##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 20-F



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| ̈ | REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------------



OR



|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------



For the Fiscal year ended December 31, 2004



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



COMMISSION FILE NUMBER



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VIRYANET LTD.

(Exact Name of Registrant as specified in its charter)



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STATE OF ISRAEL

(Jurisdiction of incorporation or organization)



8 HaMarpe St.

Har Hotzvim

P.O. Box 45041

Jerusalem 91450

Israel

(Address of principal executive offices)



Securities registered or to be registered pursuant to Section 12(b) of the Act:



|                    |  |                                          
|------------------- |  | -----------------------------------------
|Title of each class |  | Name of each exchange on which registered
|NONE                |  | N/A                                      



Securities
registered or to be registered pursuant to Section 12(g) of the Act:



Ordinary Shares, par value NIS 1.0 per share

(Title of Class)



Securities for which there is a reporting obligation pursuant to Section
15(d) of the Act:



N/A

(Title of Class)



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Indicate the number of outstanding shares of each of
issuers classes of capital or common stock as of the close of the period covered by the annual report:



As of December 31, 2004, the Registrant had outstanding 5,413,892 Ordinary Shares (on a post reverse stock split basis, taking into account the 10 to 1
reverse stock split effected on May 1, 2002).



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



Indicate by check mark which financial statement item the Registrant has elected to follow: Item 17 ̈Item 18  x



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##### Table of Contents

TABLE OF CONTENTS



|         |  |                                                                              |  |                                                                        |  |         
|-------- |  | ---------------------------------------------------------------------------- |  | ---------------------------------------------------------------------- |  | --------
|         |  |                                                                              |  |                                                                        |  | Page No.
|ITEM     |  |                                                                              |  |                                                                       
|         |  |                                                                             
|PART I   |  |                                                                              |  |                                                                       
|Item 1.  |  | Identity of Directors, Senior Management and Advisors                        |  | 3                                                                     
|Item 2.  |  | Offer Statistics and Expected Timetable                                      |  | 3                                                                     
|Item 3.  |  | Key Information                                                              |  | 3                                                                     
|         |  |                                                                              |  | Selected Consolidated Financial Data                                   |  | 3       
|         |  |                                                                              |  | Capitalization and Indebtedness                                        |  | 5       
|         |  |                                                                              |  | Reasons for the Offer and Use of Proceeds                              |  | 5       
|         |  |                                                                              |  | Risk Factors                                                           |  | 5       
|Item 4.  |  | Information on our Company                                                   |  | 18                                                                    
|         |  |                                                                              |  | History and Development                                                |  | 18      
|         |  |                                                                              |  | Business Overview                                                      |  | 19      
|         |  |                                                                              |  | Organizational Structure                                               |  | 25      
|         |  |                                                                              |  | Property, Plants and Equipment                                         |  | 25      
|Item 5.  |  | Operating and Financial Review and Prospects                                 |  | 25                                                                    
|         |  |                                                                              |  | Overview                                                               |  | 27      
|         |  |                                                                              |  | Operating Results                                                      |  | 31      
|         |  |                                                                              |  | Liquidity and Capital Resources                                        |  | 35      
|         |  |                                                                              |  | Research and Development                                               |  | 40      
|         |  |                                                                              |  | Trend Information                                                      |  | 40      
|         |  |                                                                              |  | Off-balance Sheet Arrangements                                         |  | 40      
|         |  |                                                                              |  | Tabular Disclosure of Contractual Obligations                          |  | 41      
|Item 6.  |  | Directors, Senior Management and Employees                                   |  | 41                                                                    
|         |  |                                                                              |  | Directors and Senior Management                                        |  | 41      
|         |  |                                                                              |  | Compensation                                                           |  | 43      
|         |  |                                                                              |  | Board Practices                                                        |  | 43      
|         |  |                                                                              |  | External Directors; Independent Directors                              |  | 44      
|         |  |                                                                              |  | Employees                                                              |  | 46      
|         |  |                                                                              |  | Share Ownership                                                        |  | 46      
|Item 7.  |  | Major Shareholders and Related Party Transactions                            |  | 48                                                                    
|         |  |                                                                              |  | Major Shareholders                                                     |  | 48      
|         |  |                                                                              |  | Related Party Transactions                                             |  | 49      
|         |  |                                                                              |  | Interests of Experts and Counsel                                       |  | 51      
|Item 8.  |  | Financial Information                                                        |  | 51                                                                    
|         |  |                                                                              |  | Consolidated Statements and Other Financial Information                |  | 51      
|         |  |                                                                              |  | Significant Changes                                                    |  | 51      
|Item 9.  |  | The Offer and Listing                                                        |  | 52                                                                    
|         |  |                                                                              |  | Market Price Information                                               |  | 52      
|         |  |                                                                              |  | Markets on Which our Ordinary Shares Trade                             |  | 53      
|Item 10. |  | Additional Information                                                       |  | 53                                                                    
|         |  |                                                                              |  | Share Capital                                                          |  | 53      
|         |  |                                                                              |  | Memorandum and Articles of Association                                 |  | 53      
|         |  |                                                                              |  | Material Contracts                                                     |  | 55      
|         |  |                                                                              |  | Exchange Controls                                                      |  | 55      
|         |  |                                                                              |  | Taxation                                                               |  | 55      
|Item 11. |  | Quantitative and Qualitative Disclosures about Market Risk                   |  | 63                                                                    
|Item 12. |  | Description of Securities other than Equity Securities                       |  | 63                                                                    
|PART II  |  |                                                                              |  | 63                                                                    
|Item 13. |  | Defaults, Dividend Arrearages and Delinquencies                              |  | 63                                                                    
|Item 14. |  | Material Modifications to the Rights of Security Holders and Use of Proceeds |  | 64                                                                    
|Item 15. |  | Controls and Procedures                                                      |  | 64                                                                    
|Item 16. |  | Audit Committee Financial Expert                                             |  | 65                                                                    
|         |  |                                                                              |  | Code of Ethics                                                         |  | 65      
|         |  |                                                                              |  | Principal Accountant Fees and Services                                 |  | 66      
|         |  |                                                                              |  | Exemptions from the Listing Standards for the Audit Committee          |  | 66      
|         |  |                                                                              |  | Purchases of Equity Securities by the Issuer and Affiliated Purchasers |  | 66      
|PART III |  |                                                                              |  | 67                                                                    
|Item 17. |  | Financial Statements                                                         |  | 67                                                                    
|Item 18. |  | Financial Statements                                                         |  | 67                                                                    
|Item 19. |  | Exhibits                                                                     |  | 67                                                                    



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##### Table of Contents

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS



Unless the context otherwise requires, all reference in this annual report to
ViryaNet, we, our, us and the Company refer to ViryaNet Ltd. and its consolidated subsidiaries. Reference to dollars or $ are to United States dollars. All references to NIS are
to New Israeli Shekels.



All references to Ordinary Shares,
including related share price, are made on a post reverse stock split basis, taking into account the 10 to 1 reverse stock split of ViryaNets Ordinary Shares, effected on May 1, 2002.



Matters discussed in this document may constitute forward-looking statements.
The Private Securities Litigation Reform Act of 1995 provides safe harbor protections for forward-looking statements in order to encourage companies to provide prospective information about their businesses. Forward-looking statements include
statements concerning plans, objectives, goals, strategies, future events or performance, and underlying assumptions and other statements, which are other than statements of historical facts.



We desire to take advantage of the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995 and we are including this cautionary statement in connection with this safe harbor legislation. This document and any other written or oral statements made by us or on our behalf may include forward-looking
statements, which reflect our current views with respect to future events and financial performance. The words believe, expect, anticipate, intend, estimate, forecast,
project and similar expressions identify forward-looking statements.



The forward-looking statements in this document are based upon various assumptions, many of which are based, in turn, upon further assumptions, including without limitation, managements examination of historical
operating trends, data contained in our records and other data available from third parties. Although we believe that these assumptions were reasonable when made, because these assumptions are inherently subject to significant uncertainties and
contingencies which are difficult or impossible to predict and are beyond our control, we cannot assure you that we will achieve or accomplish these expectations, beliefs or projections. In addition to these important factors and matters discussed
elsewhere herein and in the documents incorporated by reference herein, important factors that, in our view, could cause actual results to differ materially from those discussed in the forward-looking statements, including the achievement of the
anticipated levels of profitability, growth, cost, the timely development and acceptance of new products, the impact of competitive pricing, the impact of general business and global economic conditions and other important factors described from
time to time in the reports filed by us with the Securities and Exchange Commission.



Except to the extent required by law, neither we, nor any of our respective agents, employees or advisors intends or has any duty or obligation to supplement, amend, update or revise any of the forward-looking
statements contained or incorporated by reference in this document.



PART I



Item 1.Identity Of Directors, Senior Management and Advisors



Not applicable.



Item 2.Offer Statistics and Expected Timetable



Not applicable.



Item 3.Key Information



Selected Consolidated Financial Data



Certain financial data contained in this Form 20-F has been previously revised to reflect the restatements of our consolidated financial statements for the years ended December 31, 2000, 2001, 2002 and 2003 related to amounts previously
reported as revenues, provisions for doubtful accounts, other income, trade and other receivables, and working capital (deficit). The restatements were reported on December 9, 2004 and March 17, 2005 and the impact on our financial statements was
first reported in our Report on Form 20-F/A dated March 25, 2005 for the fiscal year ended on December 31, 2003, which report is available on our website using the following URL: http://www.viryanet.com/investors/sec.htm.



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##### Table of Contents

The tables that follow present portions of our financial statements and are not complete. You should read
the following selected financial data with our consolidated financial statements, notes to our consolidated financial statements and the Operating and Financial Review and Prospects section included in this annual report. Historical results are not
necessarily indicative of any results to be expected in any future period.



We derived the selected consolidated statements of operations data below for the years ended December 31, 2002, 2003 and 2004, and the selected consolidated balance sheet data as of December 31, 2003 and 2004, from
our audited consolidated financial statements, which are included elsewhere in this annual report. These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States
(GAAP). We derived the consolidated statements of operations data for the years ended December 31, 2000 and 2001 and the selected consolidated balance sheet data as of December 31, 2000, 2001 and 2002 from audited consolidated financial
statements that are not included in this annual report.



Summary Consolidated Financial Information

U.S. dollars in thousands (except share data)



|                                                                                                                                                      |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|----------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | --------- | ---- |  | - | --------- | - |  | ---- | --------- | - |  | - | --------- | -
|                                                                                                                                                      |  | Year Ended December 31, |        
|                                                                                                                                                      |  | 2000                    |         |   | 2001 |   |           | 2002 |  |   | 2003      |   |  | 2004 |          
|Statement of Operations Data:                                                                                                                         |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Revenues:                                                                                                                                             |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Software licenses                                                                                                                                     |  | $                       | 14,484  |   |      | $ | 7,800     |      |  | $ | 6,611     |   |  | $    | 4,102     |   |  | $ | 3,114     |  
|Maintenance and services                                                                                                                              |  |                         | 10,080  |   |      |   | 7,498     |      |  |   | 5,190     |   |  |      | 7,857     |   |  |   | 8,806     |  
|                                                                                                                                                      |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Total revenues                                                                                                                                        |  |                         | 24,564  |   |      |   | 15,298    |      |  |   | 11,801    |   |  |      | 11,959    |   |  |   | 11,920    |  
|Cost of revenues:                                                                                                                                     |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Software licenses                                                                                                                                     |  |                         | 938     |   |      |   | 2,420     |      |  |   | 361       |   |  |      | 482       |   |  |   | 288       |  
|Maintenance and services                                                                                                                              |  |                         | 7,857   |   |      |   | 6,458     |      |  |   | 4,380     |   |  |      | 4,996     |   |  |   | 6,741     |  
|                                                                                                                                                      |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Total cost of revenues                                                                                                                                |  |                         | 8,795   |   |      |   | 8,878     |      |  |   | 4,741     |   |  |      | 5,478     |   |  |   | 7,029     |  
|Gross profit                                                                                                                                          |  |                         | 15,769  |   |      |   | 6,420     |      |  |   | 7,060     |   |  |      | 6,481     |   |  |   | 4,891     |  
|                                                                                                                                                      |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Operating expenses:                                                                                                                                   |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Research and development, net                                                                                                                         |  |                         | 7,224   |   |      |   | 6,602     |      |  |   | 3,352     |   |  |      | 2,098     |   |  |   | 2,069     |  
|Sales and marketing                                                                                                                                   |  |                         | 16,385  |   |      |   | 14,150    |      |  |   | 6,598     |   |  |      | 4,109     |   |  |   | 4,367     |  
|General and administrative                                                                                                                            |  |                         | 3,848   |   |      |   | 3,931     |      |  |   | 2,314     |   |  |      | 1,907     |   |  |   | 2,149     |  
|Provision for doubtful accounts and write-off of bad debts                                                                                            |  |                         | 9       |   |      |   | 665       |      |  |   | (53       | ) |  |      | 40        |   |  |   |          |  
|In-process research and development write-off                                                                                                         |  |                         |        |   |      |   |          |      |  |   | 480       |   |  |      |          |   |  |   |          |  
|Amortization of deferred stock compensation (1)                                                                                                       |  |                         | 1,104   |   |      |   | (64       | )    |  |   | 36        |   |  |      | 20        |   |  |   | 98        |  
|                                                                                                                                                      |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Total operating expenses                                                                                                                              |  |                         | 28,570  |   |      |   | 25,284    |      |  |   | 12,727    |   |  |      | 8,174     |   |  |   | 8,683     |  
|Operating loss                                                                                                                                        |  |                         | (12,801 | ) |      |   | (18,864   | )    |  |   | (5,667    | ) |  |      | (1,693    | ) |  |   | (3,792    | )
|Financial income (expenses), net                                                                                                                      |  |                         | 26      |   |      |   | 190       |      |  |   | (189      | ) |  |      | (311      | ) |  |   | (363      | )
|Financial expenses related to amortization of beneficial conversion feature and compensation related to warrants to investors in convertible
loan (*) |  |                         | (16,556 | ) |      |   |          |      |  |   |          |   |  |      |          |   |  |   |          |  
|Other income                                                                                                                                          |  |                         |        |   |      |   |          |      |  |   |          |   |  |      | 350       |   |  |   |          |  
|                                                                                                                                                      |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Net loss                                                                                                                                              |  | $                       | (29,331 | ) |      | $ | (18,674   | )    |  | $ | (5,856    | ) |  | $    | (1,654    | ) |  | $ | (4,155    | )
|                                                                                                                                                      |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Basic and diluted net loss per share                                                                                                                  |  | $                       | (36.53  | ) |      | $ | (8.60     | )    |  | $ | (2.26     | ) |  | $    | (0.55     | ) |  | $ | (0.85     | )
|Weighted average number of shares used in computing basic and diluted net loss per Ordinary Share                                                     |  |                         | 802,979 |   |      |   | 2,171,113 |      |  |   | 2,587,948 |   |  |      | 3,048,319 |   |  |   | 4,888,062 |  
|                                                                                                                                                      |  |                         |         |   |     
|(1)    Amortization of deferred stock compensation relates to the following:                                                                          |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Cost of revenues                                                                                                                                      |  | $                       | 4       |   |      | $ | 32        |      |  | $ |          |   |  | $    |          |   |  | $ | 2         |  
|Sales and marketing                                                                                                                                   |  |                         | 207     |   |      |   | 12        |      |  |   | 32        |   |  |      |          |   |  |   | 31        |  
|General and administrative                                                                                                                            |  |                         | 893     |   |      |   | (108      | )    |  |   | 4         |   |  |      | 20        |   |  |   | 65        |  
|                                                                                                                                                      |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|                                                                                                                                                      |  | $                       | 1,104   |   |      | $ | (64       | )    |  | $ | 36        |   |  | $    | 20        |   |  | $ | 98        |  
|                                                                                                                                                      |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Balance Sheet Data:                                                                                                                                   |  |                         |         |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Cash and cash equivalents                                                                                                                             |  | $                       | 21,838  |   |      | $ | 8,540     |      |  | $ | 3,211     |   |  | $    | 5,087     |   |  | $ | 2,943     |  
|Working capital (deficit)                                                                                                                             |  |                         | 18,583  |   |      |   | (38       | )    |  |   | (2,271    | ) |  |      | 1,060     |   |  |   | (3,461    | )
|Total assets                                                                                                                                          |  |                         | 32,297  |   |      |   | 15,462    |      |  |   | 10,760    |   |  |      | 12,230    |   |  |   | 14,398    |  
|Long-term loan, including current maturities                                                                                                          |  |                         |        |   |      |   |          |      |  |   | 2,400     |   |  |      | 2,343     |   |  |   | 1,306     |  
|Convertible note                                                                                                                                      |  |                         |        |   |      |   |          |      |  |   |          |   |  |      |          |   |  |   | 2,500     |  
|Shareholders equity (deficiency)                                                                                                                     |  |                         | 20,638  |   |      |   | 2,012     |      |  |   | (651      | ) |  |      | 2,786     |   |  |   | 1,678     |  

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|(*) | Financial expenses related to beneficial conversion feature of convertible debentures and detachable warrants were recorded at the time of our initial public offering
(IPO) in September 2000, due to the discounted conversion feature of the convertible debentures which converted into Ordinary Shares at that time.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Capitalization and Indebtedness



Not applicable.



Reasons for the Offer and Use of Proceeds



Not applicable.



RISK FACTORS



You should carefully consider the
risks described below and in the documents we have incorporated by reference into this prospectus before making an investment decision. The risks described below and in the documents we have incorporated by reference into this prospectus are not the
only ones facing our company. Our business, financial condition or results of operations could be materially adversely affected by any of these risks. The trading price of our Ordinary Shares could decline due to any of these risks, and you may lose
all or part of your investment.



Statements included or incorporated by
reference in this prospectus that are not historical facts are forward-looking statements within the meaning of the federal securities laws. These statements may contain works such as expects, anticipates,
intends, plans, believes, estimates, or other wording indicating future results or expectations. Forward-looking statements are subject to risks and uncertainties. Our actual results may differ
materially from the results discussed in forward-looking statements. Factors that could cause our results to differ materially include, but are not limited to, those discussed below, elsewhere in this prospectus and in the documents we have
incorporated by reference. We undertake no obligation to revise or update any forward-looking statements to reflect any event or circumstance that may arise or develop after the date of this prospectus.



Risks Related to our Business



We have incurred losses in the past and may incur losses in the future.



We have incurred substantial net losses during each
of the last six fiscal years and may not achieve profitability in 2005 or in future years. As of December 31, 2004, we had an accumulated deficit of approximately $107.7 million. In order to achieve profitability we will need to increase our
revenues while containing or reducing our costs. However, a substantial portion of our expenses, including most product development and selling and marketing expenses, must be incurred in advance of when revenue is generated. Therefore, if our
projected revenue does not meet our expectations, we are likely to experience an even larger shortfall in our operating profit relative to our expectations. While our revenues in 2004, 2003, and 2002 were $11.9 million, $12.0 million, and $11.8
million, respectively, we incurred a net loss of $4.2 million, $1.7 million and $5.9 million during these periods. We cannot assure you that we will be able to increase our revenues, or, that even if we are able to increase our revenues we will be
able to achieve profitability or maintain profitability, if achieved, on a consistent basis.



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Our quarterly operating results have fluctuated significantly in the past and may fluctuate significantly in the
future which may adversely impact the price of our Ordinary Shares, making it difficult for investors to make reliable period-to-period comparisons and may contribute to volatility in the market price for our Ordinary Shares.



Our quarterly revenues, gross profits and results of operations have
fluctuated significantly in the past and we expect them to continue to fluctuate significantly in the future. The following events may cause fluctuations in our operating results and/or cause our share price to decline:



| |  |  | changes in global economic conditions in general, and conditions in our industry and target markets in particular;
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | changes in demand or timing of orders, especially large orders, for our products and services;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | the length and unpredictability of our sales cycle;
| | - |  | ---------------------------------------------------



| |  |  | timing of product releases;
| | - |  | ---------------------------



| |  |  | the dollar value and timing of contracts;
| | - |  | -----------------------------------------



| |  |  | delays in implementation;
| | - |  | -------------------------



| |  |  | the mix of revenue generated by product licenses and professional services;
| | - |  | ---------------------------------------------------------------------------



| |  |  | price and product competition;
| | - |  | ------------------------------



| |  |  | increases in selling and marketing expenses, as well as other operating expenses;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | technological changes;
| | - |  | ----------------------



| |  |  | our ability to expand our workforce with qualified personnel, as may be needed;
| | - |  | -------------------------------------------------------------------------------



| |  |  | the failure to maintain compliance with The Nasdaq SmallCap Market listing standards;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | reductions in the level of our cash balance and our ability to raise cash;
| | - |  | --------------------------------------------------------------------------



| |  |  | consolidation of our customers;
| | - |  | -------------------------------



| |  |  | the geographic mix of revenue;
| | - |  | ------------------------------



| |  |  | integration and assimilation of management, employees and product lines of acquired companies;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | effectiveness of our customer support, whether provided by our resellers or directly by us; and
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | foreign currency exchange rate fluctuations.
| | - |  | --------------------------------------------



As a result, we believe that period-to-period comparisons of our historical results of operations are not necessarily meaningful and that you should not
rely on them as an indication for future performance. Also, it is possible that our quarterly results of operations may be below the expectations of public market analysts and investors. If this happens, the price of our Ordinary Shares will likely
decrease.



