                  (principal financial officer
                                and principal accounting officer)

/s/ Corey M. Horowitz           Chairman of the Board of          April 1, 2002
------------------------------  Directors
Corey M. Horowitz

/s/ Jonathan Mark               Director                          April 1, 2002
------------------------------
Jonathan Mark

/s/ Harry Schessel              Director                          April 1, 2002
------------------------------
Harry Schessel




                                       32
<PAGE>


NETWORK-1 SECURITY SOLUTIONS, INC.


CONTENTS

                                                                            PAGE

INDEX TO FINANCIAL STATEMENTS

   Independent auditors' report                                              F-2

   Balance sheets as of December 31, 2001 and 2000                           F-3

   Statements of operations for the years ended
   December 31, 2001 and 2000                                                F-4

   Statements of stockholders' equity for the years ended
   December 31, 2001 and 2000                                                F-5

   Statements of cash flows for the years ended
   December 31, 2001 and 2000                                                F-6

   Notes to financial statements                                             F-7




















                                                                             F-1
<PAGE>



INDEPENDENT AUDITORS' REPORT

Board of Directors and Stockholders
Network-1 Security Solutions, Inc.
Waltham, Massachusetts

We have audited the accompanying balance sheets of Network-1 Security Solutions,
Inc. (the "Company") as of December 31, 2001 and 2000 and the related statements
of operations, stockholders' equity and cash flows for each of the years then
ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements enumerated above present fairly, in all
material respects, the financial position of Network-1 Security Solutions, Inc.
as of December 31, 2001 and 2000 and the results of its operations and its cash
flows for each of the years then ended in conformity with accounting principles
generally accepted in the United States of America.



/s/ Richard A. Eisner & Company, LLP
-------------------------------------------
New York, New York

February 22, 2002

(except for Note L[1] as to which the date is
March 4, 2002 and Note L[2] as to which date is
March 25, 2002)


                                                                             F-2
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

BALANCE SHEETS
<TABLE><CAPTION>
                                                                                               DECEMBER 31,
                                                                                      ---------------------------------
                                                                                          2001                 2000
                                                                                      ------------         ------------
<S>                                                                                   <C>                  <C>
ASSETS
Current assets:
   Cash and cash equivalents                                                          $  7,121,000         $  4,425,000
   Accounts receivable - net of allowance for doubtful accounts of $73,000 and
      $80,000, respectively                                                                 62,000              227,000
   Prepaid expenses and other current assets                                               113,000              153,000
   Due from purchaser of discontinued operations                                                                 59,000
                                                                                      ------------         ------------

        Total current assets                                                             7,296,000            4,864,000

Equipment and fixtures - net                                                               319,000              437,000
Capitalized software costs - net                                                           561,000              625,000
Security deposits                                                                            8,000               81,000
                                                                                      ------------         ------------

                                                                                      $  8,184,000         $  6,007,000
                                                                                      ============         ============
LIABILITIES
Current liabilities:

   Notes payable - related parties                                                                         $    326,000
   Notes payable - others                                                                                       343,000
   Accounts payable                                                                   $    405,000              224,000
   Accrued expenses and other current liabilities                                          675,000              696,000
   Interest payable - related parties                                                                            27,000
   Interest payable - others                                                                                     28,000
   Deferred revenue                                                                        245,000              181,000
                                                                                      ------------         ------------

        Total current liabilities                                                        1,325,000            1,825,000
                                                                                      ------------         ------------

Commitments and contingencies

STOCKHOLDERS' EQUITY

Preferred stock - $.01 par value; 10,000,000 shares authorized; Series D -
   convertible, voting, authorized 1,250,000 shares; 231,054 and
      115,220 shares issued and outstanding at December 31, 2001 and 2000
      respectively, liquidation preference of $705,000 and $351,000 at
      December 31, 2001 and 2000, respectively                                               2,000                1,000
   Series E - convertible, authorized 3,500,000 shares; 3,191,037 and 0
      shares issued and outstanding at December 31, 2001 and 2000
      respectively, liquidation preference of $6,765,000 at December 31, 2001               32,000
Common stock - $.01 par value; authorized 50,000,000 shares;
   6,781,374 and 6,448,363 shares issued and outstanding at December 31,
   2001 and 2000, respectively                                                              68,000               65,000
Additional paid-in capital                                                              41,274,000           30,705,000
Unearned portion of compensatory stock options and warrants                                                    (107,000)
Accumulated deficit                                                                    (34,517,000)         (26,482,000)
                                                                                      ------------         ------------

                                                                                         6,859,000            4,182,000
                                                                                      ------------         ------------
                                                                                      $  8,184,000         $  6,007,000
                                                                                      ============         ============
</TABLE>
See notes to financial statements                                            F-3
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

STATEMENTS OF OPERATIONS

<TABLE><CAPTION>
                                                                                              YEAR ENDED
                                                                                              DECEMBER 31,
                                                                                     -------------------------------
                                                                                         2001                2000
                                                                                     -----------         -----------
<S>                                                                                  <C>                 <C>
Revenues:
   Licenses                                                                          $   809,000         $   978,000
   Services                                                                              237,000             169,000
                                                                                     -----------         -----------

      Total revenues                                                                   1,046,000           1,147,000
                                                                                     -----------         -----------

Cost of revenues:
   Amortization of software development costs                                            377,000             247,000
   Cost of licenses                                                                       30,000              68,000
   Cost of services                                                                      200,000             165,000
                                                                                     -----------         -----------

      Total cost of revenues                                                             607,000             480,000
                                                                                     -----------         -----------

Gross profit                                                                             439,000             667,000
                                                                                     -----------         -----------

Operating expenses:
   Product development costs                                                           2,209,000           1,436,000
   Selling and marketing                                                               2,651,000           2,820,000
   General and administrative                                                          2,268,000           1,827,000
                                                                                     -----------         -----------

      Total operating expenses                                                         7,128,000           6,083,000
                                                                                     -----------         -----------

Loss from continuing operations before interest income (expense)                      (6,689,000)         (5,416,000)
Interest income                                                                          139,000             324,000
Interest expense                                                                         (27,000)         (1,018,000)
Interest expense - related parties                                                        (9,000)           (564,000)
                                                                                     -----------         -----------

Loss from continuing operations                                                       (6,586,000)         (6,674,000)

Gain on sale of discontinued operations, net of operating losses during
   phase-out period and including $65,000 of interest income on
   contingency payments received in 2001                                                 714,000           1,885,000
                                                                                     -----------         -----------

NET LOSS                                                                              (5,872,000)         (4,789,000)
Imputed dividend on preferred stock                                                   (2,163,000)
                                                                                     -----------         -----------

NET LOSS AVAILABLE TO COMMON STOCKHOLDERS                                            $(8,035,000)        $(4,789,000)
                                                                                     ===========         ===========

PER COMMON SHARE - BASIC AND DILUTED:

   Loss available to common shareholders per share from continuing operations        $     (1.35)        $     (1.12)
   Income per share from discontinued operations                                             .11                 .32
                                                                                     -----------         -----------