We have substantially expanded our number of employees during
2004 and the first half of 2005 and may be unable to maintain our expanded staff or may incur increased losses because of it.



During 2004, we substantially increased our overall headcount from 86 at the end of 2003 to 126 at the end of 2004. Part of this increase was related to
the assumption of 25 employees from the acquisition of Utility Partners. In June 2005, we added another 23 employees with the acquisition of e-Wise Solutions. Although we believe we currently have sufficient resources available to meet and support
our current obligations in relation to the expansion of our staff, we may not be able to maintain this expanded headcount. If we are forced to reduce headcount, our ability to meet our growth goals and our business and operations may be negatively
impacted. Furthermore, we have a history of losses and the increase in headcount during 2004 and the first half of 2005 may result in a continuation of or increase in the amount of the net loss as the additional cost of the higher headcount level
may not be offset by increased revenue.



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We may need to further expand our sales, marketing, research and development and professional services
organizations but may lack the resources to do so, which may hinder our ability to grow and meet customer demands.



We may need to substantially expand our headcount beyond our current staff in order to increase market awareness and sales of our products. We may also
need to increase our quality assurance, technical and customer support staff to support new customers and the expanding needs of existing customers. These positions require training on the use of our products and we generally expect that the
training period will take a significant amount of time before these personnel can support our customers. In addition, there is significant competition for qualified personnel. Competition for qualified people may lead to increased labor and
personnel costs. If we need to hire additional employees and are unable to attract, train and retain qualified personnel, we may not be able to achieve our objectives and our business could be harmed.



We may need additional financing and may not be able to raise additional financing on
favorable terms or at all.



We had negative cash flow
from operations for several years. In the past four years, we had an aggregate negative cash flow in the amount of $28.0 million. We raised gross proceeds of approximately $5.0 million from private equity financing transactions during 2003, $2.5
million in a convertible note financing in July 2004, and $1.3 million from a private equity financing transaction in February 2005. However, we expect that we will need additional financing to fund our business operations. Any additional financing
that is structured as a secured debt financing may require the consent of our main creditors, Bank Hapoalim and LibertyView. We cannot assure you that additional financing will be available on terms favorable to us, or at all. In the event that the
market price of our Ordinary Shares declines, we may not be able to consummate a private equity financing transaction to raise additional financing. If adequate funds are not available or are not available on acceptable terms, our ability to fund
our day to day operations, expand our research and development, marketing and sales efforts, pursue potential acquisitions, take advantage of unanticipated opportunities, develop or enhance our website content, features or services, or otherwise
respond to competitive pressures would be severely constrained. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our existing shareholders will be reduced, and any newly-issued
securities may have rights, preferences or privileges senior to those of existing shareholders.



We will need sufficient funds to re-pay our loans from Bank Hapoalim, which may be subject to immediate repayment if we do not meet our repayment schedule or meet specified conditions.



As of June 1, 2005, we had an outstanding balance on our long-term loan
arrangement with Bank Hapoalim of $0.8 million payable quarterly in equal installments of $267,000 through January 1, 2006 with interest payable quarterly at a rate of LIBOR plus 2.75%. As of June 1, 2005, we also had an outstanding balance in our
short-term borrowings with Bank Hapoalim of $1.25 million with interest payable quarterly at rates ranging from LIBOR plus 2.25% in dollars and 8% in NIS. We may need funding from third parties to meet the payment obligations under these loan
arrangements in a timely manner, and there is no assurance that Bank Hapoalim will grant us an extension to these payment dates in the future, if requested. In addition, these long and short-term debts are subject to the following covenants: (i) our
shareholders equity, on a quarterly basis, starting on January 1, 2006, shall be at least the higher of (a) 17% of our total assets, or (b) $3.0 million, and (ii) our cash balance on January 1, 2006 and on a quarterly basis thereafter, shall not be
less than $2.0 million. There can be no assurance that we will meet these covenants or that the bank will waive the compliance with any such covenants in the event that we do not meet them. If we fail to meet the quarterly payments to Bank Hapoalim
or to meet these covenants, the bank may demand immediate repayment of the outstanding debts and all interest thereon and shall be entitled to exercise the remedies available to it. This would have a material adverse effect on our business.



We may not be able to maintain compliance with the listing rules of The
Nasdaq SmallCap Market in which case our shares would be delisted, which could adversely affect the market price and trading market of our Ordinary Shares.



Our Ordinary Shares have been listed on The Nasdaq SmallCap Market since December 31, 2002. We were previously listed on The
Nasdaq National Market but were unable to comply with some of its maintenance standards. The Nasdaq SmallCap Market has several maintenance standards for continued listing, including the requirements (i) that we maintain (a) shareholders
equity of at least $2,500,000, (b) market value of $35,000,000 or (c) net income from operations of $500,000 in the last fiscal year or in two of the last three fiscal years, (ii) that we have at least 500,000 shares held by persons or entities
other than our officers, directors and beneficial owners of more than 10% of our Ordinary Shares (the Public Float), (iii) that we have an aggregate market value of Public Float of at least $1,000,000, (iv) that we have at least two
market makers, (v) that we have at least 300 shareholders who hold at least 100 Ordinary Shares each, and (vi) that we shall be in compliance with all corporate governance under rules 4350 and 4351 (the foregoing requirements are collectively
referred to as the Maintenance Standards). On July 17, 2003, we were notified by Nasdaq that we were not in compliance with the listing standard for shareholders equity and were required to provide Nasdaq with a plan to regain
compliance or our shares would be subject to delisting. On August 8, 2003, our plan was submitted to Nasdaq and acknowledged. On December 5, 2003, we issued a Report on Form 6-K to publicly demonstrate that we had regained compliance as a result of
the proceeds received from our recent financing activities.



On
June 2, 2005, we were notified by Nasdaq that we were not in compliance with the listing standard for shareholders equity and were required to provide Nasdaq with a plan to achieve and sustain compliance by July 5, 2005 or our shares would be



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subject to delisting. We have prepared a plan to regain compliance and submitted it to Nasdaq for their review on July 5,
2005. However, if our plan to regain compliance fails to satisfy Nasdaq, Nasdaq will provide us with written notification that our Ordinary Shares will be delisted from The Nasdaq SmallCap Market. The delisting of our Ordinary Shares from The Nasdaq
SmallCap Market may materially impair the ability of our shareholders to buy and sell our Ordinary Shares, even if they qualify for inclusion on the Over-the-Counter Bulletin Board (OTCBB), and could have an adverse effect on the market price and
the trading market for our Ordinary Shares. In addition, the delisting of our Ordinary Shares could significantly impair our ability to raise capital should we desire to do so in the future or utilize our Ordinary Shares in consideration for
acquisitions. Furthermore, if our Ordinary Shares are delisted from The Nasdaq SmallCap Market, the loan provided to us by LibertyView under the Convertible Note may be recalled by LibertyView.



The market price of our Ordinary Shares may be volatile and you may not be able to
resell your shares at or above the price you paid, or at all.



The stock market in general has recently experienced extreme price and volume fluctuations. The market prices of securities of technology companies have been extremely volatile, and have experienced fluctuations that have often been
unrelated or disproportionate to the operating performance of those companies. These broad market fluctuations could adversely affect the market price of our Ordinary Shares. The market price of the Ordinary Shares may fluctuate substantially due to
a variety of factors, including:



| |  |  | any actual or anticipated fluctuations in our financial condition and operating results;
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | our inability to meet any guidance or forward looking information, if provided;
| | - |  | -------------------------------------------------------------------------------



| |  |  | public announcements concerning us or our competitors;
| | - |  | ------------------------------------------------------



| |  |  | the introduction or market acceptance of new service offerings by us or our competitors;
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | changes in security analysts financial estimates;
| | - |  | --------------------------------------------------



| |  |  | changes in accounting principles;
| | - |  | ---------------------------------



| |  |  | sales of our Ordinary Shares by existing shareholders;
| | - |  | ------------------------------------------------------



| |  |  | limited market for our shares;
| | - |  | ------------------------------



| |  |  | the need to raise additional capital through private or public debt or equity financings;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | our ability to maintain compliance with all The Nasdaq SmallCap Market listing standards; and
| | - |  | ---------------------------------------------------------------------------------------------



| |  |  | changes in the political conditions in Israel.
| | - |  | ----------------------------------------------



In the past, securities class action litigation has often been brought against companies following periods of volatility in the market prices of their
securities. We may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert our managements attention and resources, which could cause serious harm to our business.



Future sales of our Ordinary Shares in the public market or issuances of additional
securities could cause the market price for our Ordinary Shares to fall.



The amount of our outstanding Ordinary Shares has increased substantially since August 4, 2003. The increase in the amount of outstanding Ordinary Shares is due primarily to the private financings that have occurred
which resulted in the issuance of 1,611,089 Ordinary Shares in exchange for approximately $5.0 million during the third and fourth quarters of 2003, the acquisition of Utility Partners, Inc. which resulted in the issuance of 898,485 Ordinary Shares
in July 2004, the issuance of 581,659 Ordinary Shares in exchange for approximately $1.3 million in February 2005, and the acquisition of e-Wise Solutions which resulted in the issuance of approximately 273,267 Ordinary Shares in June 2005. As of
June 1, 2005, we had outstanding warrants to purchase 560,265 Ordinary Shares, and we have reserved up to 1,490,000 Ordinary Shares for issuance under our option plans, of which 178,794 options have been exercised as of June 1, 2005. In addition,
our convertible note with LibertyView may be converted by LibertyView at any time into 581,449 Ordinary Shares and in the future we may re-pay the loan under the Convertible Note in Ordinary Shares based on the then current market price per Ordinary
Share. The sale, or availability for sale, of substantial quantities of our Ordinary



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Shares may have the effect of further depressing their market price. A large number of our Ordinary Shares that were
previously subject to resale restrictions are currently eligible or shall soon be eligible for resale into the public market. We also provided registration rights to certain shareholders and in connection with certain of these rights, have filed a
Registration Statement on Form F-3 with the SEC that is expected to increase in the near future the number of our Ordinary Shares eligible for resale into the public market by 2,080,057. In addition, a significant number of shares are eligible for
resale in the future (i.e. those shares in the form of warrants that may be issued if the holders of these warrants decide to exercise such warrants). Issuance of these shares will dilute existing shareholders.



We may continue to issue warrants and options and the issuance of these
securities could be dilutive to our shareholders. Certain warrants and options, when issued, may be valued at fair value and we may reflect the appropriate charges in our financial statements at that time.



Historically, our revenues have been concentrated in a few large orders and a small
number of customers. Our business could be adversely affected if we lose a key customer.



A significant portion of our revenues each year has been derived from large orders from a small number of customers which are not necessarily the same
customers each year. In 2002, three customers each accounted for approximately 9% or more of our revenues, and represented an aggregate of approximately 31% of our total revenues. In 2003, three customers each accounted for approximately 10% or more
of revenues, and represented an aggregate of 41% of our total revenues. In 2004, two customers each accounted for approximately 10% or more of revenues, and represented an aggregate of 25% of our total revenues. We do not expect that these two
customers accounting for 25% of our revenue during 2004 will represent a substantial percentage of our revenues in the future. However, we do expect that a significant portion of our future revenues will continue to be derived from a relatively
small number of customers. We cannot assure you that other customers will purchase our products and services in the future. The failure to secure new key customers, the loss of key customers or the occurrence of significant reductions in sales from
a key customer would cause our revenues to significantly decrease and make it significantly more difficult for us to be profitable.



Our sales cycle is variable and often long and involves investment of significant resources on our part, but may never result in actual sales and we may therefore
suffer additional losses.



Our sales cycle from our
initial contact with a potential customer to the signing of a license and related agreements has historically been lengthy and variable. We generally must educate our potential customers about the use and benefit of our products and services, which
can require the investment of significant time and resources, causing us to incur most of our product development and selling and marketing expenses in advance of a potential sale. In addition, a number of companies decide which products to buy
through a request for proposal process. In those situations, we also run the risk of investing significant resources in a proposal that results in a competitor obtaining the desired contract from the customer or in a decision by a customer not to
proceed. The purchasing decisions of our customers are subject to the uncertainties and delays of the budgeting, approval and competitive evaluation processes that typically accompany significant capital expenditures. If our sales cycle lengthens,
our quarterly operating results may become less predictable and may fluctuate more widely than in the past. Due to the relatively large size of some orders, a lost or delayed sale could have a material adverse effect on our quarterly revenue and
operating results.



Our business is still impacted by the effects of the
slowdown in the worldwide economy .



Our business is
dependent on current and anticipated market demand for enterprise software products. The demand for these products has been negatively impacted by the slowdown in the global economy that began in the second half of 2000 and by the terrorist attacks
of September 11, 2001, and, more recently, by continuing actions against global terrorism such as the war in Iraq and attacks in Afghanistan by coalition forces led by the United States. Many of our customers and prospective customers are still
experiencing economic downturns, including those in some of our traditional target markets, including the telecommunications and general services markets.



The uncertainty regarding the growth rate of the worldwide economies has caused companies to reduce purchasing and capital investment. Specifically, many
companies struggled with the timing of investment decisions on technology spending in light of their desire to return to positive growth and the continuation of geopolitical uncertainties which may have affected their outlook.



Should economic conditions fail to improve, our ability to sell our products
and services as well as our operating results could be negatively impacted. Furthermore, even if we are successful in selling our products and services, our ability to collect outstanding receivables may be significantly impacted by liquidity issues
of our customers, which may have a material adverse impact on our business, operating results and financial condition.



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We cannot predict if or when the growth rate of the global economy will rebound or whether the growth
rate of our business will rebound when the global economy begins to grow. The effects of the economic decline have resulted and are likely to continue to result in intensified price competition, reduced margins, lower revenue growth rates, and
longer payment terms, and may result in decreased revenues, increased losses or an inability to achieve profitability.



If we are unable to accurately predict and respond to market developments or demands, our business will be adversely affected.



The market for mobile workforce management software solutions is still
evolving. This makes it difficult to predict demand and market acceptance for our products. Changes in technologies, industry standards, customer requirements and new product introductions by existing or future competitors could render our existing
products obsolete and unmarketable, or require us to develop new products. We have limited development resources to expend on product development and those resources are utilized mainly for responding to the needs of our current customers.
Therefore, we may be unable to timely develop products that meet the markets future needs. If we were to experience a significant increase in the number of customers, or were to decide to effect a significant increase in our development of new
product offerings, or both, we would need to expend significant amounts of money, time and other resources. This could strain our personnel and financial resources.



If we fail to maintain or improve our margins on service revenues in the future, our results of operations could suffer.



Our margins on service revenues were 23% in 2004
compared to 36% in 2003 and 16% in 2002. In order to improve our margins on services revenues, we will need to increase the efficiency and utilization of our services personnel, continue to control our costs, and increase the volume of our services
revenues. There is no assurance that we will be able to maintain or improve our services margins, or, that they will not decline further in the future.



Our ability to maintain or increase our revenues may depend on our ability to make sales through third parties.



We rely upon resellers and channel partners to generate a substantial
portion of our revenues. We expect this reliance to continue due to our limited internal sales and marketing resources in existing markets and to increase due to our desire to penetrate new markets for our products outside of North America. As a
result of the limited resources and capacities of many resellers and channel partners, even if we manage to maintain and expand our relationship with such resellers and channel partners, we may be unable to attain sufficient focus and resources from
those resellers and channel partners so as to meet all of our customers needs. If anticipated orders from these resellers and channel partners fail to materialize, or if our current business agreements with resellers and channel partners are
terminated, our business, operating results and financial condition will be materially adversely affected.



If we are unable to maintain or expand our relationships with third party providers of implementation and consulting services, we may be unable to increase our
revenues.



To focus more effectively on our core
business of developing and licensing software solutions, we need to establish and maintain additional relationships with third parties that can provide implementation and consulting services to our customers. Third-party implementation and
consulting firms can also be influential in the choice of mobile workforce management solutions by new customers. If we cannot establish and maintain effective, long-term relationships with implementation and consulting providers, or if these
providers do not meet the needs or expectations of our customers, we may be unable to increase our revenues and our business could be seriously harmed. As a result of the limited resources and capacities of many third-party implementation providers,
we may be unable to attain sufficient focus and resources from the third-party providers to meet all of our customers needs, even if we establish relationships with these third parties. If sufficient resources are unavailable, we will be
required to provide these services internally, which could limit our ability to expand our base of customers. We will be subject to significant risk as we cannot control the level and quality of service provided by these third parties.



Undetected defects may increase our costs and impair the market acceptance of our
products and technology.



Our software products are
complex and may contain undetected defects, particularly when first introduced or when new versions or enhancements are released. Testing of our products is particularly challenging because it is difficult to simulate the wide variety of customer
environments in several geographic markets into which our products are deployed. Despite testing conducted by us and our customers, we have in the past shipped product releases with some defects, some customers have cited possible defects, and have
otherwise discovered other defects in our products after their commercial shipment. Our products are frequently more critical to our customers operations compared to other software solutions used by such customers, and as a result, our
customers may have a greater sensitivity to product defects relating to our products.



Defects may be found in current or future products and versions after the start of commercial shipment. This could result in:



| |  |  | a delay or failure of our products to achieve market acceptance;
| | - |  | ----------------------------------------------------------------



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| |  |  | adverse customer reaction;
| | - |  | --------------------------



| |  |  | negative publicity and damage to our reputation;
| | - |  | ------------------------------------------------



| |  |  | diversion of resources; and
| | - |  | ---------------------------



| |  |  | increased service and maintenance costs.
| | - |  | ----------------------------------------



Defects could also subject us to legal claims. Although our license agreements contain limitation of liability provisions, these provisions may not be
sufficient to protect us against these legal claims. The sale and support of our products, as well as our professional services, may also expose us to product liability claims.



Greater market acceptance of our competitors products or decisions by potential or actual customers to develop their own service
management solutions could result in reduced revenues and reduced gross margins.



The market for mobile workforce management applications and the automation of field service delivery are highly competitive yet fragmented and stratified, although a number of our traditional competitors have been
acquired by larger companies. We compete for the business of global or nationwide organizations that seek to support complex and sophisticated products across a variety of industries. We compete in the utilities and telecommunications segments of
our markets against companies like SPL Group (via its acquisition of our competitor Axiom Corporation), Service Power Technologies, plc., MDSI, Inc., ClickSoftware, Ltd., Telcordia, and Intergraph Corporation. Our primary competitors in commercial
and other general field service markets include enterprise application solution providers such as Astea International Inc., Metrix Inc., and FieldCentrix Inc., along with larger enterprise software companies such as Oracle Corporation, Siebel
Systems, Inc. and SAP A.G.



Many of our competitors may have
significant competitive advantages over us. These advantages may include greater technical and financial resources, more developed marketing and service organizations, greater expertise and broader customer bases and name recognition than us. Our
competitors may also be in a better position to devote significant resources to the development, promotion and sale of their products, and to respond more quickly to new or emerging technologies and changes in customer requirements. Current and
potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase their ability to successfully market their products. We also expect that competition will increase as a result of
consolidations in the industry. To the extent that we develop new products, we may begin to compete with companies with which we have not previously competed. We cannot assure you that competition will not result in price reductions for our products
and services, fewer customer orders, deferred payment terms, reduced gross margins or loss of market share, any of which could materially adversely affect our business, financial condition and results of operations. A number of potential customers
have the ability to develop software solutions internally thereby eliminating the requirement for suppliers like us. This could result in reduced revenues or lost business for us. In addition to the above, decisions by potential customers to use
their own internally developed solutions could result in reduced revenues and/or lost business for us.



We rely on software from third parties. If we cannot continue using that software, we would have to spend additional capital to redesign our existing software and may not be able to compete in our markets.



We utilize third-party software products to enhance
the functionality of our products. Our business would be disrupted if functional versions of this software were either no longer available to us or no longer offered to us on commercially reasonable terms. In either case, we would be required to
spend additional capital to either redesign our software to function with alternate third-party software or develop these components ourselves. If functional versions of third-party software were either no longer available to us or no longer offered
to us on commercially reasonable terms, we might be forced to limit the features available in our current or future product offerings and the commercial release of our products could be delayed, which could materially adversely affect our business,
financial condition and results of operations.



Since 2001, we have
depended upon our principal product, the ViryaNet Service Hub and related applications, and the failure of this product in the marketplace in the future could adversely affect our revenues.



In the past, we have depended on and expect to continue to depend on the
success of our principal product, ViryaNet Service Hub, and related applications. If our product does not achieve or maintain market acceptance or if our competitors release new products that achieve quicker or greater market acceptance, have more
advanced features, offer better performance or are more price competitive, our revenues may not grow and may even decline.



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We may be unable to adequately protect our proprietary rights, which may limit our ability to compete effectively.



Our success and ability to compete are substantially
dependent upon our internally developed technology. Other than our trademarks, most of our intellectual property consists of proprietary or confidential information that is not subject to patent or similar protection. In general, we have relied on a
combination of technical leadership, trade secret, copyright and trademark law and nondisclosure agreements to protect our proprietary know-how. Unauthorized third parties may attempt to copy or obtain and use the technology protected by those
rights. Any infringement of our intellectual property could have a material adverse effect on our business, financial condition and results of operations. Policing unauthorized use of our products is difficult and costly, particularly in countries
where the laws may not protect our proprietary rights as fully as in the United States.



In connection with some of our licensing agreements, we have placed, and in the future may place, our software in escrow. The software may, under specified circumstances, be made available to our customers and
resellers and this may increase the likelihood of misappropriation or other misuse of our software.