   Loss available to common shareholders per share - basic and diluted               $     (1.24)        $     (0.80)
                                                                                     ===========         ===========

WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING                                   6,471,056           5,984,165
                                                                                     ===========         ===========
</TABLE>
See notes to financial statements                                            F-4
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE><CAPTION>
                                                                        SERIES D CONVERTIBLE             SERIES E CONVERTIBLE
                                                                           PREFERRED STOCK                  PREFERRED STOCK
                                                                    -----------------------------     ----------------------------
                                                                       SHARES           AMOUNT           SHARES          AMOUNT
                                                                    ------------     ------------     ------------    ------------
<S>                                                                     <C>         <C>               <C>             <C>
BALANCE - JANUARY 1, 2000                                                491,803     $      5,000             --              --
Amortization of compensatory stock options                                  --               --               --              --
Conversion of Series D preferred stock                                  (376,583)          (4,000)            --              --
Exercise of employee and nonemployee stock options                          --               --               --              --
Exercise of warrants                                                        --               --               --              --
Conversion of notes and accrued interest                                    --               --               --              --
Compensation charge for issuance of nonqualified stock options              --               --               --              --
Compensation charge for accelerated vesting of options                      --               --               --              --
Beneficial conversion feature of Series D preferred stock
   underlying notes payable and related debt discount                       --               --               --              --
Issuance of warrants and options for services                               --               --               --              --
Unearned portion of compensatory warrants                                   --               --               --              --
Net loss                                                                    --               --               --              --
                                                                    ------------     ------------     ------------    ------------

BALANCE - DECEMBER 31, 2000                                              115,220            1,000             --              --
Amortization of compensatory stock options and warrants                     --               --               --              --
Charge for vesting of contingent options to former employees                --               --               --              --
Conversion of Series D preferred stock                                    (8,197)            --               --              --
Conversion of notes and accrued interest into Series D Preferred         124,031            1,000             --              --
Conversion of notes and accrued interest into Common Stock                  --               --               --              --
Issuance of warrants and options for services                               --               --               --              --
Issuance of Series E preferred stock and warrants                           --               --          3,191,037    $     32,000
Offering costs of Series E preferred stock and warrants offering            --               --               --              --
Beneficial conversion feature of Series E                                   --               --               --              --
Net loss                                                                    --               --               --              --
                                                                    ------------     ------------     ------------    ------------

BALANCE - DECEMBER 31, 2001                                              231,054     $      2,000        3,191,037    $     32,000
                                                                    ============     ============     ============    ============
</TABLE>
<PAGE>

<TABLE><CAPTION>
                                                                                                                       UNEARNED
                                                                                                                      PORTION OF
                                                                            COMMON STOCK              ADDITIONAL     COMPENSATORY
                                                                    ----------------------------       PAID-IN      STOCK OPTIONS
                                                                       SHARES          AMOUNT          CAPITAL       AND WARRANTS
                                                                    ------------    ------------    ------------     ------------
<S>                                                                    <C>          <C>             <C>              <C>
BALANCE - JANUARY 1, 2000                                              4,935,211    $     50,000    $ 23,941,000     $   (134,000)
Amortization of compensatory stock options                                  --              --              --            108,000
Conversion of Series D preferred stock                                   376,583           4,000            --               --
Exercise of employee and nonemployee stock options                       470,051           5,000       2,255,000             --
Exercise of warrants                                                     384,091           4,000       1,207,000             --
Conversion of notes and accrued interest                                 282,427           2,000         859,000             --
Compensation charge for issuance of nonqualified stock options              --              --           525,000             --
Compensation charge for accelerated vesting of options                      --              --           269,000             --
Beneficial conversion feature of Series D preferred stock
   underlying notes payable and related debt discount                       --              --         1,500,000             --
Issuance of warrants and options for services                               --              --            68,000             --
Unearned portion of compensatory warrants                                   --              --            81,000          (81,000)
Net loss                                                                    --              --              --               --
                                                                    ------------    ------------    ------------     ------------

BALANCE - DECEMBER 31, 2000                                            6,448,363          65,000      30,705,000         (107,000)
Amortization of compensatory stock options and warrants                     --              --              --            107,000
Charge for vesting of contingent options to former employees                --              --           230,000             --
Conversion of Series D preferred stock                                     8,197            --                 0             --
Conversion of notes and accrued interest into Series D Preferred            --              --           377,000             --
Conversion of notes and accrued interest into Common Stock               324,814           3,000         363,000             --
Issuance of warrants and options for services                               --              --           545,000             --
Issuance of Series E preferred stock and warrants                           --              --         7,083,000             --
Offering costs of Series E preferred stock and warrants offering            --              --          (192,000)            --
Beneficial conversion feature of Series E                                   --              --         2,163,000             --
Net loss                                                                    --              --              --               --
                                                                    ------------    ------------    ------------     ------------

BALANCE - DECEMBER 31, 2001                                            6,781,374    $     68,000    $ 41,274,000     $          0
                                                                    ============    ============    ============     ============
</TABLE>
<PAGE>

<TABLE><CAPTION>
                                                                    ACCUMULATED
                                                                      DEFICIT           TOTAL
                                                                    ------------     ------------
<S>                                                                 <C>              <C>
BALANCE - JANUARY 1, 2000                                           $(21,693,000)    $  2,169,000
Amortization of compensatory stock options                                  --            108,000
Conversion of Series D preferred stock                                      --                  0
Exercise of employee and nonemployee stock options                          --          2,260,000
Exercise of warrants                                                        --          1,211,000
Conversion of notes and accrued interest                                    --            861,000
Compensation charge for issuance of nonqualified stock options              --            525,000
Compensation charge for accelerated vesting of options                      --            269,000
Beneficial conversion feature of Series D preferred stock
   underlying notes payable and related debt discount                       --          1,500,000
Issuance of warrants and options for services                               --             68,000
Unearned portion of compensatory warrants                                   --                  0
Net loss                                                              (4,789,000)      (4,789,000)
                                                                    ------------     ------------

BALANCE - DECEMBER 31, 2000                                          (26,482,000)       4,182,000
Amortization of compensatory stock options and warrants                     --            107,000
Charge for vesting of contingent options to former employees                --            230,000
Conversion of Series D preferred stock                                      --                  0
Conversion of notes and accrued interest into Series D Preferred            --            378,000
Conversion of notes and accrued interest into Common Stock                  --            366,000
Issuance of warrants and options for services                               --            545,000
Issuance of Series E preferred stock and warrants                           --          7,115,000
Offering costs of Series E preferred stock and warrants offering            --           (192,000)
Beneficial conversion feature of Series E                             (2,163,000)               0
Net loss                                                              (5,872,000)      (5,872,000)
                                                                    ------------     ------------

BALANCE - DECEMBER 31, 2001                                         $(34,517,000)    $  6,859,000
                                                                    ============     ============
</TABLE>

See notes to financial statements                                            F-5
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.