Substantial litigation over intellectual property rights exists in the software industry. We expect that software products may be increasingly subject to
third-party infringement claims as the functionality of products in different industry segments overlaps. We believe that many industry participants have filed or intend to file patent and trademark applications covering aspects of their technology.
We cannot be certain that they will not make a claim of infringement against us based on our products and technology. Any claims, with or without merit, could:



| |  |  | be expensive and time-consuming to defend;
| | - |  | ------------------------------------------



| |  |  | cause product shipment and installation delays;
| | - |  | -----------------------------------------------



| |  |  | divert managements attention and resources; or
| | - |  | -----------------------------------------------



| |  |  | require us to enter into royalty or licensing agreements to obtain the right to use a necessary product or component.
| | - |  | ---------------------------------------------------------------------------------------------------------------------



Royalty or licensing agreements, if required, may not be available on
acceptable terms, if at all, and even if available on acceptable terms, shall increase our expenses and may materially affect our results of operations adversely. A successful claim of product infringement against us and our failure or inability to
license the infringed or similar technology could have a material adverse effect on our business, financial condition and results of operations.



Marketing and distributing our products outside of the United States and other international operations may require increased expenses and greater exposure to risks
that we may not be able to successfully address.



We
market and sell our products and services in the United States, Europe and the Middle East, and the Far East. We received 43% of our total revenues in 2002, 30% of our total revenue in 2003, and 21% of our total revenue in 2004 from sales to
customers located outside of the United States. In addition to our operations in the United States, we have sales and support facilities and offices in Israel, Japan, Singapore and Australia. These operations require, and the expansion of our
existing operations and entry into additional international markets will require, significant management attention and financial resources. In addition, since our financial results are reported in dollars, decreases in the rate of exchange of
non-dollar currencies in which we make sales relative to the dollar will decrease the dollar-based reported value of those sales. To the extent that decreases in exchange rates are not offset by a reduction in our costs, they may materially
adversely affect our results of operation. Historically, we have not hedged our foreign currency-denominated account receivables and expenses risks. We are also subject to a number of risks customary for international operations, including:



| |  |  | differing technology standards and language requirements;
| | - |  | ---------------------------------------------------------



| |  |  | changing product and service requirements in response to the formation of economic and marketing unions, including the European Economic Union;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | economic or political changes in international markets;
| | - |  | -------------------------------------------------------



| |  |  | greater difficulty in accounts receivable collection and longer collection periods;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | unexpected changes in regulatory requirements;
| | - |  | ----------------------------------------------



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| |  |  | the uncertainty of protection for intellectual property rights in some countries; and
| | - |  | -------------------------------------------------------------------------------------



| |  |  | multiple and possibly overlapping tax structures.
| | - |  | -------------------------------------------------



We depend on key personnel, and the loss of any key personnel could affect our ability to compete and our ability to attract additional key personnel may be
impaired.



We believe our future success will depend
on the continued service of our executive officers and other key sales and marketing, product development and professional services personnel. The loss of the services of Mr. Samuel HaCohen, the co-founder and Executive Chairman of our Company, and
other members of our senior management team could harm our business significantly. We have employment agreements with our executive officers, including Mr. HaCohen. Although these agreements generally require notification prior to departure,
relationships with these officers and key employees are at will. The loss of any of our key personnel could harm our ability to execute our business or financial strategy and compete.



Our executive officers, directors and affiliated entities will be able to influence matters requiring shareholder approval and they
may disapprove actions that you voted to approve.



As
of June 1, 2005, our executive officers and directors serving as of such date, and entities affiliated with them, in the aggregate, beneficially owned approximately 24.9% of our outstanding Ordinary Shares, including options and warrants to purchase
Ordinary Shares which are exercisable or will become exercisable within 60 days of June 1, 2005. These shareholders, if acting together, will be able to significantly influence all matters requiring approval by our shareholders, including the
election of directors and the approval of mergers or other business combination transactions.



Any future acquisitions of companies or technologies may distract our management and disrupt our business.



On February 25, 2002 we completed the acquisition of all of the outstanding shares of iMedeon, Inc. (iMedeon), a provider of mobile workforce
management solutions to the utilities sector and on July 29, 2004, we completed the acquisition of all of the outstanding shares of Utility Partners, Inc. On June 15, 2005, we completed the acquisition of substantially all of the assets of e-Wise
Solutions of Melbourne, Australia. We may, in the future, acquire or make investments in other complementary businesses, technologies, services or products if appropriate opportunities arise and we may engage in discussions and negotiations with
companies about our acquiring or investing in those companies businesses, products, services or technologies. We cannot make assurances that we will be able to identify future suitable acquisition or investment candidates, or if we do identify
suitable candidates, that we will have sufficient resources to complete such acquisitions or investments, will be able to make the acquisitions or investments on commercially acceptable terms or will be able to complete such acquisitions or
investments at all. If we acquire or invest in another company, we could have difficulty assimilating that companys personnel, operations, customers, technology or products and service offerings into our own. The key personnel of the acquired
company may decide not to work for us. These difficulties could disrupt our ongoing business, distract our management and employees, increase our expenses, consume cash resources, and adversely affect our results of operations. We may incur
indebtedness or issue equity securities to pay for any future acquisitions. The issuance of equity securities could be dilutive to our existing shareholders.



Our business may become increasingly susceptible to numerous risks associated with international operations.



The amount of our operations which occurs outside the United States is
growing. Our facilities are located in North America, Israel, Japan, Singapore, and Australia. This geographic dispersion is expected to continue for the next few years and requires significant management resources that may place us at a
disadvantage compared to our locally based competitors. In addition, our international operations are generally subject to a number of risks, including:



| |  |  | foreign currency exchange rate fluctuations;
| | - |  | --------------------------------------------



| |  |  | longer sales cycles;
| | - |  | --------------------



| |  |  | multiple, conflicting and changing governmental laws and regulations;
| | - |  | ---------------------------------------------------------------------



| |  |  | greater dependency on partners;
| | - |  | -------------------------------



| |  |  | time zone and cultural differences;
| | - |  | -----------------------------------



| |  |  | protectionist laws and business practices that favor local competition;
| | - |  | -----------------------------------------------------------------------



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| |  |  | difficulties in collecting accounts receivables; and
| | - |  | ----------------------------------------------------



| |  |  | political and economic instability.
| | - |  | -----------------------------------



We expect international revenue to increase as a percentage of total revenue and we believe we must continue to expand our international sales and
professional services activities in order to be successful. Our international sales growth will be limited if we are unable to expand our international sales management and professional services organizations either through a direct presence in
local markets or through channel partners. If we fail to manage our geographically dispersed organization, we may fail to meet or exceed our business plan and our revenues may decline.



We face risks relating to the restatement of our financial statements.



Following a review of our financial statements related to the filing of a
Registration Statement on Form F-3 with the SEC on April 14, 2004, on two occasions we restated our financial statements which affected our results for 2000, 2001, 2002, and 2003. The restatements were reported on December 9, 2004 and March 17, 2005
and the impact on our financial statements was reported in our Report on Form 20-F/A dated March 25, 2005 for the fiscal year ended December 31, 2003. This restatements or any other restatement of our financial statements may lead to litigation
claims against us. The defense of claims may cause the diversion of managements attention and resources, and we may be required to pay damages if any such claims are not resolved in our favor. Any litigation, even if resolved in our favor may
cause us to incur significant legal and other expenses.



Risks Related to
the Internet and Wireless Technologies



Our business is dependent on
the Internet and if customers do not continue to use the Internet, our business will suffer.



Our market is relatively new and evolving. Our future success will depend on the adoption by customers of business-to-business Internet solutions as an
integral part of their business model. Demand for and market acceptance of recently introduced Internet-based services are each subject to a high level of uncertainty.



The level of demand and acceptance of Internet business-to-business services may not increase for a number of reasons,
including:



| |  |  | inadequate network infrastructure and congestion of traffic on the Internet;
| | - |  | ----------------------------------------------------------------------------



| |  |  | actual or perceived lack of security of information;
| | - |  | ----------------------------------------------------



| |  |  | inconsistent quality of service;
| | - |  | --------------------------------



| |  |  | lack of availability of cost-effective, high-speed service;
| | - |  | -----------------------------------------------------------



| |  |  | lack of access and ease of use;
| | - |  | -------------------------------



| |  |  | excessive governmental regulation; and
| | - |  | --------------------------------------



| |  |  | uncertainty over intellectual property ownership.
| | - |  | -------------------------------------------------



In addition, any well-publicized compromise of security could deter businesses from using the Internet to conduct transactions that involve transmitting
confidential information. Computer viruses that spread over the Internet could disable or damage the systems we develop for our customers. Decreased Internet traffic as a result of general security concerns or viruses could cause companies to reduce
their amount of technology spending, which could hurt our results of operations



Our business is dependent on the projected growth and adoption of wireless and mobile technologies.



The wireless data and mobile application market is gaining acceptance but remains fragmented. There are few applications that have received widespread
acceptance. Our future success relies on the adoption of wireless and mobile technologies in support of mobile field service applications across all targeted vertical markets.



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The success of our solution will require that continued improvements be made in the mobile infrastructure
to ensure projected growth. If the adoption and standardization does not occur in the future, wireless mobile applications could grow more slowly than anticipated. This adoption of mobile applications has to do with several aspects that are
dependent on market maturity:



| |  |  | the cost of equipping field personnel with mobile devices;
| | - |  | ----------------------------------------------------------



| |  |  | a lack of standardization of wireless protocols;
| | - |  | ------------------------------------------------



| |  |  | the lack of ubiquitous and affordable network coverage;
| | - |  | -------------------------------------------------------



| |  |  | the cost of transmitting data over wireless networks;
| | - |  | -----------------------------------------------------



| |  |  | increased training required for workers to utilize applications, including higher demand on help desks or call centers;
| | - |  | -----------------------------------------------------------------------------------------------------------------------



| |  |  | actual or perceived slow connection and transmission speeds;
| | - |  | ------------------------------------------------------------



| |  |  | the use of standard browser based environments; and
| | - |  | ---------------------------------------------------



| |  |  | the cost of third-party middleware.
| | - |  | -----------------------------------



Utilizing Internet applications in a wireless environment will also require ongoing education to mainstream perceptions including,



| |  |  | the perception that Web applications must be used in a connected environment; and
| | - |  | ---------------------------------------------------------------------------------



| |  |  | Web applications are cumbersome and require a lot of bandwidth.
| | - |  | ---------------------------------------------------------------



We cannot assure you that improvements will be made to the mobile infrastructure and the adoption of wireless and mobile technologies will occur within
our targeted vertical markets for use within field service applications.



Risks Related to Our Location in Israel



It may be
difficult to effect service of process and enforce judgments against directors, officers and experts in Israel.





We are organized under the laws of the State of Israel. Many of our
executives, directors, certain research and development employees, and some of the experts named in this annual report are nonresidents of the United States, and a substantial portion of our assets and the assets of these persons are located outside
the United States. Therefore, it may be difficult to enforce a judgment obtained in the United States against us or any of those persons. It may also be difficult to enforce civil liabilities under United States federal securities laws in actions
instituted in Israel.



Political, economic and military conditions in
Israel could negatively impact our business.



Our
principal research and development facilities are located in Israel. We are directly influenced by the political, economic and military conditions affecting Israel. Since the establishment of the state of Israel in 1948, a number of armed conflicts
have taken place between Israel and its Arab neighbors and a state of hostility, which varies in degree and intensity, has caused security and economic problems in Israel. Any major hostilities involving Israel or the interruption or curtailment of
trade between Israel and its present trading partners could adversely affect our operations. We cannot assure you that ongoing or revived hostilities related to Israel will not have a material adverse effect on us or our business and on our share
price. Several Arab countries still restrict business with Israeli companies and these restrictions may have an adverse impact on our operating results, financial condition or the expansion of our business. We could be adversely affected by
restrictive laws or policies directed towards Israel and Israeli businesses. Despite the progress towards peace between Israel and its Arab neighbors, the future of these peace efforts is uncertain. In addition, since October 2000, there has been a
significant increase in violence, primarily in the West Bank and Gaza Strip, and a series of armed clashes between Israel and the armed forces of the Palestinian Authority. There can be no assurance that the recent relative calm and renewed
discussions with Palestinian representatives will continue.



Generally, all male adult citizens and permanent residents of Israel, under the age of 45 in some cases, are, unless exempt, obligated to perform up to 36 days of military reserve duty annually. Additionally, all Israeli residents of this
age are subject to being called to active duty at any time under emergency circumstances. Many of our employees are currently obligated to perform annual



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reserve duty. Although we have operated effectively under these requirements since we began operations, we cannot assess
the full impact of these requirements on our workforce or business if political and military conditions should change, and we cannot predict the effect on us of any expansion or reduction of these obligations.



We may be adversely affected if the rate of inflation in Israel exceeds the rate of
devaluation of the NIS against the dollar.



Most of
our revenues are in dollars or are linked to the dollar, while a portion of our expenses, principally salaries and the related expenses for our Israeli operations, are in NIS. We do not utilize hedging to manage currency risk and, therefore, are
exposed to the risk that the rate of inflation in Israel will exceed the rate of devaluation of the NIS in relation to the dollar or that the timing of this devaluation lags behind inflation in Israel. This would have the effect of increasing the
dollar cost of our operations. In 1999 and in 2000, while the rate of inflation was low, there was a devaluation of the dollar against the NIS, and in 2001 the rate of devaluation of the NIS against the dollar exceeded the rate of inflation. In
2002, the devaluation of the NIS against the dollar was similar to the rate of inflation. In 2003, the NIS gained in value against the dollar while the rate of inflation was negative and in 2004 the NIS gained 2% in value against the dollar while
the rate of inflation was 1%. We cannot predict any future trends in the rate of inflation in Israel or the rate of devaluation of the NIS against the dollar. If the dollar cost of our operations in Israel increases, our dollar-measured results of
operations will be adversely affected.



The tax benefits that we
currently receive from the Investment Center of the Israeli Ministry of Industry, Trade and Labor require us to meet several conditions and may be terminated or reduced in the future, which would increase our taxes.



We receive tax benefits under Israeli law for capital investments that are
designated as approved enterprises. To maintain our eligibility for these tax benefits, we must continue to meet conditions stipulated in applicable law and in our specific approvals, including making specified investments in fixed assets. If we
fail to comply with these conditions, in whole or in part, with respect to any approved enterprise program we establish, we may be required to pay additional taxes for the period in which we benefited from the tax exemption or reduced tax rates and
we would likely be denied these benefits in the future. We may submit requests for new programs to be designated as approved enterprises. These requests might not be approved, particularly in light of difficult economic conditions in Israel. In
addition, in March 2005, the law governing these tax benefits was amended to revise the criteria for investments that qualify for tax benefits as an approved enterprise. We cannot assure you that we will, in the future, be eligible to receive
additional tax benefits under this law. The termination or reduction of these tax benefits could seriously harm our financial condition and results of operations.



Under current Israeli law, we may not be able to enforce covenants not to compete and therefore may be unable to prevent our
competitors from benefiting from the expertise of some of our former employees.



We currently have non-competition agreements with our employees. These agreements prohibit our employees, if they cease working for us, from directly competing with us or working for our competitors. Recently, Israeli
courts have required employers seeking to enforce non-compete undertakings of a former employee to demonstrate that the competitive activities of the former employee will harm one of a limited number of material interests of the employer which have
been recognized by the courts, such as the secrecy of a companys confidential commercial information or its intellectual property. If we cannot demonstrate that harm would be caused to us, we may be unable to prevent our competitors from
benefiting from the expertise of our former employees.



The government
grants we have received for research and development expenditures restrict our ability to manufacture products and transfer technologies outside of Israel and require us to satisfy specified conditions.



From time to time we have received royalty-bearing grants from the Office of
the Chief Scientist of the Ministry of Industry and Trade of the Government of Israel (OCS). The transfer to a non-Israeli entity of technology developed with OCS funding, including pursuant to a merger or similar transaction, and the
transfer of rights related to the manufacture of more than ten percent of a product developed with OCS funding are subject to approval by an OCS committee and to various conditions, including payment by us to the OCS of a percentage of the
consideration paid to us or our shareholders in the transaction in which the technology is transferred. In connection with a merger or similar transaction, the amount payable would be a fraction of the consideration equal to the relative amount
invested by the OCS in the development of the relevant technology compared to the total investment in our company, net of financial assets that we have at the time of the transaction, but in no event less than the amount of the grant. In addition,
in the event that the committee believes that the consideration to be paid in a transaction requiring payment to the OCS pursuant to the provisions of the law described above does not reflect the true value of the technology or the company being
acquired, it may determine an alternate value to be used as the basis for calculating the requisite payments. These restrictions may impair our ability to enter into agreements for those products or technologies, without OCS approval. In addition,
if we fail to comply with any of the conditions imposed by the OCS, we may be required to refund any grants previously received, together with interest and penalties.



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Our United States investors could suffer adverse tax consequences if we are characterized as a passive foreign
investment company.



Although we believe that we will
not be treated as a passive foreign investment company in 2004, we cannot assure the shareholders that we will not be treated as a passive foreign investment company in 2003 or in future years. We would be a passive foreign investment company if (i)
75% or more of our gross income in a taxable year, including the pro rata share of the gross income of any company, US or foreign, in which we are considered to own 25% of the shares by value, is passive income, or (ii) at least 50% of the average
value of our assets (or possibly the adjusted bases of our assets in particular circumstances), including the pro rata share of the assets of any company in which we are considered to own 25% of the shares by value, in a taxable year produce, or are
held for the production of, passive income. Passive income includes interest, dividends, royalties, rents and annuities. If we are or become a passive foreign investment company, many of the shareholders will be subject to adverse tax consequences,
including:



| |  |  | taxation at the highest ordinary income tax rates in effect during your holding period on some distributions on our Ordinary Shares and gain from the sale or other disposition of
our Ordinary Shares;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | paying interest on taxes allocable to prior periods; and
| | - |  | --------------------------------------------------------



| |  |  | no increase in the tax basis for our Ordinary Shares to fair market value at the date of your death.
| | - |  | ----------------------------------------------------------------------------------------------------



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Item 4.Information On Our Company



History and Development



Both our
legal and commercial name is ViryaNet Ltd. We were incorporated and registered in Israel on March 13, 1988 under the name R.T.S. Relational Technology Systems Ltd. We changed our name to RTS Business Systems Ltd. on September 7, 1997 and to RTS
Software Ltd. on February 1, 1998. On April 12, 2000, we changed our name to ViryaNet Ltd. The principal legislation under which we operate is the Israeli Companies Law, 5759-1999, as amended, which we refer to as the Companies Law.



Our registered office is located at 8 HaMarpe Street, Science Based
Industries Campus, P.O. Box 45041, Har Hotzvim, Jerusalem, 91450, Israel, and our telephone number is 972-2-584-1000. We have appointed our United States subsidiary, ViryaNet, Inc., located at 2 Willow Street, Southborough, Massachusetts 01745-1027
as our agent for service of process.



Over the past 16 years,
we have developed, marketed, and supported field service software applications that have provided companies with solutions that improve the quality and efficiency of complex service business processes. During this period of time, numerous customers
around the world have deployed our solutions.



On September 19,
2000, we completed our IPO and our Ordinary Shares began trading on The Nasdaq National Market. As part of the IPO, we issued 400,000 Ordinary Shares in consideration of net proceeds of approximately $25.6 million.



On October 29, 2001 our Ordinary Shares began trading on the Tel-Aviv Stock
Exchange in Israel and we became a dual listed company. On March 4, 2004, we requested to be delisted from the Tel-Aviv Stock Exchange and following such request we have received the confirmation of the Tel-Aviv Stock Exchange that our Ordinary
Shares were delisted on June 3, 2004.



On February 25, 2002, we
acquired the outstanding shares of iMedeon, a provider of mobile workforce management solutions to the utilities sector. iMedeon was a privately held company, headquartered in Alpharetta, Georgia. As a result of the acquisition, iMedeon became a
wholly-owned subsidiary of ViryaNet, Inc., which is a wholly-owned subsidiary of ViryaNet Ltd.



On May 1, 2002, we effected a 10 to 1 reverse stock split, combining each ten Ordinary Shares, of NIS 0.1 par value per share, into one ordinary share, of NIS 1.0 par value per share.



On September 5, 2002, we were notified by The Nasdaq National Market that we
were not in compliance with Marketplace Rule 4450(a)(2) since we were unable to maintain a minimum market value of $5,000,000 for our publicly held shares, and were informed that we had until December 4, 2002 to regain compliance. Due to the
economic and market conditions affecting our valuation, we concluded that we would request a transfer of our securities listing from The Nasdaq National Market to The Nasdaq SmallCap Market. The transfer was approved on December 20, 2002 and the
trading of our Ordinary Shares on The Nasdaq SmallCap Market began on December 31, 2002.



On August 4, 2003, we completed a private placement of our Ordinary Shares with Telvent, GIT S.A. (Telvent), the information technology subsidiary of Abengoa, S.A. of Spain. In exchange for $1.0 million,
we issued 539,258 Ordinary Shares at a price of $1.85 per share.



On November 10, 2003, we completed a private placement of our Ordinary Shares with a large U.S. financial institution and a group of private investors. In exchange for approximately $1.8 million, we issued 517,322 Ordinary Shares at a price
of $3.406 per share. In addition, the investors also received warrants to purchase 93,723 of our Ordinary Shares at an exercise price of $4.70 per share.