STATEMENTS OF CASH FLOWS

<TABLE><CAPTION>
                                                                                                  YEAR ENDED
                                                                                                  DECEMBER 31,
                                                                                        -------------------------------
                                                                                           2001                 2000
                                                                                        -----------         -----------
<S>                                                                                     <C>                 <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
   Loss from continuing operations                                                      $(6,586,000)        $(6,674,000)
   Adjustments to reconcile loss from continuing operations to net cash
      used in operating activities:
        Interest charge from Series D convertible preferred stock                                             1,500,000
        Interest expensed and converted to Series D convertible preferred stock              34,000              30,000
        Issuance of options and warrants for services rendered                              545,000              68,000
        Provision for doubtful accounts                                                      (7,000)             40,000
        Amortization of compensatory stock options                                          107,000             108,000
        Depreciation and amortization                                                       525,000             378,000
        Changes in:
           Accounts receivable                                                              172,000            (202,000)
           Prepaid expenses and other current assets                                         40,000               2,000
           Accounts payable, accrued expenses and other current liabilities                 160,000              54,000
           Interest payable                                                                  (1,000)             52,000
           Deferred revenue                                                                  64,000             123,000
                                                                                        -----------         -----------

   Net cash used in continuing operating activities                                      (4,947,000)         (4,521,000)
   Cash provided by discontinued operations                                                                     178,000
                                                                                        -----------         -----------

              Net cash used in operating activities                                      (4,947,000)         (4,343,000)
                                                                                        -----------         -----------

CASH FLOWS FROM INVESTING ACTIVITIES:

   Acquisitions of equipment and fixtures                                                   (30,000)           (143,000)
   Capitalized software costs                                                              (313,000)           (372,000)
   Loan to officer                                                                                               88,000
   Security deposit                                                                          73,000               1,000
   Proceeds from sale of discontinued operations, net                                     1,003,000           2,700,000
                                                                                        -----------         -----------

              Net cash provided by investing activities                                     733,000           2,274,000
                                                                                        -----------         -----------
CASH FLOWS FROM FINANCING ACTIVITIES:

   Proceeds from exercise of options and warrants                                                             3,471,000
   Payments on note payable                                                                 (13,000)
   Proceeds from issuance of Series E convertible preferred stock and warrants            7,115,000
   Offering costs                                                                          (192,000)
                                                                                        -----------         -----------

              Net cash provided by financing activities                                   6,910,000           3,471,000
                                                                                        -----------         -----------

NET INCREASE IN CASH AND CASH EQUIVALENTS                                                 2,696,000           1,402,000
Cash and cash equivalents - beginning of year                                             4,425,000           3,023,000
                                                                                        -----------         -----------

CASH AND CASH EQUIVALENTS - END OF YEAR                                                 $ 7,121,000         $ 4,425,000
                                                                                        ===========         ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:

   Cash paid for interest                                                               $     2,000
   Noncash transactions:
      Issuance of common stock in connection with conversion of notes payable
        and accrued interest                                                            $   366,000         $   861,000
      Issuance of preferred stock in connection with conversion of notes payable
        and accrued interest                                                            $   378,000
</TABLE>

See notes to financial statements                                            F-6
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2001 AND 2000

NOTE A - THE COMPANY

Network-1 Security Solutions, Inc. (the "Company") develops, markets, licenses
and supports its proprietary network security software products designed to
provide comprehensive security to computer networks. The Company also provides
maintenance and training services. The Company also provided consulting services
in network security and network design through its Professional Services Group
which was sold in February 2000 and is being accounted for as a discontinued
operation (see Note G).

NOTE B - SIGNIFICANT ACCOUNTING POLICIES

[1]   CASH EQUIVALENTS:

      The Company considers all highly liquid short-term investments purchased
      with a maturity of three months or less to be cash equivalents.

[2]   REVENUE RECOGNITION:

      License revenue is recognized upon delivery of software or delivery of a
      required software key. License revenue from distributors or resellers is
      recognized as the distributor or reseller delivers software or the
      required software key to end users or original equipment manufacturers.
      Service revenues consist of maintenance and training services. Annual
      renewable maintenance fees are a separate component of each contract, and
      are recognized ratably over the contract term. Training revenues are
      recognized as such services are performed. Revenue from advance license
      fees are deferred until they are earned pursuant to the agreements.

[3]   EQUIPMENT AND FIXTURES:

      Equipment and fixtures are stated at cost and are depreciated using the
      straight-line method over their estimated useful lives of five years.

[4]   SOFTWARE DEVELOPMENT COSTS:

      Costs to maintain developed programs and development costs incurred to
      establish the technological feasibility of computer software are expensed
      as incurred. The Company capitalizes costs incurred in producing computer
      software after technological feasibility of the software has been
      established through the date that the software is ready for general
      release to customers. Such costs are amortized based on current and
      estimated future revenue of each product with an annual minimum equal to
      the straight-line amortization over the remaining estimated economic life
      of the product. The Company estimates the economic life of its software to
      be three years. At each balance sheet date, the unamortized capitalized
      software costs of each product are compared with the estimated net
      realizable value of that product and any excess capitalized costs are
      written off.

                                                                             F-7
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE B - SIGNIFICANT ACCOUNTING POLICIES  (CONTINUED)

[5]   INCOME TAXES:

      The Company utilizes the liability method of accounting for income taxes.
      Under such method, deferred tax assets and liabilities are recognized for
      the future tax consequences attributable to differences between the
      financial statement carrying amounts of existing assets and liabilities
      and their respective tax bases. Deferred tax assets and liabilities are
      measured using enacted tax rates in effect at the balance sheet date. The
      resulting asset or liability is adjusted to reflect enacted changes in tax
      law. Deferred tax assets are reduced, if necessary, by a valuation
      allowance when the likelihood of realization is not assured.

[6]   LOSS PER SHARE:

      Basic loss per share is calculated by dividing the net loss by the
      weighted average number of outstanding common shares during the year.
      Diluted per share data includes the dilutive effects of options, warrants
      and convertible securities. Potential common shares of 18,311,543 and
      3,308,708 at December 2001 and 2000 are anti-dilutive, and are not
      included in the calculation of diluted loss per share. Such potential
      common shares reflect options, warrants, convertible preferred stock and
      convertible notes. For the year ended December 31, 2001, the loss per
      share is increased by the value of the beneficial conversion feature on
      the Series E Preferred Stock which is accounted for as a preferred stock
      dividend (see Note F).

[7]   USE OF ESTIMATES:

      The preparation of financial statements in conformity with accounting
      principles generally accepted in the United States of America requires
      management to make estimates and assumptions that affect the reported
      amounts of assets and liabilities and disclosure of contingent assets and
      liabilities at the date of the financial statements and the reported
      amounts of revenues and expenses during the reporting period. Actual
      results could differ from those estimates.

[8]   FINANCIAL INSTRUMENTS:

      The carrying amounts of cash and cash equivalents, accounts receivable,
      accounts payable and accrued expenses approximate their fair value due to
      the short period to maturity of these instruments. The Company believes
      its notes payable approximate fair value based on current yields for
      similar debt instruments with similar terms.