On December 5, 2003, we completed a follow-on private placement of our Ordinary Shares with Vertex Venture Capital Israel Funds and FBR Infinity Venture
Funds, as well as a group of private investors. In exchange for approximately $2.2 million, we issued 554,509 Ordinary Shares at a price of $4.036 per share. In addition, the investors also received warrants to purchase 84,644 of our Ordinary Shares
at an exercise price of $6.61 per share.



On July 28, 2004, we
issued to LibertyView Special Opportunities Fund, L.P. $2.5 million aggregate principal amount of 7.5% Convertible Note due July 28, 2014. We are obligated to pay interest on this Note on a quarterly basis commencing October 15, 2004, with interest
to be paid either in cash or registered Ordinary Shares, at our discretion.



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On July 29, 2004, we acquired the outstanding shares of Utility Partners, a provider of mobile workforce
management solutions to the utilities sector. Utility Partners was a privately held company, headquartered in Tampa, Florida. As a result of the acquisition, Utility Partners became a wholly-owned subsidiary of ViryaNet, Inc., which is a
wholly-owned subsidiary of ViryaNet Ltd.



In February 2005, we
completed a private placement of our Ordinary Shares to Telvent Investments, S.L., a current shareholder. In exchange for approximately $1.3 million, we issued 581,659 Ordinary Shares at a price of $2.29 per Ordinary Share.



On June 15, 2005, we acquired, through our newly formed Australian
subsidiary, substantially all of the assets of e-Wise Solutions of Australia, a provider of front-office automation solutions to the utilities sector. e-Wise was a privately held business, headquartered in Melbourne, Australia.



Business Overview



ViryaNet is a
provider of integrated mobile and Web-based software applications for workforce management and the automation of field service delivery. In addition, we provide additional software applications for spare parts logistics, contract management, and
depot repair operations. Our mission is to provide companies with solutions that improve the quality and efficiency of their complex service business processes. We also provide professional services required to implement and support our software
solutions. We have approximately 80 customers worldwide with operations and support offices in the United States, Japan, Israel, Singapore and Australia.



We target companies in the utility, telecommunications, and general service industries that have distributed mobile workforces, strong commitments to
customer satisfaction, extensive service agreements, and a need to improve their service operations. We believe that these industries provide substantial growth opportunities for our products and services.



Our growth has occurred organically as well as through acquisitions. In
February 2002, we acquired Alpharetta, Georgia based iMedeon, Inc. In July 2004, we acquired another mobile workforce management company, Tampa, Florida based Utility Partners, and in June 2005, we acquired substantially all of the assets of e-Wise
Solutions of Australia, a provider of front-office automation solutions to the utilities sector. These acquisitions have provided us with domain expertise; an installed base of customers in the utilities market, our primary market focus; and
significant partnerships, and have enabled us to incorporate additional features, functions and technology into our advanced product platform.



Our principal product, the ViryaNet Service Hub, supports a wide range of work order needs: from short-duration tasks to complex, multi-day,
multi-resource projects. ViryaNet Service Hub manages the entire lifecycle of a work order, including, scheduling and dispatching, mobile technology, field-level reporting, tracking materials, managing assets, and ensuring support for entitlements
and compliance with service level agreements (SLAs). We typically issue one major version release of ViryaNet Service Hub every one to two years.



Business Strategy



Our goal is to become the leader in the mobile workforce management software market. We intend to achieve this goal by increasing our sales and marketing
efforts in North America, growing our business in the utility, retail and telecommunication sectors through predominantly a direct sales model; increasing our revenues from Europe and Asia/Pacific by expanding our partner network, adding resources
in support of international activities, and establishing a local presence in certain targeted geographic markets where a subsidiary structure is warranted; and intensifying our focus on account management and customer support to enable follow-on
sales into our installed base.



Markets



We deliver state-of-the-art solutions specific to the needs of key markets,
including utilities, telecommunications and cable/broadband companies, general service providers, and retail/grocery companies. We reach prospects within each of these markets through our direct sales force as well as through our partner network,
including, among others, GE Energy, Telvent, Aspective and EDS.



Utilities. The utilities market targeted by us consists of electric, gas and water companies. We see substantial opportunities within this market, as companies have need to (i) add new technology to improve their service offering, and (ii)
replace their old technology in favor of an Internet and wireless-based solution model, and (iii) continue with the initial build-out of their systems infrastructure, especially in developing geographies.



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Telecommunications and Cable/Broadband. We target companies within these segments of the
telecommunications sector: cable and satellite, data services, fixed line services, and wireless communications services providers.



Retail. Within the retail sector, we target grocery companies, drug stores and pharmacies, retail marketing companies, and consumer packaged goods
companies.



General Field Service. This includes heating,
ventilation, and air conditioning; property maintenance; office and home appliance/equipment maintenance; and security companies  many of which require mobile workforce management solutions. We evaluate these companies on a case-by-case
business in the context of their size, business processes, as well as our domain understanding and products fit.



Our revenues are derived mainly from the sale of software licenses and from maintenance and services that we provide in support of our software. The
following table describes, for the periods indicated, the percentage of revenues represented by each of the items on our consolidated statements of operations:



|                         |  |                         |   |  |      |   |  |      |  
|------------------------ |  | ----------------------- | - |  | ---- | - |  | ---- | -
|                         |  | Year Ended December 31, |  
|                         |  | 2002                    |   |  | 2003 |   |  | 2004 |  
|Revenues:                |  |                         |   |  |      |   |  |      |  
|Software licenses        |  | 56.0                    |   |  | 34.3 |   |  | 26.1 |  
|Maintenance and services |  | 44.0                    |   |  | 65.7 |   |  | 73.9 |  
|                         |  |                         |   |  |      |   |  |      |  
|Total revenues           |  | 100                     | % |  | 100  | % |  | 100  | %



The following table
summarizes the revenues from our products and services by country, stated as a percentage of total revenues for the periods indicated:



|                           |  |                         |   |  |      |   |  |      |  
|-------------------------- |  | ----------------------- | - |  | ---- | - |  | ---- | -
|                           |  | Year Ended December 31, |  
|Country                    |  | 2002                    |   |  | 2003 |   |  | 2004 |  
|United States              |  | 57                      |   |  | 70   |   |  | 79   |  
|Europe and the Middle East |  | 28                      |   |  | 13   |   |  | 11   |  
|Far East                   |  | 15                      |   |  | 17   |   |  | 10   |  
|                           |  |                         |   |  |      |   |  |      |  
|Total                      |  | 100                     | % |  | 100  | % |  | 100  | %



Our North American
strategy utilizes a direct sales model, supplemented by key partners like GE Energy , Telvent and EDS. Our international strategy is to use a combination of direct and indirect sales channels in order to sell effectively into local markets and
perform certain implementation activities on our behalf. In certain targeted geographic markets where growth opportunities in our key vertical markets support a local presence, such as Australia, we may determine that the investment in a subsidiary
structure is warranted. Otherwise, we will continue to explore and establish indirect sales channels through relationships with agents, local resellers who offer complementary products and solutions, global systems integrators, and application
service providers.



A substantial portion of our revenue is
derived from our growing partnership network. We expect to benefit from marketing programs and leads generated by these partners, as well as cooperation from the sales forces of these partners in sales opportunities. We intend to expand our
marketing and implementation capacity through the use of third parties, including systems integrators, vendors of complementary products and providers of service applications. By employing third parties in the marketing and implementation process,
we expect to enhance sales by taking advantage of the market presence of these third parties.



Our sales and marketing staff consists of professionals in a variety of fields, including marketing and media relations, direct sales, technical sales consultants, product management, and business development. As of
December 31, 2004, we employed 24 sales, marketing and business development personnel. In 2002, we restructured our sales and support organization in Europe from a combination of direct and indirect channels to exclusively indirect channels,
utilizing partners actively invested in the mobile workforce sector capable of supporting ViryaNets solutions within their own mobile practices. These partners and their customers are supported by our business development and professional
services organizations in the United States, Israel, Japan and Australia. The majority of our sales personnel operate through our United States subsidiary covering North America, Europe and portions of Asia Pacific, and the rest operate through our
subsidiaries in Japan and Australia.



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Application service providers are used to provide our product to customers who wish to avoid the initial
cost of our product combined with the required hardware platforms and infrastructure investments. Through an application service provider, customers will be billed a monthly rental or subscription fee. We have three partners that have hosting
capability: EDS, Aspective, and One Network.



ViryaNet Service Hub and
Applications



Our principal product, the ViryaNet Service
Hub, was introduced in 1999 as an Internet-architected service business platform. We currently package our applications for specific industries by seeking tocapture best business practices and embedding them into our application, incorporating
processes, workflows, reports, and screens appropriate for companies in our target industries. These best practices, coupled with powerful functionality capabilities, allow us to package ViryaNet Service Hub and applications into industry bundles,
including:



| |  |  | ViryaNet Service Hub for Utilities:We will continue to enhance the product with industry-specific requirements, migrate unique Utilities Partners WorkUP functionality to the ViryaNet Service Hub platform,
and add functionality to automate storm and vegetation management market needs.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | ViryaNet WorkUP:We will begin to combine the functionality and technology of WorkUP and ViryaNet Service Hub for Utilities to enable an easy migration from either platform to the merged product.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | ViryaNet Service Hub for Telecommunications: We will continue to enhance the product with industry-specific requirements and building interfaces to key products resident in
the operations support system (OSS), specifically, customer care and billing interfaces.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | ViryaNet Service Hub for Retail:We will continue to add industry-specific requirements as well as develop additional functionality to accommodate refrigerant management
legislation and sub-contractor needs.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | ViryaNet Service Hub for General Service:We will continue enhancing the functionality of our core product.
| | - |  | ----------------------------------------------------------------------------------------------------------



ViryaNet Service Hub is built using open standards (Java, XML), common to
Internet, wireless, and workflow technologies, allowing customers to adapt and easily integrate ViryaNet Service Hub to their continuously changing conditions. ViryaNet Service Hub includes an information service portal that provides community
access and collaboration; business intelligence for real-time reporting, analysis, and responsive action; workflow-driven business processes; a powerful integration server and application program interface (API) set that interfaces to other
applications, including enterprise resource planning (ERP) applications, customer relationship management (CRM) applications, data warehouses and other commonly used service applications; and a mobile gateway that allows mobile users to access and
communicate service information using a wide variety of devices over popular wire-line and wireless networks.



With ViryaNet Service Hub, a service organization can quickly transition its complex business processes into a manageable, scalable Internet operation,
with goals of increasing efficiency, quality of service, customer satisfaction, customer retention, and profitability. Using ViryaNet Service Hub, our customers can manage the continuum of their service operations, from ensuring that the right
person is in the right place at the right time with the right parts and information about the customer, to automating the repair processes utilizing the Internet and at the least cost.



ViryaNet Service Hub Internet Platform Components



Service Portal:The ViryaNet Service Portal is a singular, personalized gateway that allows internal users as
well as customers, field employees and external partners, suppliers, and vendors to interface with Service Hub through the Web. The Service Portal allows users to access service information in real-time, share documents, collaborate with other users
and obtain service.



mService
Gateway: ViryaNet mService Gateway provides mobile users with access to the data and applications they require, allowing them to stay productive, regardless of location. ViryaNet mService Gateway enables mobile users to work in both
on-line and off-line mode utilizing both thin clients and fat clients.



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Service Intelligence & Data Mart:Service Intelligence is based on a pool of key
performance indicators (KPIs) that track data based on criteria, such as: financial trends, service performance, service rates, revenue, and cost-per-product.



Service Workflow Engine/ Editor:The Service Workflow Engine/Editor defines and applies rules to automate movement of documents, work
orders and information, between users. The Workflow Engine also includes a tool for monitoring active processes and auditing completed processes. The Service Workflow Engine provides a working environment that guarantees maximum flexibility.



Integration Server:A key component of ViryaNet
Service Hub is its Integration Server, which enables organizations to integrate with all of its other systems, including external web applications.



ViryaNet Service Hub Application Components



ViryaNet Mobile Workforce Management:ViryaNet Mobile Workforce Management, an integral component of ViryaNet Service Hub, provides
beginning-to-end management of work orders and the real-time capture of field workforce activity, tasks and events with wireless devices. ViryaNet Mobile Workforce Management allows for optimal scheduling and workforce management efficiency. It
dispatches field technicians and mobile employees, based on numerous variables, including geographical location, customer site responsibilities, available parts and skill sets. All of these factors are integral to reducing windshield time as well as
the number of technician visits. ViryaNet Service Hub can be deployed on any device and network and fully supports store and forward capability when a resource is out of wireless coverage.



ViryaNet Service Scheduler:ViryaNet Service Scheduler is a
powerful schedule and route optimization product that uses constraint and rules based, heuristic algorithms to automatically schedule the right resource, at the right time, based on skills and relative proficiency, service level agreements, drive
time, availability, and other factors.



ViryaNet
eContract:ViryaNet eContract is a comprehensive and flexible contract management application. ViryaNet eContract supports total contract lifecycle management driven by business rules.



ViryaNet eStock:ViryaNet eStock provides a closed-loop
inventory and logistics system.



ViryaNet eRepair:ViryaNet eRepair is a Web-based repair management system that automates an organizations depot repair processes, from initiating the return materials authorization (RMA) process, through receiving the product or part, inspecting and
repairing it, performing quality checks, billing for the work, and shipping it back to the customer. ViryaNet eRepair allows repair organizations to collaborate with their service communities as they balance the cost of service with the faster
turnaround times being demanded by customers.



ViryaNets Customers



Over 700 person-years of technical and business
experience have been invested in the ViryaNet products. ViryaNet Service Hub and the ViryaNet service applications have been licensed to and implemented at numerous customers. Descriptions of product usage and resulting benefits of improved service
delivery and enhanced customer satisfaction from some of our customers include:



Aquilathis leading utility, serving electric and natural gas customers in seven US states, has been a WorkUP customer since 1996. ViryaNet WorkUP allows Aquila to manage its entire field workforce.



CAL-AIRthis leading specialty mechanical contractor provides technical services to facilities throughout California. CAL-AIR, the first
customer to go-live with ViryaNet Service Scheduler, utilizes ViryaNets solutions to schedule and dispatch field workers, track and schedule preventative maintenance service, and automate many of the tasks associated with contract
administration.



Citizens (Frontier)
Communicationsthe largest independent local exchange carrier in the United States. Citizens uses the ViryaNet Service Hub to automate the dispatching of service orders, trouble tickets, and work requests to its 2,500 technicians. Citizens
uses ViryaNet Service Hub to manage the critical issues facing customer service organizations, such as deploying the right technician, diminishing travel times, satisfying customer requests, reacting responsively to increased volumes, assimilating



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acquisitions, and managing costs. Citizens technicians carry hand-held CE devices or laptops that route them
through their daily responsibilities via ViryaNet Service Hubs mobile gateway. Dispatchers monitor and assist these technicians through ViryaNet Service Hub, while senior management and supervisors receive immediate visibility into the
operations performance.



ConEdthis leading
utility, and one of the largest investor-owned energy companies in the United States, has utilized WorkUP for its natural gas emergency operations since early 2002 and plans a further roll-out this year within its Orange & Rockland subsidiary.



JEAthis municipal utility is one of the largest in the nation,
supplying electricity, water, and sewerage services to customers in the Jacksonville, FL area. Our solutions provide JEA with a comprehensive view of its entire mobile workforce, including where work crews are located; the work being performed; what
tools, parts, and support are needed; what work is on the horizon; and how the crews can be more efficient.



Leslies PoolMartthe worlds largest swimming pool equipment and supplies retail chain with headquarters in Phoenix, AZ and offices
across the United States, uses ViryaNet Service Hub to manage the installation, replacement, and onsite maintenance (and preventive maintenance) of pumps, filters, heaters and other devices and equipment for public and private swimming pools.
ViryaNet Service Hub and applications optimize the scheduling, dispatch, appointment booking, and field reporting of Leslies PoolMarts seasonal field resources and support staff.



Lockheed Martin Corporationthis large defense and commercial
contractor uses ViryaNet Service Hub and service applications as the basis for its command center to support an outsource service infrastructure for the US Navy, resulting in the ability to deliver tires to various Navy locations within the
contractual requirements of their service level agreements.



LoJackthis recognized world leader in stolen vehicle tracking and recovery, licensed ViryaNet Service Hub to streamline the installation of its recovery systems, and support its rapidly expanding sales and installation channel
strategy. ViryaNet Service Hub and applications optimize LoJacks 300 field technicians and 100 support staff who manage the functions of appointment booking, dispatch, and scheduling.



Louisville Water Companya publicly owned and privately operated
for-profit utility serving more than 800,000 people in and around Greater Louisville, Kentucky, selected ViryaNet Service Hub for Utilities suite of applications to improve the efficiency of its technicians and field service processes who perform
activities such as meter exchanges, emergency responses, services connects and disconnects, and preventive maintenance on assets.



News America Marketinga division of News Corporation Limited, News America Marketing is the leading single-source provider of advertising and
promotional services for the retail store environment delivered under the SmartSource® brand name. News America Marketing uses ViryaNet Service Hub and ViryaNets Mobile Workforce Management application to automate activities performed by its retail field workforce in a complete mobile
environment, manage and automate the installation and maintenance of its SmartSource® product line and targeted merchandising programs, and integrate these activities with several existing systems, applications and databases.



Publix Super Marketsthe largest employee-owned supermarket chain and one of the 10 largest volume supermarket
chains in the United States, uses ViryaNet Service Hub to automate its maintenance and facilities operations, including the activities associated with workforce management and asset and repair management. Publix uses ViryaNet Service Hub (Mobile
Workforce Management, Service Scheduler, Service Supply Chain, and eRepair modules) to manage and automate a variety of short-duration tasks, such as preventive maintenance activities on equipment, to more complicated projects. In addition, ViryaNet
Service Hub enables Publix to optimize the use of its internal workforce and to better manage its large subcontractor base.



Ricoh Technosystemsthis subsidiary of Ricoh Company Ltd. based in Japan, uses ViryaNet Service Hub (Mobile Workforce Management, Service
Scheduler, eSupply, and eContract applications) to manage its Network Integration business in the performance of network planning, design, installation, and maintenance services. ViryaNet Service Hub enables Ricoh Technosystems to optimize its 1,000
field engineers and 500 support staff in the areas of dispatch, contract administration, and spare parts logistics. ViryaNet Service Hub also provides managers with analysis on the data accumulated during service processes and support their
decision-making about business issues.



Singapore Power
Servicesthis wholly-owned subsidiary of Singapore Power, an Asian utility and energy group based in Singapore, will use ViryaNet Service Hub for Utilities in conjunction with GE to automate its field workforce activities.



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Spencer Technologiesthis provider of cabling, systems integration, installation and
maintenance services to the most advanced retail environments, selected ViryaNet Service Hub and Workforce Management, eStock, and eContract applications to manage its installation and service business. ViryaNet Service Hub schedules and dispatches
Spencers field engineers, capture logistics and labor activity at its source, report and measure field activity using key performance indicators, and integrate with several existing Spencer systems to improve billing activities and customer
satisfaction.



Symbolthis provider of wireless and
Internet-based mobile data management systems offers a combination of priority phone and on-site hardware repair services to the retail, transportation, healthcare, and manufacturing markets. Symbol uses ViryaNet Service Hub to migrate its
traditional service processes to the Internet, allowing users to access information from various locations throughout the organization, such as call centers, financial systems and data warehouses, and make that information available to any member
within the service community who requires it.



Teraoka
Seikothis Japanese manufacturer of point-of-sale devices, weighing scales and wrapping equipment, uses ViryaNet Service Hub and its full suite of applications to have the requisite solutions to unite their field service personnel on the
Internet and position its services business as a profitable entity while collecting valuable information to effectively achieve its current business goals and influence future manufacturing directions.



T-Mobile International AG & Co. K.G.the mobile
communications subsidiary of Deutsche Telekom AG, T-Mobile is a major international telecommunications company based in Europe. T-Mobile utilizes ViryaNet Service Hub for Telecommunications to improve the effectiveness of its field engineers using
scheduling and dispatching, capture logistics and labor activity, monitor, report and measure field activity, and unite the many constituents of the companys service community through web browsers, cellphones, personal digital assistants, and
other wireless devices.



UGIthis leading provider
of natural gas to distribution residential and commercial customers in Pennsylvania is ranked highest in Customer Satisfaction by J.D. Power and Associates for two years in a row, and has been a production WorkUP customer since 1996. UGI fully embraces WorkUPs latest map-based dispatch functionality with embedded GPS/AVL capabilities
for its service technicians.



XO Communicationsa
leading broadband communications service provider for small/medium business, large enterprises and carriers in North America, XO Communications uses the ViryaNet Service Hub for Telecommunications suite of applications comprised of Workforce
Management, Advanced Scheduling Optimization, Mapping, Contract Entitlement, Field Parts Logistics, and automated work flow processing to automate its technicians and field service business processes.



ViryaNet Partnerships



The unique strength of the ViryaNet Service Hub platform, combined with our broad and modular service applications, has
allowed us to form strategic alliances with world-class systems integrators (SIs) and value-added resellers (VARs), including:



| |  |  | Aspectivea European eBusiness solution provider, specializing in front-office applications for sales, marketing and customer service that positions ViryaNet Service Hub
and mobile workforce management applications in the UK, with vast reach into continental Europe.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | EDSa global outsourcing services company and application service provider, resells the ViryaNet Service Hub platform along with value-added services from EDS, for
implementation in a variety of industries looking to optimize their mobile field service workforces.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | GE Energya business unit of GE Power Systems and leading global supplier of strategic network solutions to the utilities industry. GE has integrated ViryaNet Service
Hub and mobile workforce management application into its existing portfolio, and positions the ViryaNet offering to the utilities and telecommunications industry.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Hitachi Systems and Servicesa high technology provider operates within the Japanese market, positioning ViryaNet Service Hub and applications within several vertical
markets.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Telventthe information technology subsidiary for Abengoa, S.A. of Spain and an affiliate of ViryaNets shareholder, Telvent markets, sells, and services ViryaNet
solutions in the utilities, oil and gas, and telecommunications markets in Spain, Portugal and Latin America.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Organizational Structure



We are
organized under the laws of the State of Israel. We are the parent company of our wholly owned subsidiaries which are specified in the table below.



|                       |  |                         
|---------------------- |  | ------------------------
|Name of Subsidiary     |  | Country of Incorporation
|ViryaNet, Inc.         |  | Delaware, USA           
|Utility Partners, Inc. |  | Delaware, USA           
|ViryaNet Pty Ltd.      |  | Australia               
|iMedeon, Inc.          |  | Georgia, USA            
|ViryaNet Europe Ltd.   |  | United Kingdom          
|ViryaNet Japan KK      |  | Japan                   



Property, Plants and Equipment



We do not own any real property. We lease approximately 9,500 square feet of space in Jerusalem, Israel, used primarily for research and development, with an annual rent of approximately $141,000. The lease agreement for these premises
expires on October 31, 2006.



ViryaNet, Inc., our subsidiary
located in Massachusetts, leases 13,807 square feet of office space in Southborough, Massachusetts, that is utilized primarily for administrative, marketing, sales, service and technical support purposes. The lease agreement for these premises was
extended until June 2008 in exchange for a reduction in the annual rent from approximately $331,000 to approximately $252,000. A portion of these premises are sublet for a current annual fee of approximately $54,000.



iMedeon, the subsidiary of ViryaNet, Inc. located in Alpharetta, Georgia,
leased approximately 7,000 square feet of office space used primarily for sales, services and technical support purposes. The premises were leased under a lease agreement that expired on May 2, 2004 although certain payment obligations continued for
six months thereafter. Under the terms of the lease agreement, approximately $134,000 of rent was due and payable in 2004, and a contingent liability of $135,539 under a note would be waived by the landlord when the rent of approximately $134,000
was paid in full. After the lease term expired on May 2, 2004, and after all payment obligations were met, we moved to smaller offices in the Alpharetta area and entered into a two year lease that expires in April 2006 with an annual rent of
approximately $38,000.



Utility Partners, the subsidiary
of ViryaNet, Inc. located in Tampa, Florida, leased approximately 2,800 square feet of office space used primarily for engineering, sales, services and technical support purposes. The premises are leased under a lease agreement that expires on
December 31, 2005, with a total annual rent of approximately $120,000, including certain communication costs. Currently, we intend to seek to renew this lease agreement on similar terms or to seek similar office space at approximately the same
annual cost, if available.



ViryaNet Japan KK, our
subsidiary in Japan leases approximately 2,100 square feet of office space under a lease agreement that will expire on June 30, 2006, with a total annual rent of approximately $101,000.



ViryaNet Pty Ltd., our subsidiary in Australia leases approximately 1,400 square feet of office space in Melbourne,
Australia under a lease agreement that will expire on July 15, 2005, with a total annual rent of approximately $17,000. Currently, we intend to seek a short-term renewal for this space on similar terms or seek office space at approximately the same
annual cost, if available.



Item 5.Operating and Financial Review and Prospects



YOU SHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS IN CONJUNCTION WITH ITEM 3 SELECTED CONSOLIDATED FINANCIAL DATA AND OUR CONSOLIDATED
FINANCIAL STATEMENTS AND NOTES THERETO INCLUDED ELSEWHERE IN THIS ANNUAL REPORT. IN ADDITION TO HISTORICAL INFORMATION, THE FOLLOWING DISCUSSION CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS THAT INVOLVE KNOWN AND UNKNOWN RISKS AND UNCERTAINTIES, SUCH
STATEMENTS OF OUR PLANS, OBJECTIVES, EXPECTATIONS AND INTENTIONS. SEE CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS.



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Restatement



Certain financial data contained in this Form 20-F has been previously revised to reflect the restatements of our consolidated financial statements for
the years ended December 31, 2000, 2001, 2002 and 2003 related to amounts previously reported as revenues, provisions for doubtful accounts, other income, trade and other receivables, and working capital (deficit). The restatements were reported on
December 9, 2004 and March 17, 2005 and the impact on our financial statements was reported in our Report on Form 20-F/A dated March 25, 2005 for the fiscal year ended December 31, 2003. We have included below a description of the events and
circumstances which led to the restatement of our financial statements.



On April 15, 2004, we filed a registration statement on Form F-3 with the SEC for the purpose of registering Ordinary Shares we had previously issued. On May 14, 2004, we received an initial comment letter from the
staff of the SEC (Staff) that requested further information about the Form F-3 and our annual report on Form 20-F for the year ended December 31, 2003, filed on April 9, 2004. We provided our response to these comments on June 3, 2004.
Subsequently, we and the Staff continued to correspond. Among its other comments, the Staff inquired about our revenue recognition for software license transactions with extended payment term arrangements. The Staff queried whether we had
established normal payment terms with our customers and had a sufficient history of successful collections in past extended payment term arrangements with similar payment terms. At our request, on February 10, 2005, we held a phone conference with
the Staff and representatives of Ernst & Young, our independent auditors, with the intent of clarifying our response to these concerns.



During the phone conference and in response to the Staffs concerns, it became evident to us that in order to recognize revenue in license
transactions according to SOP 97-2 for extended payment term arrangements, we needed to demonstrate that we had established normal payment terms with our customers and a sufficient history of successful collections in past extended payment term
arrangements with similar payment terms. It also became evident to us that our interpretation of SOP 97-2, which did not require a sufficient history of successful collections in prior arrangements in determining revenue recognition for software
license transactions with payment terms of less than twelve months, did not coincide with the Staffs position. Our position took into consideration other factors such as the length of the product lifecycle, the low risk of technical
obsolescence within the payment period, the importance of the software to the customer, and the low frequency of major software upgrades.



Subsequent to that phone conference, we conducted a review of all software license transactions we had entered into during 1999 through 2003 to determine
whether we could demonstrate that we had a sufficient history of successful collections in similar extended payment term arrangements in order to support revenue recognition for 2000 through 2003. The factors we considered in this review included
(i) the life cycle of its software which was released in 1998, (ii) the limited number of licensing arrangements underlying the software, especially in the earlier years, (iii) the nature of the arrangements, and (iv) the diverse payment terms
agreed to with the customers.



As a result of this review
process, we determined that for 2000 through 2002, we did not have normal payment terms as the payment terms for all arrangements varied significantly, ranging from 30 days to eleven months and we were not able to establish a sufficient historical
basis of successful collections in similar extended payment term arrangements. For 2003, we determined that we did not have any payment arrangements where revenue was recognized upon delivery of our software with payment terms greater than three
months, but that a sufficient historical basis of successfully collecting on licensing transactions with payment terms of three months or less had been attained. Prior to February 10, 2005, we did not monitor historical payment arrangements for the
purpose of examining their effects on our revenue recognition policy because our interpretation of SOP 97-2 did not consider a sufficient history of successful collections as a factor in determining revenue recognition for software license
transactions with payment terms of less than twelve months. In addition, our payment terms with customers varied significantly and we were unable to establish normal payment terms as the basis for revenue recognition.



Accordingly, we concluded that, and with our auditors concurrence, in
hindsight, for license transactions in 2000 through 2002 where revenue was recognized upon delivery of our software, we should have recognized revenues as payments were due provided collectibility was deemed probable, or as payments were collected.
We restated our financial statements accordingly. For 2003, we concluded, and with our auditors concurrence, in hindsight, to restate three transactions whose payment was not collected when due but was subsequently collected during 2004.



As a result of this review and the restatement, we have strengthened our
internal controls relating to revenue recognition to improve compliance with applicable revenue recognition accounting guidance by (i) documenting normal payment terms with our customers, so as to be able to identify payment terms under which
upfront revenue recognition would not be appropriate, (ii) monitoring compliance of payment terms with our revenue recognition policy at the time of each transaction, and (iii) analyzing all new payment arrangements for software licenses
transactions against our historical basis and examining their effect, if any, on our revenue recognition policy on a quarterly basis.



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There were no material costs associated with these actions taken by us, as set forth above.



Overview



We are a provider of
integrated mobile and Web-based software applications for workforce management and the automation of field service delivery. In addition, we provide software applications for spare parts logistics, contract management, and depot repair operations.
Our mission is to provide companies with solutions that improve the quality and efficiency of their complex service business processes. With ViryaNet Service Hub, our principal product, a service organization can quickly transition its complex field
service business processes into a manageable, scalable Internet operation, with goals of increasing efficiency, quality of service, customer satisfaction, customer retention, and profitability. Using ViryaNet Service Hub, our customers can manage
the continuum of their service operations, from ensuring that the right person is in the right place at the right time with the right parts and information about the customer, to automating the repair processes utilizing the Web and at the least
cost.



Revenues



We derive revenues from licenses of our software products and from the
provision of related services. Our operating history shows that a significant percentage of our quarterly revenue results from orders placed toward the end of a quarter. Software license revenues are comprised of perpetual software license fees
primarily derived from contracts with our direct sales clients and indirect partner channels. We recognize revenues in accordance with the AICPA Statement of Position 97-2, Software Revenue Recognition, or SOP 97-2, as amended, and AICPA
Statement of Position 81-1, Accounting for Performance of ConstructionType and Certain ProductionType Contracts and also adopted Staff Accounting Bulletin (SAB) No. 104 Revenue Recognition (See
Critical Accounting Policies and notes to our consolidated financial statements).



Services revenues are comprised of revenues from the performance of implementation, consulting, integration, post-contract maintenance support and training services. Implementation, consulting, integration and
training services are billed at an agreed upon rate plus incurred expenses. Customers that license our products generally purchase these services from us or from our resellers and systems integrators. Post-contract maintenance support provides
technical support and the right to unspecified software upgrades when available. Post-contract maintenance support revenues are charged to customers as a percentage of license fees depending upon the level of support coverage desired by the
customer.



We sell our products through our direct sales force
through relationships with system integrators, application service providers, resellers and vendors of complementary products. Our sales cycle from our initial contact with a potential customer to the signing of a license and related agreements has
historically been lengthy and variable. We generally must educate our potential customers about the use and benefit of our products and services, which can require the investment of significant time and resources, causing us to incur most of our
product development and selling and marketing expenses in advance of a potential sale. In addition, a number of companies decide which products to buy through a request for proposal process. In those situations, we also run the risk of investing
significant resources in a proposal that results in a competitor obtaining the desired contract from the customer or in a decision by a customer not to proceed.



The majority of our revenues are derived from customers in the United States, with the balance generated by customers in Europe and the Middle East,
and the Far East. We expect that the percentage of revenues from outside the United States will increase in 2005 as we have placed greater management focus on business opportunities in international markets, established a new subsidiary in Australia
which acquired substantially all of the assets of e-Wise Solutions, and established a sales office in Singapore. We price our products based on market conditions in each jurisdiction where we operate. Historically, a significant portion of our
revenues has been derived from a small number of relatively large companies and we expect this trend to continue. See Risk FactorsHistorically, our revenues have been concentrated in a few large orders and a small number of customers, a
trend which has been increasing over time. Our business could be adversely affected if we lose a key customer.



Cost of Revenues



The cost of revenues consists of the cost of software license revenues and cost of maintenance and services. The cost of software license revenues
consists of costs of third-party software that is either embedded in our software or licensed for resale from third-party software providers to enhance the functionality of our software, amortization of acquired technology, and to a lesser extent
royalty payments to the OCS. The cost of acquired technology is established as part of the purchase price allocation and amortized over the period of its useful life on a straight line basis. The royalty payments to the OCS are pursuant to grant
agreements under which we receive grants for research and development expenses from the OCS and commit to pay royalties at a rate of 3% to 5% of



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sales of the product developed with the grant. The aggregate amount of royalties we could be obligated to pay would be up
to 100% to 150% of the amount of grants received, with annual interest equal to LIBOR at the time of the grant. Cost of maintenance and services consists of salaries and expenses of our professional services organization employees, costs related to
third-party consultants and contractors, and other administrative expenses incurred in support of these personnel. As a result of the increase in the amount of professional services headcount from 45 at the end of 2003 to 63 at the end of 2004, we
expect the cost of services to increase on an annual basis.



Operating
Expenses



Operating expenses are categorized into research
and development expenses, sales and marketing expenses, general and administrative expenses, and amortization of stock-based compensation.



Research and development expenses include costs relating to the development of our products. These costs consist primarily of salaries and benefits for
research and development employees, facilities and other administrative expenses, and the cost of consulting development resources that supplement our internal development team. These expenses are net of any governmental grants. Due to the
relatively short time between the date our products achieve technological feasibility and the date they generally become available to customers, costs subject to capitalization under SFAS No. 86 have been immaterial and have been expensed as
incurred.



Sales and marketing expenses consist of salaries and
commissions for sales and marketing employees and consultants, office expenses, travel, printing and distribution, market research, advertising and promotional expenses, and other administrative expenses.



General and administrative expenses consist of salaries for administrative,
executive and finance personnel, information system costs, insurance, audit, legal and other administrative expenses.



Amortization of stock-based compensation includes the amortization of employee stock-based compensation and expenses for stock options granted to
consultants in exchange for services. Stock-based compensation expense is amortized over the vesting schedule of the stock options using the straight line approach, or, over the term of the services provided.



On February 25, 2002, we acquired the outstanding shares of iMedeon, a
provider of mobile workforce management solutions to the utilities and energy sectors. iMedeon was a privately held company, headquartered in Alpharetta, Georgia. The purchase price for this transaction was approximately $2.95 million based on the
estimated fair market value of 510,055 of our Ordinary Shares which were issued to iMedeons shareholders in exchange for all of the outstanding shares of iMedeon. We incurred transaction related expenses of approximately $0.7 million in
connection with this acquisition. We recorded goodwill of approximately $2.8 million for the acquisition, reflecting the excess of the purchase price over the estimated fair value of the net assets. Impairment tests for goodwill are performed
annually according to SFAS no. 142. A one time expense of $480,000 to write-off in-process research and development was recorded at the time of the acquisition related to the portion of technological feasibility that had yet to be established and
for which no alternative future use existed. We also acquired approximately $1.8 million of net cash as part of the iMedeon transaction.



In 2002, we restructured our sales and support organization in Europe and, as a result, instead of relying upon a combination of direct and indirect
channels to market and sell products in Europe, we now exclusively utilize indirect channels. The restructuring resulted in the termination of twelve ViryaNet personnel and contractors employed directly by our subsidiary in the United Kingdom. The
indirect channels we rely on in Europe consist of partners in the mobile workforce sector capable of supporting ViryaNet solutions within their own mobile practices. These partners and their customers are supported by our business development and
professional services organizations in the United States and Israel. We have retained all customers formerly supported by our UK subsidiary at the time of the restructuring. For further information on restructuring, see note 1(e) in the consolidated
financial statements.



On July 29, 2004, we acquired the
outstanding shares of Utility Partners (UP), a provider of mobile workforce management solutions to the utilities industry and headquartered in Tampa, Florida. We acquired UP in order to solidify our position within the utilities sector of our
market. The purchase price for this transaction was approximately $4.6 million based on (i) the estimated fair market value of 898,485 of our Ordinary Shares issued to the shareholders of UP, (ii) approximately $1.4 million of cash to certain
shareholders in exchange for all of the outstanding shares of UP, and (iii) approximately $0.2 million of transaction related expenses incurred with this acquisition. We recorded goodwill of approximately $3.8 million reflecting the excess of the
purchase price over the estimated fair value of the net assets. We also acquired approximately $0.6 million of cash as part of the UP transaction and assumed all of their employees.



On June 15, 2005, we acquired substantially all of the assets of e-Wise Solutions of Melbourne, Australia, a privately held
provider of front-office automation solutions to the utilities sector. These assets became part of ViryaNet Pty Ltd, our newly



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established Australian subsidiary. We established our new subsidiary to build a local presence in a geography that we
believe is a growing market for workforce management solutions. The purchase price for this transaction consisted of (i) an initial consideration of $0.7 million USD payable in 273,267 of our Ordinary Shares, and (ii) additional consideration of up
to $0.7 million USD in Ordinary Shares payable to e-Wise in 2006 based on the then current Ordinary Share market value (the Contingent Consideration), subject to the achievement of certain performance objectives for the period starting
from June 15, 2005 until December 31, 2005. On July 5, 2005, we signed an amendment to the agreement with e-Wise under which we received an option to pay 90% of the Contingent Consideration at any time before October 15, 2005, as satisfaction of our
payment obligation in connection with such Contingent Consideration. In addition, as part of the acquisition, we agreed to assume approximately $0.3 million USD of unsecured debt.

|
|



Our Reporting Currency



Our reporting currency is the United States dollar.
Transactions and balances of subsidiaries whose functional currency is not the dollar have been translated to dollars under the principles described in Financial Accounting Standards Board Statement No. 52. Under this FASB Statement, assets and
liabilities have been translated at period-end exchange rates and results of operations have been translated at average exchange rates. The exchange gains and losses arising from these translations are recorded as accumulated other comprehensive
losses in the shareholders equity section of our balance sheet.



Recently Issued Accounting Pronouncements



For
a discussion of applicable recently issued accounting pronouncements, see Note 2 to our financial statements included below.



Critical Accounting Policies



The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been
prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. These estimates are evaluated by us on an on-going basis. We base our estimates on our historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying amount values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.



We believe that application of the following critical accounting policies
entails the more significant judgments and estimates used in the preparation of our consolidated financial statements.



Revenue Recognition



Revenue results are difficult to predict, and any shortfall in revenues or delay in recognizing revenues could cause our operating results to vary
significantly from quarter to quarter and could result in future operating losses. In addition, the timing of our revenue recognition influences the timing of certain expenses, such as commissions and royalties, which could cause our expenses to
fluctuate from period to period. We follow very specific and detailed guidelines in measuring revenues, however, certain judgments affect the application of our revenue policy.



Revenues from software product license agreements that do not involve significant customization and modification of the
software product are recognized, under Statement of Position No. 97-2, Software Revenue Recognition, or SOP 97-2, as amended. This means that we recognize software license revenues when persuasive evidence of an arrangement exists, the
fee is fixed and determinable, collection is considered probable and delivery has occurred. We have also adopted SAB No. 104 Revenue Recognition.



If the fee due from a customer is not fixed or determinable, revenue is recognized as payments become due from that customer, assuming all other revenue
recognition criteria have been met. During 2002, we recognized revenues on software license transactions as payments were due, provided collectibility of the amount was deemed probable, or as payments were collected. During 2003 and 2004, we believe
that we attained a sufficient history of successfully collecting on licensing transactions with payments terms of three months or less without making a concession. As a result, we recognized revenues on such arrangements upfront on the date of the
delivery, provided collectibility was deemed probable at the date of the transaction. We consider all arrangements with payment terms extending beyond three months not to be fixed or determinable. In judging the probability of collection of software
license fees, we continuously monitor collection and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that we have identified. In
connection with customers with whom we have no previous experience, we may utilize independent resources to evaluate the creditworthiness of those customers. From time to time, we may perform credit evaluations of our customers. If the financial
situation of any of our customers were to deteriorate, resulting in an impairment of their ability to pay amounts owed to us, additional allowances may be required.



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Revenues from software license agreements that require significant customization and modification of the
software product are recognized in accordance with SOP 81-1 Accounting for Performance of ConstructionType and Certain ProductionType Contracts, using the percentage-of-completion method, based on the relationship of actual
labor days incurred to total labor days estimated to be incurred over the duration of the contract. We classify revenue from these arrangements as license and service revenues based on the estimated fair value of each element.



In recognizing revenues based on the percentage-of-completion method, we
estimate time to completion with revisions to estimates made in the period in which the basis of such revisions becomes known. If we do not accurately estimate the resources required or scope of work to be performed, manage our projects properly
within the planned periods of time or satisfy our obligations under the contracts, then future services margins may be significantly and negatively affected or a provision for estimated contract losses on existing contracts may need to be recognized
in the period in which the loss becomes probable and can be reasonably estimated.



Where software arrangements involve multiple elements that typically consist of license, professional services, and post-contract maintenance and support, and when the services included in these arrangements are not
considered essential to the functionality of the software, revenue is allocated to each element. License revenues are recorded based on the residual method according to SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, for such
transactions. Under the residual method, revenue is recognized for the delivered elements when (1) there is vendor-specific objective evidence (VSOE) of the fair values of all the undelivered elements, (2) VSOE of fair value does not
exist for one or more of the delivered elements in the arrangement, and (3) all revenue recognition criteria of the amended SOP 97-2 are satisfied. Under the residual method, any discount in the arrangement is allocated to the delivered element. Our
VSOE used to allocate the sales price to professional services and maintenance is based on the price charged when the undelivered elements are sold separately. We do not have multiple element arrangements where VSOE of fair value does not exist for
all undelivered elements. However, if VSOE of fair value does not exist for all elements to support the allocation of the total fee among all delivered and undelivered elements of the arrangement, revenue would be deferred until such evidence exists
for the undelivered elements, or until all elements are delivered, whichever occurs earlier.