[9]   STOCK-BASED COMPENSATION:

      The Company accounts for its employee stock-based compensation plans under
      Accounting Principles Board Opinion No. 25 ("APB No. 25"), "Accounting for
      Stock Issued to Employees" and related interpretations. Under the
      provisions of APB No. 25, compensation cost for stock options is measured
      as the excess, if any, of the estimated market value of the Company's
      common stock at the date of the grant over the amount an employee must pay
      to acquire the stock. The Company has adopted the disclosure-only
      provisions of Statement of Financial Accounting Standards (SFAS) No.123,
      "Accounting for Stock-Based Compensation." The Company accounts for stock
      based compensation to non-employees utilizing the fair value method
      prescribed by SFAS 123.

[10]  ADVERTISING COSTS:

      Advertising costs are expensed as incurred. Advertising expense was
      $164,000 and $387,000 for the years ended December 31, 2001 and 2000,
      respectively.

                                                                             F-8
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE B - SIGNIFICANT ACCOUNTING POLICIES  (CONTINUED)

[11]  RECENTLY ISSUED ACCOUNTING STANDARDS:

      In June 2001, the Financial Accounting Standards Board ("FASB") issued
      SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other
      Intangible Assets. SFAS No. 141 requires business combinations initiated
      after June 30, 2001 to be accounted for using the purchase method of
      accounting. It also specifies the types of acquired intangible assets that
      are required to be recognized and reported separately from goodwill. SFAS
      No. 142 will require that goodwill and intangibles with indeterminate
      lives will no longer be amortized, but instead tested for impairment. SFAS
      No. 142 is required to be applied starting with fiscal years beginning
      after December 15, 2001, with early application permitted in certain
      circumstances. The Company will adopt SFAS No. 142 in 2002 and does not
      expect this statement to have a material impact on the Company's financial
      position or results of operations.

      In August 2001, the FASB issued SFAS No. 144, Accounting for the
      Impairment or Disposal of Long-Lived Assets. This statement supercedes
      SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for
      Long-Lived Assets to Be Disposed Of. The statement retains the previously
      existing accounting requirements related to the recognition and
      measurement of the impairment of long-lived assets to be held and used
      while expanding the measurement requirements of long-lived assets to be
      disposed of by sale to include discontinued operations. It also expands on
      the previously existing reporting requirements for discontinued operations
      to include a component of an entity that either has been disposed of or is
      classified as held for sale. The Company is required to implement SFAS No.
      144 on January 1, 2002. Management does not expect this statement to have
      a material impact on the Company's financial position or results of
      operations.

NOTE C - EQUIPMENT AND FIXTURES

Equipment and fixtures are summarized as follows:

                                                     DECEMBER 31,
                                            ---------------------------
                                               2001              2000
                                            ---------         ---------
       Office and computer equipment        $ 565,000         $ 535,000
       Furniture and fixtures                 114,000           114,000
                                            ---------         ---------

                                              679,000           649,000
       Less accumulated depreciation         (360,000)         (212,000)
                                            ---------         ---------

                                            $ 319,000         $ 437,000
                                            =========         =========

Depreciation expense was $148,000 and $131,000 for the years ended December 31,
2001 and 2000, respectively.

                                                                             F-9
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE D - CAPITALIZED SOFTWARE COSTS

                                                          YEAR ENDED
                                                         DECEMBER 31,
                                                 ---------------------------
                                                    2001              2000
                                                 ---------         ---------
       Balance, beginning of year (net of
         accumulated amortization)               $ 625,000         $ 500,000
       Additions                                   313,000           372,000
       Amortization                               (377,000)         (247,000)
                                                 ---------         ---------

       Balance, end of year (net of
         accumulated amortization)               $ 561,000         $ 625,000
                                                 =========         =========

NOTE E - NOTES PAYABLE

In December 1999, the Company raised $3,000,000 through the issuance of
convertible notes payable, Series D convertible preferred stock and warrants
(See Note F[1]).

In December 1999, the Company issued $1,500,000 of convertible promissory notes
(the "Notes") bearing interest at 8%, which matured in December 2001 ($525,000
of which was payable to related parties). The Notes were convertible into
491,803 shares of Series D preferred stock of the Company (570,492 shares if
interest through the maturity of the notes is considered) and an equal number of
five-year warrants to purchase 491,803 shares of Common Stock (570,492 shares if
interest through the maturity of the notes is considered) at an exercise price
of $3.00 per share, subject to certain adjustments. The conversion price of the
Series D preferred stock ($1,500,000) and the exercise price of the warrants
($1,475,000) was less than the aggregate market price ($5,102,000) of the common
stock obtainable upon conversion and exercise on the closing date of the private
placement. Accordingly, upon approval of the conversion feature by a majority
vote of the stockholders of the Company in April 2000, the Company incurred an
interest charge of $1,500,000, representing the beneficial conversion feature of
the preferred stock, limited to the $1,500,000 proceeds received on the issuance
of the notes.

During the fiscal year ended December 31, 2000, $831,000 of the above notes,
including $199,000 payable to related parties and $30,000 of accrued interest
payable on the notes, including $12,000 payable to related parties were
converted, at a conversion price of $3.05 per share, into 282,427 shares of
Series D convertible preferred stock and an equal number of five year warrants.
The preferred stock then converted into 282,427 shares of common stock.

During the fiscal year ended December 31, 2001, $339,000 of the above notes,
including $300,000 to related parties and $39,000 of accrued interest payable on
the notes, including $36,000 payable to related parties were converted, at a
conversion price of $3.05 per share, into 124,031 shares of Series D convertible
preferred stock and an equal number of five year warrants. An additional $30,000
of the notes and $3,000 of accrued interest payable on the notes were converted,
at a conversion price of $3.05 per share, into 10,897 shares of common stock and
an equal number of warrants. Pursuant to the notes anti-dilution provisions, as
a result of the Company's Series E Preferred stock and warrant offering in
October 2001, the conversion price of the Series D preferred stock was changed
to $1.80, the conversion rate at which the Series D convertible prefered stock
may be converted into common stock was changed from 1:1 to 1:1.69431, and the
exercise price of the warrants outstanding at $3.00 and warrants to be issued
upon conversion of outstanding convertible notes was changed to $1.114. In
December 2001, $287,000 of notes and $46,000 of accrued interest were converted
into 185,278 shares of Series D convertible preferred stock and an equal number
of warrants. The Series D convertible preferred stock was simultaneously
converted into 313,917 shares of common stock. The remaining balance of $13,000
of these notes that was not converted into preferred or common stock was paid to
the noteholder, who is a director of the Company.