Service revenues from professional services include implementation and consulting, post-contract maintenance support and training. Implementation and consulting services revenues are generally recognized on a time and
material basis as these services are performed. Post-contract maintenance support agreements provide technical support and the right to unspecified software updates, when available. Revenues from post-contract maintenance support services are
recognized ratably over the contractual support term, generally one year. Amounts collected from customers in excess of revenues recognized are recorded as deferred revenue. Revenues from training and other services are recognized as the related
services are provided.



Goodwill



Under Statement of Financial Accounting Standard No.142, Goodwill and
Other Intangible Assets (SFAS No. 142) goodwill acquired in a business combination that closes on or after July 1, 2001 is deemed to have indefinite life and will not be amortized. SFAS No.142 requires goodwill to be tested for
impairment on adoption and at least annually thereafter or between annual tests in certain circumstances, and written down when impaired, rather than being amortized as previous accounting standards required. Goodwill is tested for impairment by
comparing the fair value of the reporting unit with its carrying value. Fair value is determined using market multiples and comparative analysis. Significant estimates used in the methodologies include estimates of market multiples for the
reportable unit. We have recorded goodwill of approximately $2.8 million related to our acquisition of iMedeon on February 25, 2002 and $3.8 million related to our acquisition of Utility Partners, Inc. on July 29, 2004. We have performed impairment
tests and determined that our goodwill in the aggregate of approximately $6.6 million is not subject to an impairment charge as of year-end 2004.



Allowance for Doubtful Accounts



We evaluate the collectibility of accounts receivable based on a combination of factors related to our customers. In circumstances where we are aware of a
specific customers inability to meet its financial obligations to us (e.g. bankruptcy filings, substantial down-grading of credit ratings), we record a specific reserve for bad debts against amounts due to reduce the net recognized receivable
to the amount we reasonably believe will be collected. For all other customers, we recognize reserves for bad debts based on the length of time the receivables are past due and on our historical experience in collecting such receivables.



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Operating Results



The following
table describes, for the periods indicated, the percentage of revenues represented by each of the items on our consolidated statements of operations:



|                                              |  |                         |   |  |       |   |  |       |  
|--------------------------------------------- |  | ----------------------- | - |  | ----- | - |  | ----- | -
|                                              |  | Year Ended December 31, |  
|                                              |  | 2002                    |   |  | 2003  |   |  | 2004  |  
|Revenues:                                     |  |                         |   |  |       |   |  |       |  
|Software license                              |  | 56.0                    | % |  | 34.3  | % |  | 26.1  | %
|Maintenance and services                      |  | 44.0                    |   |  | 65.7  |   |  | 73.9  |  
|                                              |  |                         |   |  |       |   |  |       |  
|Total revenues:                               |  | 100.0                   |   |  | 100.0 |   |  | 100.0 |  
|Cost of revenues:                             |  |                         |   |  |       |   |  |       |  
|Software licenses                             |  | 3.1                     |   |  | 4.0   |   |  | 2.4   |  
|Maintenance and services                      |  | 37.1                    |   |  | 41.8  |   |  | 56.6  |  
|                                              |  |                         |   |  |       |   |  |       |  
|Total costs of revenues                       |  | 40.2                    |   |  | 45.8  |   |  | 59.0  |  
|Gross profit                                  |  | 59.8                    |   |  | 54.2  |   |  | 41.0  |  
|                                              |  |                         |   |  |       |   |  |       |  
|Operating expenses:                           |  |                         |   |  |       |   |  |       |  
|Research and development, net                 |  | 28.4                    |   |  | 17.5  |   |  | 17.4  |  
|Sales and marketing                           |  | 55.9                    |   |  | 34.4  |   |  | 36.6  |  
|General and administrative                    |  | 19.2                    |   |  | 16.2  |   |  | 18.0  |  
|In-process research and development write-off |  | 4.1                     |   |  | 0.0   |   |  | 0.0   |  
|Amortization of deferred stock Compensation   |  | 0.3                     |   |  | 0.2   |   |  | 0.8   |  
|                                              |  |                         |   |  |       |   |  |       |  
|Total operating expenses                      |  | 107.9                   |   |  | 68.3  |   |  | 72.8  |  
|Operating loss                                |  | (48.0                   | ) |  | (14.2 | ) |  | (31.8 | )
|Financial income (expenses), net              |  | (1.6                    | ) |  | (2.6  | ) |  | (3.1  | )
|Other income                                  |  | 0.0                     |   |  | 2.9   |   |  | 0.0   |  
|                                              |  |                         |  
|Net loss                                      |  | (49.6                   | ) |  | (13.8 | ) |  | (34.9 | )



Geographic Distribution



The following table summarizes the revenues from our
products and services by country/region, stated as a percentage of total revenues for the periods indicated.



|                           |  |                         |   |  |      |   |  |      |  
|-------------------------- |  | ----------------------- | - |  | ---- | - |  | ---- | -
|                           |  | Year Ended December 31, |  
|Country/region             |  | 2002                    |   |  | 2003 |   |  | 2004 |  
|United States              |  | 57                      |   |  | 70   |   |  | 79   |  
|Europe and the Middle East |  | 28                      |   |  | 13   |   |  | 11   |  
|Far East                   |  | 15                      |   |  | 17   |   |  | 10   |  
|                           |  |                         |   |  |      |   |  |      |  
|Total                      |  | 100                     | % |  | 100  | % |  | 100  | %



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Comparison of Fiscal Years Ended December 31, 2003 and 2004



Revenues



Our total revenues decreased slightly from $12.0 million in 2003 to $11.9
million in 2004. Our revenue from software licenses declined by approximately $1.0 million in 2004 compared to 2003; however this decrease was offset by an increase of $0.9 million in our professional services revenue. The professional services
revenue growth came primarily from an increase in our maintenance and support revenue as described below in Maintenance and Services. During 2004, we expected to derive more revenue from sales in Europe and Asia Pacific. However,
revenues from outside of North America declined as a percentage of total revenue from 30% in 2003 to 21% in 2004. The decline was primarily attributable to delays in establishing additional reseller channels for markets in Europe and Asia Pacific
and a slower than anticipated sales ramp through our existing partnership network. The revenue contributed by the acquisition of UP and UPs installed base of customers was approximately $1.5 million, a majority of which was services revenue,
and helped to alleviate some of the revenue shortfall outside North America.



In 2005, we believe that we can expect growth in our revenue from the full-year contribution of revenue from UPs installed base and the revenue contribution resulting from the acquisition of e-Wise in June 2005.



Software Licenses



Software license revenues decreased by 24% from $4.1 million in 2003 to $3.1
million in 2004. This decrease of $1.0 million was attributable to longer or delayed sales cycles for our products, particularly in international markets in which we are more reliant upon the success of channel partners in closing transactions.



As a percentage of revenue, software licenses decreased from
34.3% of revenue in 2003 to 26.1% of revenue in 2004. The reduction in the percentage of revenue provided by software licenses is attributable to the decline in software license revenue due to longer or delayed sales cycles experienced during the
year and the growth of maintenance and services revenues from new and existing customers from 2003 to 2004. There were no rate changes in our license fees that had a material impact on our revenues.



Maintenance and Services



Our maintenance and services revenues increased by 12% from $7.9 million in
2003 to $8.8 million in 2004. The increase of $0.9 million is attributable to the increase in post-contract support revenues due to the growth in the installed base of customers using our software, including customers assumed from the UP
acquisition. There were no rate changes in our maintenance and services fees that had a material impact on our revenues.



Cost of Revenues



Total cost of revenues increased by 28% from $5.5 million in 2003 to $7.0 million in 2004, as further explained below.



Cost of Software Licenses



The cost of software licenses decreased by 40% from $0.5 million in 2003 to
$0.3 million in 2004. The decrease was due to the reduction in the amount of software licenses sold in 2004 compared with 2003.



Cost of Maintenance and Services



The cost of maintenance and services increased by 35% from $5.0 million in 2003 to $6.7 million in 2004. The increase in the cost of maintenance and
services of $1.7 million is attributable to the increase in maintenance and services personnel from 45 at the end of 2003 to 63 at the end of 2004. Maintenance and services costs as a percentage of maintenance and services revenues increased from
64% in 2003 to 77% in 2004. The increase in maintenance and services costs as a percentage of maintenance and services revenues resulted primarily from the additional personnel needed to deliver professional services revenue.





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Operating Expenses



Research and Development, Net



Our net research and development expenses, which include government grants received from the OCS, were essentially unchanged from $2.1 million, comprising
17.4% of revenue in 2004 compared to $2.1 million or 17.5% of revenue in 2003. We did not receive any government grants from the OCS during 2004 compared with grants received in 2003 in the amount of $0.1 million. The reduction in the amount of
government grants received from the OCS was offset by a similar reduction in the amount of depreciation expenses recorded in 2004.



We expect that we will continue to devote a substantial portion of our revenues to research and development to enhance our existing products, merge
certain features and functionality of WorkUP with
ViryaNet Service Hub, and develop new features and functionality that will benefit all of our customers. In 2005, we expect the amount of expenses for research and development to increase in comparison to the amount of those expenses in 2004.
However, expenses for research and development as a percentage of revenue should be maintained if revenue growth occurs as expected. See Cautionary Statement Regarding Forward-Looking Statements.



Sales and Marketing



Our sales and marketing expenses were $4.4 million, or 36.6% of revenue in
2004 compared to $4.1 million or 34.4% of revenue in 2003, a year over year increase of $0.3 million or 6.2%. This increase was attributable to an increase in personnel costs resulting from the acquisition of UP on July 29, 2004. We expect sales and
marketing expenses to increase in 2005 as a result of (i) the full year impact of the UP acquisition, (ii) an expected increase in variable compensation related to higher volume of sales and revenue, (iii) a planned increase in marketing expenses,
(iv) the creation of an account management group focused on sales to installed base customers, and (v) our continued effort to expand our sales presence in international markets and the acquisition of e-Wise Solutions and the related establishment
of a subsidiary in Australia. However, we expect expenses for sales and marketing as a percentage of revenue to remain essentially unchanged, to the extent that revenue growth occurs as expected. See Cautionary Statement Regarding
Forward-Looking Statements.



General and
Administrative



Our general and administrative
expenses were $2.1 million, or 18.0% of revenue in 2004 compared to $1.9 million, or 15.9% of revenue in 2003, a year over year increase of $0.2 million or 12.6%. This increase was primarily attributable to an increase in personnel and
administrative costs due to the UP acquisition. We expect that for the foreseeable future general and administrative expenses will increase as a result of (i) the full year impact of the UP acquisition, (ii) an increase in professional fees related
to compliance with the Sarbanes-Oxley Act, and (iii) the acquisition of e-Wise Solutions and the establishment of a subsidiary in Australia. However, general and administrative costs as a percentage of revenue should decline if revenue growth occurs
as expected. See Cautionary Statement Regarding Forward-Looking Statements.



Amortization of Stock-Based Compensation



Stock-based compensation recorded as operating expenses was $98,000 in 2004 compared to $20,000 in 2003. The increase in stock-based compensation recorded as operating expenses was related to an increase in the
warrants and options issued in 2004 and the full-year impact of similar warrants and options issued in 2003, whose fair value was estimated using the Black-Sholes options pricing model. In 2003 and 2004, we issued warrants as part of services
provided to us, and granted stock options to certain consultants with immediate full vesting.



Financial Income and Financial Expenses



Net financial expenses increased from $311,000 in 2003 to $363,000 in 2004. Financial expenses increased from $347,000 to $462,000. The increase is attributable to $75,000 of expenses incurred due to our delay in
meeting certain registration commitments as part of the LibertyView convertible note  See Liquidity and Capital Resources Equity and Bank Financings  and the balance of the increase is primarily related to higher interest
expenses incurred as a result of the LibertyView convertible note issued during 2004. Financial income increased from $36,000 in 2003 to $99,000 in 2004 as a result of favorable foreign currency translation adjustments.



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Other Income



Other income decreased from $350,000 in 2003 to zero in 2004. During 2003, we received payment of an insurance claim against
a credit insurer in the amount of $350,000 related to a customer transaction in 2001 in which the customer defaulted on its debt to us.



Comparison of Fiscal Years Ended December 31, 2002 and 2003



Revenues



Our total revenues increased slightly from $11.8 million in 2002 to $12.0 million in 2003. This resulted from the growth of our professional services
revenue being offset by a reduction in the amount of software license revenue as described below in Software Licenses. Our total revenues were impacted by many of the factors that affected the market for our products in 2002 which were
also in effect during 2003. Specifically, many companies struggled with the timing of investment decisions on technology spending in light of their desire to return to positive growth and the continuation of geopolitical uncertainties that may have
affected their outlook.



Software Licenses



Software license revenues decreased by 38% from $6.6
million in 2002 to $4.1 million in 2003. This decrease of $2.5 million was attributable to longer or delayed sales cycles for our products as many potential customers in our primary target markets (utilities, telcos, and retail) struggled with the
timing of investment decisions on technology spending despite the recent improvement in general economic conditions.



As a percentage of revenue, software licenses decreased from 56.0% of revenue in 2002 to 34.3% of revenue in 2003. The reduction in the percentage of
revenue provided by software licenses was attributable to the decline in software license revenue due to longer or delayed sales cycles experienced during the year and the growth of maintenance and services revenues from new and existing customers
from 2002 to 2003. There were no rate changes in our license fees that had a material impact on our revenues.



Maintenance and Services



Our maintenance and services revenues increased by 51% from $5.2 million in 2002 to $7.9 million in 2003. The increase of $2.7 million was attributable to
an increase in professional services revenue of $2.4 million largely from implementation services provided to some of our larger, installed base customers who had previously delayed or postponed such implementation projects under less certain
business and economic conditions, and, to a lesser extent, an increase in maintenance revenues of $0.3 million attributable to growth in the installed base of customers using our software. There were no rate changes in our maintenance and services
fees that had a material impact on our revenues.



Cost of
Revenues



Total cost of revenues increased by 16% from
$4.7 million in 2002 to $5.5 million in 2003, as further explained below.



Cost of Software Licenses



The cost of software licenses increased by 34% from $0.4 million in 2002 to $0.5 million in 2003. The increase was primarily due to an increase in the mix of third-party software licenses sold as part of our products.



Maintenance and Services



The cost of maintenance and services increased by 14% from $4.4 million in
2002 to $5.0 million in 2003. This increase was attributed mainly to the increase in the number of personnel required to support the growth of overall services revenues. Maintenance and services costs as a percentage of maintenance and services
revenues declined from 84% in 2002 to 64% in 2003. The decrease in maintenance and services costs as a percentage of maintenance and services revenues resulted primarily from the improved efficiency and utilization of services personnel.



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Operating Expenses



Research and Development, Net



Our net research and development expenses, which include government grants from the OCS, were $2.1 million, or 17.5% of
revenue in 2003 compared to $3.4 million or 28.4% of revenue in 2002, a year over year reduction of $1.3 million or 37.4%. The decrease in our net research and development expenses was largely attributable to a $1.5 million decrease in expenses due
to the use of our research and development personnel in the delivery of maintenance and services whose cost was allocated to cost of services and, to a lesser extent, to a decline in depreciation expenses of $0.2 million resulting from lower capital
expenditures for hardware and software. The decrease in research and development expenses was offset by a reduction of $0.4 million in the amount of government grants received from the OCS in 2003 compared to the amount of grants received from the
OCS in 2002.



Sales and Marketing



Our sales and marketing expenses were $4.1 million, or 34.4% of revenue in 2003 compared to
$6.6 million or 55.9% of revenue in 2002, a year over year reduction of $2.5 million or 37.7%. This reduction was attributable to a decline in personnel costs of $2.0 million and a reduction in marketing programs of $0.5 million. These savings were
primarily related to the full year impact of the restructuring of our operations in Europe during 2002.



General and Administrative



Our general and administrative expenses were $1.9 million, or 15.9% of revenue in 2003 compared to $2.3 million, or 19.6% of revenue in 2002, a year over
year reduction of $0.4 million or 17.6%. This reduction was attributable to the full-year benefit of the reductions in personnel that took place during 2002 of approximately $0.3 million and, to a reduction in the administrative costs to support
these personnel of approximately $0.1 million.



Write-off
of In-Process Research and Development



The write-off
of in-process research and development declined from $480,000 in 2002 to $0 in 2003. In 2002, we recorded a one time expense of $480,000 to write-off in-process research and development related to its acquisition of iMedeon on February 25, 2002, for
which technological feasibility was not established and for which no alternative future use existed.



Amortization of Stock-Based Compensation



Stock-based compensation recorded as operating expenses was $36,000 in 2002, and $20,000 in 2003.



Financial Income and Financial Expenses



Net financial expenses increased from $189,000 in 2002 to $312,000 in 2003.
In 2002 and 2003, financial expenses were $346,000 and $348,000, respectively. Financial income decreased from $157,000 to $36,000 due to a lower level of cash and cash equivalents during the course of the year. The financial expense resulted from
interest expenses incurred from the use of bank lines of credit and short-term and long-term bank debt, and the financial income resulted from interest earned on our cash and cash equivalents balances.



Other Income



Other income increased from $0 in 2002 to $350,000 in 2003. We received
payment of an insurance claim against a credit insurer in the amount of $350,000 related to a customer transaction in 2001 in which the customer defaulted on its debt to us.



Liquidity and Capital Resources



How We Have Financed Our Business



On
September 19, 2000, we completed our IPO. In this offering, we raised gross proceeds of $32.0 million and issued 400,000 Ordinary Shares at a price of $80.00 per share. Since the time of our IPO, we have financed our operations primarily through
additional sales of our Ordinary Shares through private placements or incurrence of convertible debt, bank related financings and sale of receivables. Historically, cash flow from operations has not been sufficient to fund operations without the use
of these additional financing measures.



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Sources of Cash



Equity or Convertible Debt Financings



During 2003, we raised approximately $4.6 million of net proceeds from the sale of our Ordinary Shares from private equity
financings. These transactions consisted of the following:



| |  |  | On August 4, 2003, we completed a private placement of our Ordinary Shares with Telvent, the information technology subsidiary of Abengoa, S.A. of Spain. In exchange for gross
proceeds of $1.0 million, we issued 539,258 Ordinary Shares at a price of $1.85 per share.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | On November 10, 2003, we completed a private placement of our Ordinary Shares with a large U.S. financial institution and a group of private investors. In exchange for gross
proceeds of approximately $1.8 million, we issued 517,322 Ordinary Shares at a price of $3.406 per share. In addition, the investors also received warrants to purchase 93,723 Ordinary Shares at an exercise price of $4.70 per share. These warrants
are exercisable until the earlier of November 10, 2006, or, an M&A transaction as defined in such warrants.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | On December 5, 2003, we completed a follow-on private placement of our Ordinary Shares with Vertex Venture Capital Israel Funds and FBR Infinity Venture Funds, as well as a group of
private investors. In exchange for gross proceeds of approximately $2.2 million, we issued 554,509 Ordinary Shares at a price of $4.036 per share. In addition, the investors also received warrants to purchase 84,644 Ordinary Shares at an exercise
price of $6.61 per share. These warrants are exercisable until the earlier of December 5, 2006, or, an M&A transaction as defined in such warrants.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | On July 28, 2004, we issued to LibertyView Special Opportunities Fund, L.P. a 7.5% Convertible Note in the aggregate principal amount of $2.5 million due July 28, 2014. We are
obligated to pay interest on the Note on a quarterly basis commencing October 15, 2004, either in cash or our registered Ordinary Shares, at our discretion. The Note is convertible, at the option of LibertyView, at any time before its maturity date
into our Ordinary Shares at a fixed conversion price of $4.2996 per Ordinary Share. LibertyView also has an option to require us to purchase the Note in an amount equal to 100% of the principal amount plus accrued and unpaid interest, on July 15,
2008, July 15, 2009, and July 15, 2011. If LibertyView elects to require us to purchase the Note, we can elect to pay the repurchase price in cash, Ordinary Shares, or a combination thereof. The Note is also subject to repurchase for cash, at
LibertyViews option and at a repurchase price equal to 100% of the principal amount plus accrued and unpaid interest, on the occurrence of certain events, including the following: (i) an acquisition of our company for cash only, (ii) an
acquisition of our company by another company whose market value is less than $25.0 million, (iii) if we cease to be traded on the Nasdaq SmallCap Market, and (iv) if we become subject to bankruptcy or similar proceedings. In connection with the
Note, we agreed to file an F-3 Registration Statement covering the Ordinary Shares which may be issued upon conversion of the Note within the earlier of (i) 60 days from the date of the Note, and (ii) 5 business days after the registration statement
that was filed with the SEC prior to the date the Note is declared effective by the SEC. In that respect, we have also agreed that in the event the F-3 is not filed on time or not declared effective by the SEC within 90 days after it is filed, we
will pay LibertyView cash compensation equal to 1% of the loan under the Note for each month of delay (on a pro-rated basis). On May 27, 2005, we entered into a letter agreement with LibertyView under which we agreed to issue to LibertyView 50,000
of our Ordinary Shares and pay a cash amount of $40,000 as the sole and complete remedy for our inability to meet such registration deadlines. On June 29, 2005, we entered into an additional letter agreement with LibertyView under which LibertyView
agreed, for the period ending on January 1, 2006, to waive its right to require us to repurchase the note if we cease to be traded on the Nasdaq SmallCap Market. In connection with such waiver, we issued 10,000 of our Ordinary Shares to LibertyView.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In February 2005, we completed a private placement of our Ordinary Shares to Telvent Investments, S.L., a current shareholder. In exchange for approximately $1.3 million, we issued
581,659 Ordinary Shares at a price of $2.29 per Ordinary Share.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Bank Financing



In February 2002, our line of credit with Bank Hapoalim, under which we were able to borrow up to $6.0 million, was extended
until January 31, 2003. On January 21, 2003, that line of credit was terminated and the $3.45 million outstanding on that date was converted to a loan subject to re-payment by July 21, 2003. On July 14, 2003, Bank Hapoalim restructured this loan by
converting $2.4 million of the $3.45 million short-term loan into a long-term loan. The balance of $1.05 million was paid back by the end of November 2003. The $2.4 million long-term loan is payable quarterly in equal installments of $267,000
beginning on January 1, 2004, with interest payable quarterly at a rate of LIBOR plus 2.75%. This debt arrangement was subject to certain conditions, which were replaced in connection with our March 2005 arrangement with Bank Hapoalim described
below.