                                                                            F-10
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE F - STOCKHOLDERS' EQUITY

[1]   PREFERRED STOCK:

      (a)   Series D preferred stock:

            Pursuant to the private placement discussed in Note E, in December
            1999 the Company received $1,500,000 from the sale of 491,803 shares
            of Series D convertible preferred stock at $3.05 per share including
            172,129 shares to related parties. Such stock is convertible into
            common shares at a conversion rate of 1.69431 (as adjusted), has
            identical voting rights as the Company's common stock, and is
            entitled to equivalent dividend rights as those paid on shares of
            common stock obtainable on conversion. The holders of the Series D
            convertible preferred stock are entitled to a liquidation preference
            of $3.05 per share plus any declared but unpaid dividends before any
            payments are made to holders of common stock, and rank equal with
            Series E Preferred Stock in the event of liquidation, dissolution or
            winding up of the Company. In connection therewith, the Company also
            issued five-year warrants to purchase 491,803 shares of common stock
            at an exercise price of $3.00 per share. The exercise price of the
            warrants was reduced to $1.00 because the Company did not achieve a
            specified revenue target. Holders of warrants for 444,857 shares,
            including 424,411 warrants obtained upon conversion of notes and
            accrued interest (Note E), waived such exercise price reduction. Of
            these warrants, 147,149 were exercised during 2000.

            Pursuant to anti-dilution features of the Series D Convertible
            Preferred Stock, Convertible Notes and warrants, in connection with
            the October 2, 2001 private offering of Series E Preferred Stock and
            warrants (see (b) below), the holders of (i) outstanding Series D
            Preferred Stock, (ii) certain warrants to purchase Common Stock and
            (iii) convertible notes (convertible into Series D Preferred Stock
            and warrants) in the principal amount of $300,000, all issued in
            connection with the Company's private offering completed in December
            1999, received the right to receive 1,145,207 additional shares of
            Common Stock (exclusive of conversion of interest with respect to
            the convertible notes) upon conversion or exercise of Series D
            Preferred Stock, convertible notes and warrants as a result of the
            anti-dilution provisions of such securities. In addition, the
            exercise price of outstanding warrants and warrants obtainable upon
            conversion of the promissory notes and accrued interest was adjusted
            from $3.00 to $1.114.

      (b)   Series E preferred stock:

            On October 2, 2001, the Company completed a $6,765,000 private
            offering of Series E Preferred Stock ("Series E") and Warrants (the
            "2001 Financing"). An aggregate of 3,191,037 shares of Series E
            together with Warrants to purchase 6,882,074 shares of common stock
            were sold. The Warrants were issued at the rate of two Warrants,
            each to purchase a share of common stock at $1.27 per share, with
            every share of Series E, plus an additional Warrant to purchase
            500,000 shares to an investor, Falconstor Software, Inc.
            ("Falconstor"), for investing more than $2,000,000 (the "Additional
            Warrant"). In connection with the 2001 Financing, the Company and
            FalconStor entered into a ten year License and Distribution
            Agreement pursuant to which FalconStor has the right to distribute
            the Company's product offerings in its indirect and OEM channels. As
            part of the License and Distribution Agreement, FalconStor paid the
            Company a non-refundable advance of $500,000 against future royalty
            payments (the "Advance"). For accounting purposes, $350,000 of the
            Advance, representing the estimated fair value of the Additional
            Warrant was accounted for as its purchase price, resulting in total
            proceeds attributable to the Financing of $7,115,000. For accounting
            purposes, an allocation of $4,952,000 and $2,163,000 was made to the
            Series E and Warrants, respectively, based on the relative fair
            values of the common stock obtainable upon conversion of the Series
            E and the Warrants on the date of the Financing. The difference
            between the proceeds allocated to the Series E and the fair market
            value of the common stock obtainable upon conversion of the Series E
            represents a beneficial conversion feature, which has been imputed
            as a Preferred Stock dividend in calculating the net loss available
            to common stockholders.

                                                                            F-11
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE F - STOCKHOLDERS' EQUITY  (CONTINUED)

[1]   PREFERRED STOCK:  (CONTINUED)

      (b)   Series E preferred stock:  (continued)

            Holders of the Series E may convert each such share into two shares
            of Common Stock at any time, subject to adjustment. The Series E is
            entitled to vote on all matters with the holders of the Company's
            common stock based on the number of shares of common stock into
            which such shares may be converted except that the holders of the
            Series E have irrevocably waived any increased voting rights that
            may be afforded to the holders of Series E resulting from
            anti-dilution protection. Holders of Series E shall receive
            dividends and other distributions, when, as and if declared by the
            Board of Directors out of funds legally available therefore
            equivalent to those dividends paid on shares of common stock. The
            holders of Series E will be entitled to a liquidation preference of
            $2.12 per share plus any declared but unpaid dividends before any
            payments are made to holders of Common Stock and the Series E ranks
            equal with the Series D upon liquidation. The Company also agreed
            with the holders of the Series E that, without the approval of the
            Series E designee, a principal stockholder of the Company (see Note
            K[4]), it will not take certain action including (i) issue
            securities except for securities issued under its stock option plan,
            (ii) incur debt in excess of $250,000, (iii) enter into a merger,
            acquisition or sale of substantially all of its assets and (iv) take
            any action to amend its Certificate of Incorporation or By-laws that
            could in any way adversely affect the rights of the holders of the
            Series E. In addition, the investors were granted registration
            rights with respect to the shares of Common Stock to be received
            upon conversion of the Series E Preferred Stock and exercise of the
            Warrants.

            The 6,382,074 warrants issued with the 3,191,037 shares of Series E
            are two year warrants and the Additional Warrant to purchase 500,000
            shares of common stock is a five year warrant. The warrants were
            valued using the Black Scholes method using the following
            assumptions: volatility of 113.45%, expected life of 1.0 year and
            3.0 years, dividend yield of 0, and risk free rates of 2.47% and
            3.14%.

[2]    STOCK OPTIONS:

       During 1996, the Board of Directors and stockholders approved the
       adoption of the 1996 Stock Option Plan (the "1996 Plan"). The 1996 Plan,
       as amended, provides for the granting of both incentive and non-qualified
       options to purchase common stock of the Company. A total of 4,000,000
       shares are available under the plan.

       The term of options granted under the 1996 Plan may not exceed ten years
       (five years in the case of an incentive stock option granted to an
       optionee owning more than 10% of the voting stock of the Company) ("10%
       stockholder"). The option price for incentive stock options can not be
       less than 100% of the fair market value of the shares of common stock at
       the time the option is granted (110% for a 10% stockholder). Option terms
       and vesting periods are set by the Compensation Committee in its
       discretion.

                                                                            F-12
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE F - STOCKHOLDERS' EQUITY  (CONTINUED)

[2]   STOCK OPTIONS:  (CONTINUED)

      The following table summarizes stock option activity for the years ended
      December 31:

<TABLE><CAPTION>
                                                                   2001                         2000
                                                         --------------------------   --------------------------
                                                                                      WEIGHTED         WEIGHTED
                                                                                       AVERAGE         AVERAGE
                                                          OPTIONS         EXERCISE     OPTIONS         EXERCISE
                                                        OUTSTANDING         PRICE    OUTSTANDING        PRICE
                                                         ---------        ---------   ---------        ---------
<S>                                                      <C>                 <C>      <C>                <C>
      Options outstanding at beginning of year           1,602,842           4.94     1,641,924          $4.16
      Granted                                              900,595 (a)       1.73       721,163           6.19
      Exercised                                                                        (470,051)          4.81
      Cancelled                                           (741,785)          4.82      (290,194)          5.27
                                                         ---------                    ---------

      Options outstanding at end of year                 1,761,652 (b)       3.36     1,602,842 (b)       4.94
                                                         =========                    =========

      Options exercisable at end of year                   960,012           3.89       793,092           4.22
                                                         =========                    =========
</TABLE>

       (a)  Includes 265,095 options granted in January 2001, with an exercise
            price of $3.06, the fair value of the common stock on the date of
            grant, that vest 50% if the closing stock price of the Company's
            common stock is at or above $10 per share for 8 out of 10 trading
            days. The remaining 50% vest if the closing stock price is at or
            above $15 per share for 8 out of 10 trading days. The options expire
            in 10 years. Of such options, 26,250 were granted to consultants or
            service providers. As the vesting of the options is contingent upon
            the market price of the Company's common stock, but the services
            have been provided, the valuation of the options and accordingly the
            expense recognized, is subject to adjustment based on, among other
            factors, the market price on the date of the valuation. The Company
            will estimate the value of the options' at each reporting date until
            they have vested. In 2001, the Company recognized $32,000 of expense
            based on the fair value of the options at December 31, 2001 using
            the Black Scholes method of valuation using the following
            assumptions: volatility of 114%, risk free rate of 5.07%, dividend
            yield of O and an expected life of 8 years.

       (b)  Includes a 5 year option to purchase 294,879 shares of common stock
            at an exercise price of $2.42 per share issued outside the 1996
            Plan. The option was issued in May 1998 in connection with an
            employment agreement with the Company's former President and Chief
            Executive Officer.

            The option vested 34% immediately and then 22% per year thereafter.
            As the estimated fair value of the Company's common stock at the
            date of grant of the option ($5.60 per share) was in excess of the
            exercise price, the Company incurred aggregate compensation expense
            of approximately $938,000 over the service period, which has been
            fully charged to expense as of June 2001. Expense pursuant to the
            options was $26,000 and $108,000 in 2001 and 2000, respectively. In
            June 2001, the President and Chief Executive Officer resigned.

                                                                            F-13
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE F - STOCKHOLDERS' EQUITY  (CONTINUED)

[2]    STOCK OPTIONS:  (CONTINUED)

       (c)  The following table presents information relating to stock options
            outstanding and exercisable at December 31, 2001:

<TABLE><CAPTION>
                                             WEIGHTED                                         WEIGHTED
          RANGE OF                           AVERAGE      WEIGHTED AVERAGE                    AVERAGE
          EXERCISE             OPTIONS       EXERCISE         REMAINING          OPTIONS      EXERCISE
           PRICES            OUTSTANDING      PRICE         LIFE IN YEARS      EXERCISABLE      PRICE
     -----------------         -------        -----              ----            --------      -------
<S>                            <C>            <C>                <C>               <C>         <C>
     $  .70  -  $ 1.18         421,500        $1.00              9.68              58,070      $   .74
     $ 1.50  -  $ 2.91         532,223         2.24              7.41             434,409         2.36
     $ 3.00  -  $ 3.75         336,006         3.29              8.57             124,590         3.63
     $ 4.13  -  $ 5.69         188,200         5.46              8.19             122,520         5.36
     $ 6.00  -  $ 6.875        177,723         6.17              7.52             170,203         6.15
     $10.00  -  $10.125        106,000        10.11              8.36              50,220        10.10
                             ---------                                           --------
                             1,761,652         3.36              8.33             960,012         3.89
                             =========                                           ========
</TABLE>

            The weighted average fair value on the option grant date, including
            the accelerated vesting of options for PSG employees (Note G),
            during the year ended December 31, 2001 and 2000, were $1.53 and
            $6.46 per option, respectively. The fair value on the option granted
            date was estimated using the Black-Scholes option pricing model
            utilizing the following weighted average assumptions:

                                                            DECEMBER 31,
                                                         -----------------
                                                         2001         2000
                                                         ----         ----
              Risk-free interest rates                   4.61%        5.64%
              Expected option life in years              6.60         6.00
              Expected stock price volatility             113%         113%
              Expected dividend yield                       0%           0%

       The Company recognized $26,000 and $902,000, during 2001 and 2000,
       respectively, of compensation costs related to employee stock options. In
       2000, $794,000 of these costs were charged against the gain on sale of
       discontinued operations.

       Had the Company elected to recognize compensation cost based on the fair
       value of the options at the date of grant as prescribed by SFAS 123, net
       loss applicable to common stock for the years ended December 31, 2001 and
       2000 would have been $(9,010,000) and $(6,905,000) or $(1.39) and $(1.15)
       per share, respectively.

                                                                            F-14
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE F - STOCKHOLDERS' EQUITY  (CONTINUED)

[3]    WARRANTS:

       As of December 31, 2001, the Company has the following outstanding
       warrants to purchase shares of common stock:

              NUMBER OF      EXERCISE
               WARRANTS       PRICE         EXPIRATION DATE
              ---------       -----         ---------------
                110,278       $1.00         December 22, 2004
                 62,080        1.61         October 11, 2003 - January 15, 2004
                 62,856        2.42         May 18, 2003 - April 4, 2004
                100,104        6.44         March 14, 2006 - February 24, 2007
                170,000        9.30         November 12, 2003
                 93,120        9.66         March 14, 2006
                200,000        3.33         November 8, 2002 (a)
                 20,000        5.00         October 31, 2003 (b)
                 20,000        7.50         January 2, 2004 (b)
                 20,000       10.00         February 28, 2004 (b)
                300,000         .70         July 11, 2011 (c)
                250,000        1.48         October 8, 2006 (c)
              1,350,364        1.11         December 22, 2004 (d)
                500,000        1.27         October 2, 2006 (e)
              6,382,074        1.27         October 2, 2004 (e)
                 66,621        2.03         April 13, 2006 (f)
                 64,352        2.00         July 2, 2006 (f)
                  4,489        2.10         October 1, 2006 (f)
              ---------
              9,776,338
              =========

       (a)  In November 2000, the Company entered into a business development
            agreement with a marketing company and issued 200,000 warrants to
            purchase the Company's common stock. The warrants expire in November
            2002, have an exercise price of $3.33, and have a cashless exercise
            provision. The warrants vest as specified performance and revenue
            targets are attained. Several of the performance targets were
            attained in 2001 and accordingly, 12,000 warrants vested. Expense of
            $12,000 was recorded based on the estimated fair value of the
            warrants when vested. Additional expense could be substantial
            depending upon, among other factors, the fair market value of the
            Company's stock on the dates any future targets are obtained.