During March 2005, Bank Hapoalim agreed to provide us
with an additional credit line in the amount of $1.0 million in addition to our existing overdraft facility with Bank Hapoalim. The credit line can be drawn in either dollars or NIS with interest payable quarterly at rates ranging between LIBOR plus
2.25% in dollars or 8% in NIS. In addition, the bank agreed to cancel the existing covenants for the long-term loan arrangement and replace them in their entirety with the following covenants: (i) our shareholders equity, on a quarterly basis,
starting on January 1, 2006, shall be at least the higher of (a) 17% of our total assets, or (b) $3.0 million, and (ii) our cash balance, on January 1, 2006 and on a quarterly basis thereafter, shall not be less than $2.0 million.



As consideration for the additional credit line, we issued to Bank Hapoalim a
warrant to purchase 50,000 of our Ordinary Shares at an exercise price of $2.06 per Ordinary Share.



As of June 1, 2005, we had an outstanding balance on our long-term loan arrangement with Bank Hapoalim of $0.8 million, including current maturities,
payable quarterly in equal installments of $267,000 through January 1, 2006 with interest payable quarterly at a rate of LIBOR plus 2.75%. As of June 1, 2005, we had an outstanding balance in our short-term borrowings with Bank Hapoalim, including
the credit line and overdraft facility, of $1.25 million with interest payable quarterly ranging from LIBOR plus 2.25% in USD and 8% in NIS.



To ensure compliance with the bank covenants explained above, we are trying to control our cost structure while maximizing our cash collection efforts.
However, in the event that we are unable to maintain compliance with the bank covenants, we may request a waiver from the bank. If we breach the covenants and are unable to obtain a waiver, the bank may call in its loan or credit line. In such an
event, we would need to seek alternate financing as we deem necessary for our business operations. However, we cannot provide assurance that any such alternate financing would be available on terms acceptable to us or at all.



Sale of Receivables



We sold receivables to Bank Hapoalim under an arrangement in which the bank
pays us the amount of the accounts receivable less an agreed upon commission, and we irrevocably assigned to the bank the accounts receivable sold with recourse to the bank. Our ability to sell such receivables in the future to Bank Hapoalim or
other institutions on current terms and conditions is uncertain and is dependent on the creditworthiness of the customers involved, the credit risks in the specific countries concerned and the institutions policies from time to time.



As of December 31, 2004, no amount was outstanding under this
arrangement. As of December 31, 2003, $0.9 million was outstanding under this arrangement as short-term bank debt.



Cash



As of December 31, 2004, we had cash and cash equivalents of $2.9 million, compared to $5.0 million as of December 31, 2003. In summary, the $2.1 million
decrease in cash and cash equivalents is attributable to the $2.7 million of net cash used in operating activities and $1.3 million of net cash used in investing activities, offset by $1.9 million of net cash provided by financing activities.



Net cash used in operating activities was $2.7 million in
2004, primarily resulting from our net loss from operations net of depreciation of $3.4 million. For 2003, net cash used in operating activities was $1.4 million, resulting primarily from our net loss from operations of $1.7 million. For 2002, net
cash used in operating activities was $6.7 million, resulting primarily from our net loss from operations of $5.9 million.



Net cash used in investing activities was $1.3 million attributable to $1.1 million of cash used in connection with the acquisition of Utility Partners,
Inc. and approximately $0.2 million of capital equipment purchases. For 2003, net cash provided by investing activities was $16,000. For 2002, net cash provided by investing activities was $1.7 million, primarily attributable to cash provided by the
acquisition of iMedeon.



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Net cash provided by financing activities was $1.9 million in 2004 which included $2.5 million of net
proceeds raised in the convertible note financing from LibertyView, an increase in short-term bank credit with Bank Hapoalim of $0.6 million, offset by the re-payment of the long term debt with Bank Hapoalim of $1.0 million and payment of issuance
expenses of $0.2 million. For 2003, net cash provided by financing activities was $3.3 million which included the net proceeds from both the sale of our Ordinary Shares and stock option exercises in the amount of $5.0 million, offset by the $1.7
million net reduction of short-term and long-term borrowing activities with Bank Hapoalim In 2002, net cash used in financing activities was $0.5 million resulting from a net reduction in the amount of short-term bank borrowings against the line of
credit with Bank Hapoalim.



Future Cash Needs



In addition to our need to continue to meet our
payment obligations to Bank Hapoalim under the terms of our debt arrangement, our capital requirements depend on numerous factors, including market demand and acceptance of our products, the resources we devote to developing, marketing, selling and
supporting our products, and the timing and extent of establishing additional international operations. We intend to continue investing significant resources in our selling and marketing and research and development operations in the future. We
believe that our cash and cash equivalents and funds generated from operations will be sufficient to finance our operations for at least the next twelve months. Our ability to achieve profitability using our currently available cash and cash
equivalents will depend on our ability to increase our revenues while continuing to control our expenses. We cannot assure you that we will be able to achieve profitability, particularly given the risk factors outlined earlier in this Form 20-F. If
we are not successful doing so, we will be required to seek new sources of financing. If additional funds are raised through issuance of equity or debt securities, these securities could have rights, preferences and privileges senior to those of
holders of Ordinary Shares, and the terms of these securities could impose restrictions on our operations, and will result in additional dilution to our shareholders. Our ability to raise additional secured debt may require the consent of Bank
Hapoalim and LibertyView.



Research and Development
Grants



We conduct our research and development activities primarily
at our principal offices in Israel. Our research and development efforts have been financed, in part, through grants from the OCS. Under these grants, royalties are payable to the OCS at the rate of 3% to 5% of revenues derived from products
developed by us according to those programs. The aggregate amount of royalties we could be obligated to pay would be up to 100% to 150% of the amount of grants received, with annual interest at the rate of LIBOR at the time of the grant.



The State of Israel does not own proprietary rights in technology
developed with OCS funding and there is no restriction on the export of products manufactured using technology developed with OCS funding. The technology is, however, subject to transfer restrictions, as described below. These restrictions may
impair our ability to sell our technology assets or to outsource manufacturing and the restrictions continue to apply even after we have paid the full amount of royalties payable for the grants. In addition, the restrictions may impair our ability
to consummate a merger or similar transaction in which the surviving entity is not an Israeli company.



The transfer to a non-Israeli entity of technology developed with OCS funding, including pursuant to a merger or similar transaction, and the transfer of
rights related to the manufacture of more than ten percent of a product developed with OCS funding are subject to approval by an OCS committee and to the following conditions:



| |  |  | Transfer of Technology.If the committee approves the transfer of OCS-backed technology, such a transfer would be subject to the payment to the OCS of a portion of the
consideration we receive for such technology. The amount payable would be a fraction of the consideration equal to the relative amount invested by the OCS in the development of such technology compared to our total investment in the technology, but
in no event less than the amount of the grant. However, in the event that in consideration for our transfer of technology out of Israel we receive technology from a non-Israeli entity for use in Israel, we would not be required to make payments to
the OCS if the approval committee finds that such transfer of non-Israeli technology would significantly increase the future return to the OCS.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Transfer of Manufacturing Rights.The committee is authorized to approve transfers of manufacturing rights only if the transfer is conditioned upon either (1) payment of
increased aggregate royalties, ranging from 120% to 300% of the amount of the grant plus interest, depending on the percentage of foreign manufacture or (2) a transfer of manufacturing rights into Israel of another product of similar or more
advanced technology.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | Merger or Acquisition.If the committee approves a merger or similar transaction in which the surviving entity is not an Israeli company, such a transaction would be subject
to the payment to the OCS of a portion of the consideration paid. The amount payable would be a fraction of the consideration equal to the relative amount invested by the OCS in the development of such technology compared to the total investment in
the company, net of financial assets that the company has at the time of the transaction, but in no event less than the amount of the grant.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In the event that the committee believes that the consideration to be paid in a transaction requiring payment to the OCS pursuant to the provisions of the
law described above does not reflect the true value of the technology or the company being acquired, it may determine an alternate value to be used as the basis for calculating the requisite payments.



In 2001 and 2002, we received approvals for grants from the OCS in the amount
of $372,000, which have been received by us through December 31, 2003. We have not yet determined whether we can satisfy the terms and conditions of these grants. During 2004, we made royalty payments of $8,000 to the OCS related to these grants and
as of December 31, 2004, we have an outstanding contingent liability to pay royalties in the amount of $377,000.



In 1998 and 2002, we received grants in an aggregate amount of $514,000 from the United States-Israel Binational Industrial Research and Development
Foundation (BIRD-F) for a development project on our Service Suite line of products conducted by us and a United States partner. Under the terms of these grants, we are obligated to pay to the foundation royalties of 3% to 5% of the
revenues derived from sales of products developed in this project (the Supported Project), up to an aggregate amount of 100% to 150% of each grant, linked to the dollar and to the U.S. consumer price index. We have informed BIRD-F that
the Supported Project has failed, and we believe that consequently we will not be required to pay BIRD-F any royalties from the sale of any of our products. Therefore, as of December 31, 2004, we had not paid or accrued royalties relating to the
repayment of BIRD-F grants.



Effects of Currency
Fluctuations



Revenues generated and costs incurred
outside of the United States are generally denominated in non-dollar currencies. For the years 2002, 2003 and 2004, 17%, 19% and 17% of our revenues, respectively, were denominated in non-dollar currencies. Costs not effectively denominated in
United States dollars are translated to United States dollars, when recorded, at the prevailing exchange rates for the purposes of our financial statements. Consequently, fluctuations in the rates of exchange between the dollar and non-dollar
currencies will affect our results of operations. An increase in the value of a particular currency relative to the dollar will increase the dollar reporting value for transactions in that particular currency, and a decrease in the value of that
currency relative to the dollar will decrease the dollar reporting value for those transactions. This effect on the dollar reporting value for transactions is generally only partially offset by the impact that currency fluctuations may have on
costs. In 2002, we had net income of $66,000 due to currency fluctuations. In 2003 and 2004, we incurred a net loss of $104,000 and $42,000, respectively, due to currency fluctuations. We generally do not engage in currency hedging transactions to
offset the risks with variations in currency exchange rates. Consequently, significant foreign currency fluctuations and other foreign exchange risks may have a material adverse effect on our business, financial condition and results of operations.



Impact of Inflation



Since our revenues are generated in United States dollars and currencies
other than New Israeli Shekels (NIS), and a portion of our expenses is incurred and will continue to be incurred in NIS, we are exposed to risk by the amount that the rate of inflation in Israel exceeds the rate of devaluation of the NIS in relation
to the dollar and other currencies. We are also exposed to risk if the timing of the devaluation lags behind inflation in Israel. In 1994, 1995 and 1996, the inflation rate in Israel exceeded the rate of devaluation of the NIS against the dollar and
other currencies. This trend was reversed during 1997 and 1998. In 1999 and in 2000, while the rate of inflation was low, there was a devaluation of the dollar against the NIS, and in 2001 the rate of devaluation of the NIS against the dollar
exceeded the rate of inflation. In 2002, the devaluation of the NIS against the dollar was similar to the rate of inflation. In 2003 and 2004, the NIS gained in value against the dollar while the rate of inflation was negative. In 2004, the NIS
gained 2% in value against the dollar while the rate of inflation was 1%. We generally do not engage in any hedging or other transactions intended to manage risks relating to foreign currency exchange rate or interest rate fluctuations. We also do
not own any market risk sensitive instruments. However, we may in the future undertake hedging or other transactions or invest in market risk sensitive instruments if we determine that it is necessary to offset these risks.



Effective Corporate Tax Rate



Our effective corporate tax rate will reflect a mix of the United States,
Japan, United Kingdom and Australian statutory tax rates on our United States, Japan, United Kingdom and Australian income and the Israeli tax rate discussed below. On June 29, 2004, the



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Israeli corporate tax rate was reduced from 36% to 35% in 2004 and will continue to decline to a rate of 30% in 2007. The
majority of our income, however, is derived from our two investment programs with approved enterprise status under the Law for the Encouragement of Capital Investments and is eligible for some tax benefits, subject to certain conditions and
restrictions.



Under our investment programs we will enjoy a
tax exemption on income derived during the first ten years in which these investment programs produce taxable income, provided that we do not distribute the income as dividends. All of these tax benefits are subject to various conditions and
restrictions.



See the discussion in the Tax section in Item
10.



As of December 31, 2004, we had net operating loss
carryforwards for tax reporting purposes of approximately $62.5 million in the United States, $16.0 million in Israel, $16.5 million in the United Kingdom and $1.5 million in Japan. In the United States, the internal revenue code limits the use in
any future period of net operating loss carryforwards following a significant change in ownership interests. Since we have incurred tax losses through December 31, 2004, we have not used these net operating losses.



Research and Development



We
believe that our future success depends, to a significant extent, on our ability to maintain and extend our technological leadership through our research and development activities. We employ product managers in our research and development
activities. These managers provide a critical interface between our research engineers and customer needs and industry developments. This interface helps focus our research and development personnel on developing market-driven applications. By using
information provided by our product managers, we can also manage our research and development resources to address perceived market trends.



Our research and development net expenditures for 2002, 2003 and 2004 were $3.4 million, $2.1 million and $2.1 million, respectively (see the paragraph
headed We may be unable to maintain or expand our sales, marketing, research and development and support organizations which may hinder our ability to grow and meet customer demands in the Risk Factors set forth in Item 3 above).



Trend Information



Our quarterly
results of operations related to revenues may be subject to significant fluctuations due to several factors, primarily the timing of large orders, which represent a significant percentage of our revenues, and other factors, customer budget cycles
and impact on the timing for buying decisions, competitive pressures, the ability of our partners to become effective in selling and marketing our products, and other factors.



As a percentage of our total revenue, our software license revenue decreased from 56.0% in 2002 to 34.3% in 2003. This
decline is attributable to reduced sales of new licenses to customers and an increase in the recurring revenues from existing customers related to professional services and post-contract maintenance and support, which are not dependent on the sales
of new licenses. During 2004, this trend continued as software license revenue declined to 26.1% while revenues contributed from professional services and post-contract maintenance and support increased. The revenues derived from the acquisition of
Utility Partners during 2004 were primarily services related and also contributed to the decline in the percent of revenue from software licenses.



In general, we do not believe the decline in revenue from software as a percentage of total revenue will impact future maintenance and services revenue or
our business as a whole since we expect to sell more licenses in the future which will generate more professional services and maintenance and support revenue in addition to recurring services revenue with existing customers. While the mix of our
software license revenue fell from 56.0% in 2002 to 26.1% in 2004, our total revenues during this period have essentially been unchanged.



For information about our expectations regarding our future cost of revenues, future operating expenses and liquidity and capital resources, please see
the discussion under the Risk Factors section of Item 3 and the Operating Results section and the Liquidity and Capital Resources section of Item 5.



Off-balance Sheet Arrangements



We are not party to any material off-balance sheet arrangements.



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Tabular Disclosure of Contractual Obligations



|                                                   |  |                                           |       |                  |   |             |  |             |       |  |  
|-------------------------------------------------- |  | ----------------------------------------- | ----- | ---------------- | - | ----------- |  | ----------- | ----- |  | -
|Contractual Obligations as ofDecember 31, 2004 (1) |  | Payments due by Period (US$ in thousands)
|                                                   |  | Total                                     |       | One Year or Less |   | 1  3 Years |  | 4  5 Years
|Long-term Debt (2)                                 |  | $                                         | 1,335 |                  | $ | 1,068       |  | $           | 267   |  | 
|Operating Leases (3)                               |  | $                                         | 2,254 |                  | $ | 882         |  | $           | 1,372 |  | 
|Total Contractual Cash Obligations:                |  | $                                         | 3,589 |                  | $ | 1,950       |  | $           | 1,639 |  | 

---

|(1) | Excludes Convertible Note in the aggregate principal amount of $2.5 million issued to LibertyView in July 2004 and which can be paid in cash or our Ordinary Shares, at our option,
other than in specified situations. See Liquidity and Capital Resources Equity or Convertible Debt Financings. Also excludes accrued severance pay recorded under Israeli law as a long-term liability on our balance sheet. See Note 2 to
our financial statements for further information regarding accrued severance pay.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | See Liquidity and Capital Resources Bank Financing.
|--- | -----------------------------------------------------

|(3) | Includes leases for facilities and car leases.
|--- | ----------------------------------------------



Operating Leases



Payments under non-cancelable operating lease agreements for facilities expire on various dates through 2008. As of the date hereof, our annual aggregate
lease obligations for facilities for the period 2005 through 2008 are $651,000, $432,000, $252,000, and $126,000, respectively.



Item 6.Directors, Senior Management and Employees



Directors and Senior Management



|                      |  |     |  |                                             
|--------------------- |  | --- |  | --------------------------------------------
|Name                  |  | Age |  | Position                                    
|Samuel I. HaCohen     |  | 48  |  | Executive Chairman of the Board of Directors
|Paul V. Brooks        |  | 50  |  | President and Chief Executive Officer       
|Albert A. Gabrielli   |  | 46  |  | Chief Financial Officer                     
|Kiyoshi Abe           |  | 37  |  | General Manager, ViryaNet Japan             
|Mark Hosking          |  | 41  |  | General Manager, ViryaNet Australia         
|Vladimir Morgenstern  |  | 47  |  | Director                                    
|Peter Gyenes          |  | 59  |  | Director                                    
|Manuel Sanchez Ortega |  | 41  |  | Director                                    
|Lior Bregman          |  | 46  |  | Director                                    
|Ronit Lerner          |  | 35  |  | Director                                    



Samuel I.
HaCohen co-founded ViryaNet in March 1988. Since March 1988, Mr. HaCohen has served as our chairman of the board of directors. From March 1988 until February 2001, Mr. HaCohen served as our chief executive officer and as the chairman of the
board of directors. Before co-founding ViryaNet, Mr. HaCohen held senior systems management positions in John Bryce Systems Ltd., a software company, and the Hadassah Hospital, Jerusalem. Mr. HaCohen holds a Bachelor of Science degree in computer
science and statistics from the Hebrew University of Jerusalem and has completed all course work for a Master of Science degree in statistics from the Hebrew University of Jerusalem.



Paul V. Brooksjoined ViryaNet in July 2004 as president and chief operating officer. In November 2004, Mr. Brooks
was promoted to president and chief executive officer. Mr. Brooks was president and chief executive officer of Utility Partners, Inc. prior to its acquisition by ViryaNet. Before joining Utility Partners, Mr. Brooks was president and chief executive
officer of Pivotal, Inc.



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Mr. Brooks also held several general management positions over a 17-year period at IBM Corporation, including general
manager for the Insurance and Healthcare business, and vice president responsible for strategy development and execution for the global insurance business. Mr. Brooks holds an AB in management science from Duke University.



Albert A. Gabrielli has served as our chief financial officer since
April 2001.From August 2000 until March 2001, Mr. Gabrielli served as the chief financial officer of Ziplink, a provider of wholesale internet connectivity services. From October 1999 until July 2000, he served as vice president, finance for
Ziplink. From August 1998 until August 1999, Mr. Gabrielli served as vice president, finance, Enterprise Data Product Group for Nortel Networks, a telecommunication networking company. From June 1998 until August 1998, he served as vice president,
finance, Internet/Telecommunications and Enterprise Product Group for Bay Networks, a data networking company. From July 1995 until June 1998, he served in a number of senior management positions with Bay Networks. From 1982 until July 1995 Mr.
Gabrielli was employed at Digital Equipment Corporation in a variety of finance and finance management roles, supporting the professional services, data networking, and systems integration businesses. Mr. Gabrielli received his Bachelor of Science
degree in Economics and Finance from Bentley College.



Kiyoshi Abe has served as our general manager of ViryaNet Japan since February 2004. Mr. Abe joined ViryaNet in November 1998, and during the past six years, was responsible for professional services and pre-sales activities in
Japan. Prior to joining ViryaNet, Mr. Abe was a business consultant in the Financial Services Group at Accenture, providing consulting services to Banking, Insurance, and Securities companies. Mr. Abe has a Bachelor of Science degree in Biology from
Kobe University in Japan.



Mark Hosking joined the
Company in June 2005 from e-Wise Solutions and currently serves as the general manager of ViryaNet Australia. Mr. Hosking founded e-Wise Solutions in June 1998 and served as the chief executive officer and chief technical officer. Prior to the
founding of e-Wise Solutions, Mr. Hosking was a senior manager at Ipex Computers Australia, a systems integrator that grew from 40 to 450 employees during his tenure. Mr. Hosking holds a Bachelor of Science degree in Electrical Engineering from
Melbourne University of Victoria, Australia.