       (b)  Represents warrants issued pursuant to a consulting agreement with
            an advisory firm. Under the agreement, entered into on October 31,
            2000, the Company was required to pay a monthly fee and issue 60,000
            warrants. The warrants have exercise prices ranging from $5.00 to
            $10.00, expire three years after issuance, and are issued 1/3 at the
            inception of the agreement, 1/3 at 60 days, and 120 days after
            inception. The warrants were valued at $82,000 using the
            Black-Scholes option pricing model using the following weighted
            average assumptions on the issuance dates: risk free interest rate
            of 5.60, volatility of 113%, dividend yield of 0 and expected life
            of 3 years. The value of the warrants was charged to expense over
            the six month term of the agreement, resulting in $55,000 and
            $27,000 being charged to expense in 2001 and 2000, respectively.


                                                                            F-15
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE F - STOCKHOLDERS' EQUITY  (CONTINUED)

[3]    WARRANTS:  (CONTINUED)

       (c)  Issued to Capital Management Corp. ("CMH") in 2001, a company owned
            by the Chairman of the Board (see Note K[1]).

       (d)  Reflects adjustments required pursuant to anti-dilution provisions
            of Series D preferred stock and notes payable offering (see Note
            F[1]).

       (e)  Issued with private offering of Series E preferred stock (see Note
            F[1]).

       (f)  Issued to a software development company for services rendered. The
            Company recognized $80,000 expense related to the warrants based on
            their estimated fair value using the Black-Scholes method utilizing
            the following weighted average assumptions: risk free rate of 4.5%,
            expected life of 3 years, volatility of 113%, and a dividend yield
            of 0. The software development company has claimed they are entitled
            to additional warrants for the services rendered (see Note H[5]).

NOTE G - DISCONTINUED OPERATIONS

On February 9, 2000, the Company completed the sale of its Professional Services
Group ("PSG") to Exodus Communications, Inc. ("Exodus") for $4.0 million in
cash, of which $1.3 million was held in escrow subject to certain conditions.
Release to the Company of cash held in escrow was conditioned upon (i) as to
$1,000,000, certain PSG employees remaining employed by Exodus for at least one
year and (ii) as to $300,000, to the extent purchase orders or commitments are
secured by Exodus from certain customers within 90 days of the closing, up to a
maximum of $300,000. PSG provided consulting services in network security and
network design. Effective upon the sale, the Company granted options to acquire
104,063 shares of common stock at $2.91 per share and accelerated the vesting of
24,556 options that would have otherwise expired, with exercise prices ranging
from $1.50 to $6.50 to certain employees of PSG. In connection therewith, the
Company incurred a compensation charge of $794,000 based upon the intrinsic
value of the portion of the options vesting at such date. The balance of the
options vest one year after the closing provided that the employees are still
employed by Exodus. In addition, the Company agreed to pay bonuses aggregating
$160,000 to the former employees provided that they remained with Exodus for at
least one year. Charges relating to the contingent options and the remittance of
the bonuses are reflected as reductions of the gain on sale of discontinued
operations.

In the first quarter of 2000, Exodus secured $59,000 of purchase orders from the
designated customers and the Company recognized the related gain. In 2001, the
Company received the $1,000,000 from the escrow for the PSG employees remaining
employed by Exodus for one year, $115,000 as satisfaction of the remaining
$300,000 escrow, and $65,000 of interest on the two contingency payments. The
options vesting in February 2001, were valued at $230,000 using the Black-Sholes
option pricing model using the following an assumptions on the date of vesting:
risk free interest rate of 5.38%, volatility of 112.58%, dividend yield of 0 and
expected life of 6 years. In addition, the Company paid the $160,000 of bonuses
to the PSG employees and $17,000 of related payroll taxes. The completion of the
sale resulted in an additional net gain recognized in 2001 of $714,000.

                                                                            F-16
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE G - DISCONTINUED OPERATIONS  (CONTINUED)

The results of PSG have been reported separately as discontinued operations in
the consolidated statement of operations. Components of amounts reflected in the
statement of operations are presented below.

                                                           YEAR ENDED
                                                           DECEMBER 31,
                                                  ----------------------------
                                                      2001             2000
                                                  -----------      -----------
       Revenue                                                     $   148,000
       Cost of revenue                                                (143,000)
       Operating expenses                                              (32,000)
                                                                   -----------

                                                                       (27,000)
       Gain on sale of discontinued operations        714,000        1,912,000
                                                  -----------      -----------

                                                  $   714,000      $ 1,885,000
                                                  ===========      ===========


NOTE H - COMMITMENTS AND CONTINGENCIES

[1]    OPERATING LEASES:

       The Company leases office facilities in Massachusetts, New Hampshire and
       Shanghai, China under operating leases which expire in 2003, 2004 and
       2003, respectively. Rental commitments for the remaining terms of the
       leases are as follows:

                   YEAR ENDING
                   DECEMBER 31,

                     2002                             $    315,000
                     2003                                   99,000
                     2004                                    4,000
                                                      ------------

                                                      $    418,000
                                                      ============

       Rental expense for the years December 31, 2001 and 2000 aggregated
       $319,000 and $223,000, respectively.

[2]    SOFTWARE DISTRIBUTION AGREEMENTS:

       (a)  Pursuant to a software distribution agreement entitling the Company
            to incorporate certain technology into its software, $100,000 of
            royalty payable was accrued as of December 31, 2001.

       (b)  Pursuant to an agreement under which certain technology was
            developed for the Company, royalty payments of up to $100,000 may be
            payable. As of December 31, 2001 royalties owed pursuant to such
            agreement were not significant.

                                                                            F-17
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE H - COMMITMENTS AND CONTINGENCIES  (CONTINUED)

[3]    EMPLOYMENT AGREEMENTS:

       The Company has an employment agreement with its Chief Financial Officer,
       who also assumed the position of President upon the resignation noted in
       F[2] providing for an annual salary of $185,000 through June 2003. The
       agreement provides for the granting of bonuses at the discretion of the
       Board of Directors, as well as options to purchase shares of common
       stock.

       See Note L for an employment agreement entered into in March 2002.

[4]    SAVINGS AND INVESTMENT PLAN:

       The Company has a Savings and Investment Plan which allows participants
       to make contributions by salary reduction pursuant to Section 401(k) of
       the Internal Revenue Code of 1986. The Company also may make
       discretionary annual matching contributions in amounts determined by the
       Board of Directors, subject to statutory limits. The Company did not make
       any contributions to the 401(k) Plan during the years ended December 31,
       2001 and 2000.

[5]    SOFTWARE DEVELOPMENT CONTRACT DISPUTE:

       The Company has a dispute with a software development company pertaining
       to the number of warrants the Company is required to issue for services
       rendered. The software development company has claimed they are entitled
       to approximately 325,000 additional warrants than the Company has
       included in the warrants outstanding in Note F [3]. The Company has
       included in accrued expenses any additional liability it reasonably
       expects to incur regarding this matter.

NOTE I - INCOME TAXES

At December 31, 2001, the Company has available net operating loss carryforwards
to reduce future federal taxable income of approximately $24,546,000 for tax
reporting purposes, which expire from 2009 through 2021. Pursuant to the
provisions of the Internal Revenue Code, future utilization of these past losses
is subject to certain limitations based on changes in the ownership of the
Company's stock that have occurred.

The principal components of the net deferred tax asset are as follows:

                                                         YEAR ENDED
                                                         DECEMBER 31,
                                                -----------------------------
                                                    2001              2000
                                                -----------       -----------
       Deferred tax assets:
          Net operating loss carryforwards      $ 9,205,000       $ 7,353,000
          Options and warrants not yet
            deducted, for tax purposes              715,000           418,000
          Other                                     221,000            96,000
                                                -----------       -----------

                                                 10,141,000         7,867,000
       Valuation allowance                      (10,141,000)       (7,867,000)
                                                -----------       -----------

       Net deferred tax assets                  $         0       $         0
                                                ===========       ===========

The Company has recorded a valuation allowance for the full amount of its
deferred tax assets as the likelihood of its future realization cannot be
presently determined. The valuation allowance was increased by $2,274,000 in
2001 and $1,467,000 in 2000.

                                                                            F-18
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE I - INCOME TAXES  (CONTINUED)

The difference between the tax benefit and the amount that would be computed by
applying the statutory federal income tax rate to loss before taxes is
attributable to the following:

                                                          YEAR ENDED
                                                          DECEMBER 31,
                                                       ------------------
                                                       2001          2000
                                                       ----          ----
       Income tax benefit - statutory rate            (34.0)%       (34.0)%
       State and local, net                            (3.5)         (3.5)
       Permanent difference - interest charge
          representing beneficial conversion
          feature on preferred stock                                 11.7
       Increase in valuation allowance on deferred
          tax assets                                   38.7          30.6
       Other                                           (1.2)         (4.8)
                                                       ----          ----

                                                        0.0%          0.0%
                                                       ====          ====

NOTE J - CONCENTRATIONS

[1]    For the year ended December 31, 2001 two customers accounted for sales of
       approximately $154,000 (15%) and $144,000 (14%). The customer
       representing 14% of sales was a reseller located in China. For the year
       ended December 31, 2000, sales of approximately $136,000 (12%) was from
       one customer. Accounts receivable at December 31, 2000 includes $80,000
       (35%) from this customer.

[2]    For the years ended December 31, 2001 and 2000, export sales, which were
       primarily from Asia, amounted to approximately $219,000 and $125,000,
       respectively.

[3]    The Company places its cash investments in high quality financial
       institutions insured by the Federal Deposit Insurance Corporation
       ("FDIC"). At December 31, 2001 the Company maintained cash balances of
       $7,174,000 in excess of FDIC limits.

NOTE K - RELATED PARTY TRANSACTIONS AND RELATIONSHIPS

[1]    In June 2001, upon the resignation of the Company's Chief Executive
       Officer, the Company entered into a six month consulting agreement with
       CMH, a company owned by the Chairman of the Board of the Company.
       Pursuant to the agreement, the Company paid CMH $17,500 per month and
       issued a warrant to purchase 300,000 shares of the Company's Common Stock
       at an exercise price of $.70 per share, which was the market price of the
       Common Stock on the date of issuance. In addition, CMH was reimbursed for
       $44,000 of expenses incurred during the year ended 2001, including the
       allocable portion of rent for office space in New York City. The warrants
       were valued utilizing the Black Scholes pricing model resulting in an
       estimated fair value of $180,000 which was expensed. In addition, in
       October 2001, in consideration of additional consulting and financial
       advisory services, the Company issued to CMH an additional warrant to
       purchase 250,000 shares of the Common Stock at an exercise price of $1.48
       per share, which was the market price of the Company's Common Stock on
       the date of issuance. The warrants were valued utilizing the Black
       Scholes pricing model resulting in an estimated fair value of $256,000,
       which was expensed upon grant. The weighted average assumptions used in
       the Black Scholes valuations were risk free rate of 4.03%, volatility of
       114%, expected life of 4.6 years and 0 dividend yield. In December 2001,
       the agreement was extended to the lesser of six months or three months
       after the date of hire of a new Chief Executive Officer (See Note L).

                                                                            F-19
<PAGE>

NETWORK-1 SECURITY SOLUTIONS, INC.

NOTE K - RELATED PARTY TRANSACTIONS AND RELATIONSHIPS  (CONTINUED)

[2]    Investors in the 2001 Financing completed on October 2, 2001 [see Note
       F[1](b)] included FalconStor ($2,650,000, including $350,000 allocated
       from the Advance as the purchase price of the additional warrant they
       received), Barry Rubenstein and affiliated entities ($1,750,000),
       including $400,000 from Wheatley Partners II, L.P. and related entities,
       all principal stockholders of the Company, and the wife ($75,000) of the
       Chairman of the Board of Directors and a principal stockholder of the
       Company.

[3]    In December 2001, the Company entered into a one year financial advisory
       agreement with an investment banking firm, which requires the Company to
       pay $200,000 over the next ten months. At the time of entering into the
       agreement, the firm's Chairman of the Board owned shares of Series E
       Preferred Stock and an affiliate was the general partner of a partnership
       that owned Common Stock and held convertible notes payable, subsequently
       converted into Common Stock. The Company has paid $35,000 of which,
       $17,000 has been expensed during the year ended December 31, 2001.

[4]    As noted in F[1], the Company entered into a ten year License and
       Distribution agreement with Falconstor, an investor in the 2001
       Financing. The agreement requires Falconstor to pay royalties after
       utilizing the Advance as a credit. Deferred revenue at December 31, 2001
       includes $138,000 from this agreement representing the unearned portion
       of the $150,000 allocated from the Advance to the license fee, less
       royalties earned of $12,000. One of the Company's principal stockholders
       is also a principal stockholder of Falconstor, and an affiliated entity
       is the Series E designee noted in F[1].

 NOTE L - SUBSEQUENT EVENT

[1]    On March 4, 2002, the Company entered into a two year employment
       agreement commencing on March 11, 2002, with its new Chief Executive
       Officer and President, with an annual salary of $200,000. In connection
       with the agreement, 1,200,000 options to purchase the Company's common
       stock at $1.65 per share were granted, the exercise price being equal to
       the closing price of the Company's common stock on the grant date. The
       options vest 25% on the first anniversary of the grant date and 6.25%
       quarterly thereafter. In addition, under certain circumstances, such as a
       change in control of the Company, the vesting of the stock options will
       be accelerated. The executive is also eligible to receive bonuses up to
       $150,000 per year upon the attainment of specified performance targets.

       The options granted include 242,400 options issued under the Company's
       1996 Plan and 957,600 options issued outside the plan.

[2]    During the period from January 1, 2002 through March 25, 2002, holders of
       389,140 shares of Series E converted their shares into 778,280 shares of
       common stock.

       In addition, holders of warrants to purchase 118,026 shares of common
       stock at exercise prices ranging from $1.114 to $1.27 exercised their
       warrants resulting in proceeds to the Company of $133,000.

                                                                            F-20