Vladimir
Morgenstern co-founded the Company with Mr. HaCohen. He has served as one of the Companys directors since July 1999. Mr. Morgenstern currently serves as a business and technology advisor to several start-up companies. From November 1999
until October 2001, Mr. Morgenstern served as the Companys executive vice president, corporate programs. Mr. Morgenstern served as the Companys technical manager and chief technology officer from March 1988 until November 1999. Before
co-founding ViryaNet, Mr. Morgenstern held senior systems management positions at John Bryce Systems Ltd. and the Hadassah Hospital, Jerusalem. Mr. Morgenstern holds a Bachelor of Science degree in physics from Vilnius University in Lithuania and
has completed all course work for a Master of Science degree in applied mathematics.



Peter Gyenes has served as one of our directors since September 2002. Mr. Gyenes currently serves as the chief executive officer of Ascential Software, an IBM company. Mr. Gyenes has more than 30 years of
experience in sales, marketing and general management positions within the computer systems and software industry. Mr. Gyenes was formerly Chief Executive Officer of Informix Corporation and led the sale of its database business to IBM and the
subsequent transition from Informix to Ascential. Prior to Informixs acquisition of Ardent Software, Inc., he was chairman, president and Chief Executive Officer of Ardent, which he joined in 1996. Before joining Ardent, he was the president
and Chief Executive Officer of Racal Interlan, Inc. Previously, Mr. Gyenes served in executive sales, marketing, and general management positions at Data General Corporation, Encore Computer Corporation and Prime Computer, Inc. He serves on the
boards of Applix Computer Systems (NASDAQ: APLX), Axis Computer Systems, and the Massachusetts Software and Internet Council. Mr. Gyenes received a Bachelor of Arts degree in Mathematics and a Masters of Business Administration from Columbia
University.



Manuel Sanchez Ortega has served as
a director of ViryaNet since October 2003. Mr. Sanchez currently serves as the chairman and chief executive officer of Telvent GIT, S.A. (Nasdaq: TLVT), a global information technology company based in Madrid, Spain. From 2000 to 2001, Mr. Sanchez
was the general manager of Telvent Energia Y Medio Ambiente, a subsidiary of Telvent focused on the energy and environmental markets. From 1995 to 1999, Mr. Sanchez was the general manager for Telvent Mexico. Prior to his employment with Telvent
Mexico, Mr. Sanchez served as a manager in Telvent Energia y Medio Ambiente. Mr. Sanchez received a Bachelor of Science degree in electrical engineering from the Universidad Pontificia Comillas (ICAI) of Madrid, and a Master in Business
Administration from the IPADE of Mexico.



Lior Bregman
has served as a director of ViryaNet since November 2003. Mr. Bregman is currently a private investor focused on identifying new trends and potential beneficiaries mostly in the technology sector as well in other special situations where in-depth
analysis could provide an edge. From 1988 to 2001 Mr. Bregman served as a Managing Director with CIBC/Oppenheimer. Mr. Bregman was involved in the development of CIBC/Oppenheimers high technology effort and was responsible for its
telecommunication equipment research effort in general and the wireless communication area in particular, as well as its research on defense and Israeli companies. Mr. Bregmans work was recognized by the Wall Street Journal and Institutional
Investor All Star



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surveys. Until 2001 Mr. Bregman was also a partner in Genesis I, an Israeli-based venture capital fund, and also served
on the investment committee of Genesis II. Prior to joining CIBC/Oppenheimer, he served as a research analyst at Hambrecht & Quist. Mr. Bregman also serves as a member of the board of directors for Team Telecom International Ltd. (TTI). Mr.
Bregman received his MBA from Stanford University in 1986, and his BA from the Hebrew University of Jerusalem.



Ronit Lerner has served as a director of ViryaNet since November 2003. Ms. Lerner currently serves as the chief financial officer of BMC Software
Israel Ltd., a subsidiary of BMC Software, Inc. Prior to BMC, Ms. Lerner served as the director of mergers, acquisitions and accounting for ECI Telecom from 2000 until July 2002. Ms. Lerner joined the Israel accounting standards board, an affiliate
of the Israel Securities Authority, at its inception in 1997 and served as a manager and senior research supervisor. During the period of 1996 to 2004, Ms. Lerner taught accounting at the Tel Aviv Univesity. From 1994 to 1997, Ms. Lerner served as a
senior manager at KPMG. Ms. Lerner received a Bachelor of Arts degree in Business Administration and Accounting from Tel Aviv Management College and received a Master in Business Administration in Finance, with honors, from Bar Ilan University. Ms.
Lerner is a certified public accountant in Israel.



Compensation



The aggregate
remuneration we paid for the year ended December 31, 2004 to our directors and executive officers as a group was $1,169,257 in salaries, fees, commissions and bonuses. Included in this amount is remuneration of $282,802 to two of our former
executive officers. There were no amounts set aside or accrued to provide for pension, retirement or similar benefits to our directors and executive officers. We have entered into executive incentive bonus or commission plans with all of our
executive officers.



On November 26, 2003, our shareholders
approved a compensation plan for our directors who are not executive officers. Any non-executive director attending any of the five (5) scheduled meetings of the Board of Directors is entitled to receive $1,000 for each meeting attended in person,
or $500 for each meeting attended by phone only. Participation in all other meetings of the Board of Directors or the audit committee does not entitle any director to additional compensation. All directors are reimbursed for their expenses incurred
for each Board of Directors or committee meeting attended. With respect to our external directors, such compensation and reimbursement of expenses are made in accordance with the applicable provisions of our Companies Law. For additional
information, please see the discussion under the heading External Directors; Independent Directors.



During 2004, options to purchase 198,000 Ordinary Shares were granted to our directors and executive officers. Options granted to our directors were
approved by our shareholders. Included in this amount are options to purchase 30,000 Ordinary Shares granted to a former director and executive officer who continues to provide services to us. The weighted average exercise price of these options was
$2.25 per share, with quarterly vesting over two years for 180,000 options, and annual vesting over four years for 18,000 options. All options were issued pursuant to our 1999 Stock Option and Incentive Plan.



In January 2002, certain directors and executive officers of ViryaNet
tendered and irrevocably canceled options to purchase a total of 249,500 Ordinary Shares of ViryaNet previously granted to such directors and executive officers. In September 2002, ViryaNets Board of Directors approved the grant of replacement
options to such directors and executive officers, ViryaNets shareholders approved the grant of replacement options to such directors, and such replacement options were granted.



Board Practices



The following
table sets forth certain information concerning our current directors and executive officers:



|                         |  |                                              |  |                        |  |                                   
|------------------------ |  | -------------------------------------------- |  | ---------------------- |  | ----------------------------------
|Name                     |  | Current Office(s) Held                       |  | Commencement of Office |  | Termination/Renewal Date of Office
|Samuel I. HaCohen        |  | Executive Chairman of the Board of Directors |  | March 1998             |  | 2005 Annual Meeting               
|Paul V. Brooks           |  | President and Chief Executive Officer        |  | November 2005          |  | Not applicable                    
|Albert A. Gabrielli      |  | Chief Financial Officer                      |  | April 2001             |  | Not applicable                    
|Kiyoshi Abe              |  | General Manager, ViryaNet Japan              |  | January 2004           |  | Not applicable                    
|Mark Hosking             |  | General Manager, ViryaNet Australia          |  | June 2005              |  | Not applicable                    
|Vladimir Morgenstern     |  | Director                                     |  | July 1999              |  | 2005 Annual Meeting               
|Peter Gyenes (1),(2),(3) |  | Director                                     |  | September 2002         |  | 2005 Annual Meeting               
|Manuel Sanchez Ortega    |  | Director                                     |  | October 2003           |  | 2005 Annual Meeting               
|Lior Bregman (2),(3)     |  | Director                                     |  | November 2003          |  | 2005 Annual Meeting               
|Ronit Lerner (1),(2),(3) |  | Director                                     |  | November 2003          |  | 2006 Annual Meeting               

---

|(1) | External Directors under the Companies Law
|--- | ------------------------------------------



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|(2) | Member of Audit Committee
|--- | -------------------------

|(3) | Independent Directors
|--- | ---------------------



Other than our employment agreement with Mr. HaCohen, we do not have any employment or service contracts with our directors that provides for benefits
upon termination of employment. Mr. HaCohens employment agreement contains various provisions, including provisions relating to acceleration of his options to purchase our Ordinary Shares upon a change in the control of our company. In
addition, he is entitled to 6 months of severance benefits in the event we terminate his employment without cause, under the circumstances provided in his employment agreements or in the event that he resigns due to a demotion.



Our Articles of Association provide that directors are elected at our annual
general meeting of the shareholders by a vote of the holders of a majority of the voting power represented at that meeting. Each director, except for the external directors as described below, holds office until the next annual general meeting of
the shareholders.



External Directors; Independent Directors



Israeli Companies Law



We are subject
to the provisions of the Israeli Companies Law. Under the Companies Law, companies incorporated under the laws of Israel whose shares have been offered to the public in or outside of Israel, are required to appoint at least two external directors.
Mr. Gyenes and Ms. Lerner serve as our External Directors.



Who May Be Appointed



A person may not
be appointed as an external director if the person or the persons relative, partner, employer or any entity under the persons control, has, as of the date of the persons appointment to serve as external director, or had, during the
two years preceding that date, any affiliation with the company, any entity or person controlling the company or any entity controlled by the company or by a controlling shareholder of the company. The term affiliation includes:



| |  |  | an employment relationship;
| | - |  | ---------------------------



| |  |  | a business or professional relationship maintained on a regular basis;
| | - |  | ----------------------------------------------------------------------



| |  |  | control; and
| | - |  | ------------



| |  |  | service as an office holder.
| | - |  | ----------------------------



Under recent amendments to the Companies Law, at least one of the external directors serving on a companys board of directors is required to have
financial expertise and the other external director or directors are required to have professional expertise. The definition of each of these terms is to be determined under relevant regulations, which have not yet been
published.



Conflicts of Interest



No person can serve as an external director if the persons position or
other business creates, or may create, conflicts of interests with the persons responsibilities as an external director or may impair his ability to serve as an external director. Until the lapse of two years from termination of office of an
external director, for any reason, a company may not engage such former external director to serve as an office holder and cannot employ or receive services from that person, either directly or indirectly, including through a corporation controlled
by that person.



How External Directors Are Elected



External directors are generally elected by a
majority vote at a shareholders meeting, provided that either:



| | (a) | the majority of the shares voted at the meeting, including at least one third of the shares of non-controlling shareholders or their representatives voted at the meeting, vote in
favor of the election; or
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | (b) | the total number of shares of non-controlling shareholders voted against the election of an external director does not exceed one percent of the aggregate voting rights in the
company.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Term of Service



The initial term of an external director is three
years and may be extended by the shareholders for an additional three years. If, when we elect an external director, all of our directors are of the same gender, then the next external director must be of the other gender. Each committee exercising
powers of the Board of Directors is required to include at least one external director and the audit committee of the Company is required to include all external directors.



Independent Directors



Our Ordinary Shares are currently listed for quotation on The Nasdaq SmallCap Market and are subject to the rules of The
Nasdaq SmallCap Market applicable to quoted companies. Under the Nasdaq rules, we are required to appoint a minimum of three independent directors. The independence standard under the Nasdaq rules excludes any person who is a current or former
employee of a company as well as the immediate family members of an executive officer of a company. Messrs. Bregman, Gyenes, and Ms. Lerner serve as independent directors and meet the independence standard of the Nasdaq rules.



Audit Committee



Nasdaq Rules and Israeli Companies Law



Our Board of Directors has formed an audit committee. The audit committee exercises the powers of the Board of Directors for
our accounting, reporting and financial control practices. Under the Companies Law, both of the External Directors should be members of the Audit Committee. Messrs. Bregman and Gyenes, and Ms. Lerner are members of our audit committee.



Under the Nasdaq rules, we are required to form an audit committee
consisting of at least three independent directors. The responsibilities of the audit committee under the Nasdaq rules include evaluating the independence of a companys outside auditors. Our current audit committee complies with the Nasdaq
rules. Under the Companies Law, the Board of Directors of any company that is required to nominate external directors must also appoint an audit committee. The Companies Law requires that the audit committee be comprised of at least three directors,
including all of the external directors, but excluding:



| |  |  | a chairman of the Board of Directors;
| | - |  | -------------------------------------



| |  |  | a controlling shareholder or the relative of a controlling shareholder; or
| | - |  | --------------------------------------------------------------------------



| |  |  | any director employed by the company, or who provides services to the company on a regular basis.
| | - |  | -------------------------------------------------------------------------------------------------



Role of Audit Committee



The roles of our audit committee under the Companies Law include identifying irregularities in the management of the companys business and approving
related party transactions as required by law. The responsibilities of the audit committee under the Nasdaq rules include, among other things, evaluating the independence of a companys outside auditors.



In addition to such functions as the audit committee may have under the
Companies Law or under the Nasdaq rules, the primary purpose of our audit committee is to assist the board of directors in fulfilling its responsibility to oversee managements conduct of the financial reporting process, the systems of internal
accounting and financial controls and the annual independent audit of the companys financial statements. The audit committee reviews with management and our outside auditors the audited financial statements included in our Annual Report on
Form 20-F and our interim quarterly financial results included on Form 6-K.



The audit committee must observe the independence of our outside auditors and has the authority and responsibility to nominate for shareholder approval, evaluate and, where appropriate, replace our outside auditors.



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In discharging its oversight role, our audit committee is empowered to investigate any matter brought to
its attention with full access to all books, records, facilities and personnel of our company and the power to retain outside counsel, auditors or other experts for this purpose.



Conflicts of Interest



An audit committee of a public company may not approve an action or a transaction with an interested party, an office
holder, a controlling shareholder, or an entity in which they have a personal interest unless at the time of approval the two external directors are serving as members of the audit committee and at least one of the external directors was present at
the meeting in which an approval was granted. Our external directors are members of our audit committee.



Employees



As of December 31,
2004, we had 43 employees in Israel, 76 in the United States, and 8 in Japan. Of our 126 employees, 25 were engaged in research and development, 24 in sales, marketing and business development, 63 in professional services and technical support and
14 in finance, administration and operations. None of our employees is represented by a labor union.



We are not a party to any collective bargaining agreement with our employees. However, some provisions of the collective bargaining agreement between the
Histadrut, the General Federation of Labor in Israel, and the Coordination Bureau of Economic Organizations, including the Industrialists Association of Israel, are applicable to our Israeli employees under expansion orders of the Israeli
Ministry of Labor and Welfare. These provisions principally concern the length of the work day and the work week, minimum wages for workers, contributions to pension funds, insurance for work-related accidents, procedures for dismissing employees
and determination of severance pay. Under these provisions, the wages of most of our employees are automatically adjusted based on changes in the Israeli consumer price index. The amount and frequency of these adjustments are modified occasionally.
We consider our relationship with our employees to be good and have never experienced a strike or work stoppage.



We have to comply with various labor and immigration laws throughout the world, including laws and regulations in Israel, the United States and Japan.
Compliance with these laws has not been a material burden for us. If the number of our employees increases over time, our compliance with these regulations could become more burdensome.



Share Ownership



As of June 1,
2005, the aggregate number of our Ordinary Shares beneficially owned by our directors and executive officers as a group was 1,584,545, and includes options and warrants to purchase up to 269,284 Ordinary Shares which are exercisable or will become
exercisable within 60 days of June 1, 2005. The aggregate number of our Ordinary Shares beneficially owned by our directors and executive officers as a group includes Ordinary Shares held by Telvent since an affiliate of Telvent serves on our Board
of Directors and, accordingly, such designee may be deemed to be the beneficial owner of the Ordinary Shares held by Telvent. Such designee disclaims beneficial ownership of such shares. See Major Shareholders and Related Party
Transactions in Item 7 below.



As of June 1, 2005,
options to purchase up to 385,979 Ordinary Shares granted to our directors and executive officers were outstanding under our option plans. The weighted average exercise price of these options was $1.92 per share. From these options, options to
purchase 252,979 Ordinary Shares granted to our directors and executive officers are exercisable or will become exercisable within 60 days of June 1, 2005.



As of June 1, 2005, there were approximately 900 shareholders of record.



Option Plans



We maintain four option plans, the 1996 Stock Option and Incentive Plan, the 1997 Stock Option and Incentive Plan, the 1998
Stock Option and Incentive Plan and the 1999 Stock Option and Incentive Plan.



The purpose of the option plans is to afford an incentive to our officers, directors, employees and consultants, or any of our subsidiaries, to acquire a proprietary interest in us, to continue as officers, directors,
employees and consultants, to increase their efforts on behalf of ViryaNet and to promote the success of our business.



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The 1996 Stock Option and Incentive Plan



In 1996, we adopted the 1996 Stock Option and Incentive Plan and reserved
options to purchase an aggregate of 140,000 Ordinary Shares for issuance. As of June 1, 2005, options to purchase 15,490 Ordinary Shares were outstanding under the 1996 Stock Option and Incentive Plan and options to purchase 30,731 Ordinary Shares
were exercised into Ordinary Shares. The 93,779 Ordinary Shares that were available for grants of additional options were transferred to the 1999 Stock Option and Incentive Plan. The exercise prices of options granted under the 1996 Stock Option and
Incentive Plan range from $6.11 to $10.00.



The 1997
Stock Option and Incentive Plan



In 1997, we adopted
the 1997 Stock Option and Incentive Plan and reserved options to purchase an aggregate of 50,000 Ordinary Shares for issuance. As of June 1, 2005, options to purchase 325 Ordinary Shares were outstanding under the 1997 Stock Option and Incentive
Plan and options to purchase 7,990 Ordinary Shares were exercised into Ordinary Shares. The 41,685 Ordinary Shares that were available for grants of additional options were transferred to the 1999 Stock Option and Incentive Plan. The exercise price
of the options granted under the 1997 Stock Option and Incentive Plan is $23.00.



The 1998 Stock Option and Incentive Plan



In 1998, we adopted the 1998 Stock Option and Incentive Plan and reserved options to purchase an aggregate of 150,000 Ordinary Shares for issuance. As of June 1, 2005, options to purchase 6,900 Ordinary Shares were
outstanding under the 1998 Stock Option and Incentive Plan and options to purchase 950 Ordinary Shares were exercised into Ordinary Shares. The 142,150 Ordinary Shares that were available for grants of additional options were transferred to the 1999
Stock Option and Incentive Plan. The exercise prices of the options granted under the 1998 Stock Option and Incentive Plan range from $10.00 to $39.00.



The 1999 Stock Option and Incentive Plan



In 1999, we adopted the 1999 Stock Option and Incentive Plan and reserved options to purchase an aggregate of 300,000 Ordinary Shares for issuance and
transferred an additional 277,614 Ordinary Shares to the 1999 Stock Option and Incentive Plan from the 1996 Stock Option and Incentive Plan, the 1997 Stock Option and Incentive Plan and the 1998 Stock Option and Incentive Plan.



In June 2001, November 2003, and December 2004, our shareholders approved the
reservation of options to purchase additional Ordinary Shares in the amounts of 300,000, 200,000, and 350,000, respectively, for an aggregate additional amount of 850,000 Ordinary Shares to be granted under the 1999 Stock Option and Incentive Plan.



As of June 1, 2005, options to purchase 1,131,616 Ordinary
Shares were outstanding under the 1999 Stock Option and Incentive Plan, options to purchase 178,794 Ordinary Shares were exercised into Ordinary Shares and 179,590 additional Ordinary Shares were available for grants of additional options. The
exercise prices of the options granted under the 1999 Stock Option and Incentive Plan range from $1.59 to $120.00.



Administration of Our Option Plans



Our option plans are administered by the Board of Directors. Under the option plans, options to purchase our Ordinary Shares may be granted to the
officers, directors, employees or consultants of ViryaNet or of any of our subsidiaries. Under the option plans, the exercise price of options shall be determined by the Board of Directors. The vesting schedule of the options is also determined by
the Board of Directors but generally the options vest over a two to four year period. Each option granted under the option plans is exercisable, unless extended, until seven years from the date of the grant of the option. The 1996 Stock Option and
Incentive Plan, the 1997 Stock Option and Incentive Plan, the 1998 Stock Option and Incentive Plan and the 1999 Stock Option and Incentive Plan will expire on December 31, 2005, 2006, 2007 and 2008, respectively.



In March 2002, we granted 95,365 options to employees that participated in
the option exchange program and were employed by the Company at the time of the grant (certain employees who previously tendered their options under the stock option exchange program were not employed by the Company in March 2002 and thus were not
eligible for the issuance of replacement options). Each new option has the same vesting commencement date and vesting schedule as the option for which it was exchanged. The exercise price of each new option was based on the fair market value of our
Ordinary Shares at the time of grant, which was $5.60.



In
September 2002, we granted 310,260 options to certain directors, consultants and employees of ViryaNet that voluntarily terminated certain stock option grants during January 2002. The exercise price of each new replacement option was based on the
fair market value of our Ordinary Shares at the time of grant, which was $1.64.



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Item 7.Major Shareholders and Related Party Transactions



Major Shareholders



The following
table summarizes information about the beneficial ownership of our outstanding Ordinary Shares as of June 1, 2005 for each person or group that we know owns more than 5% of our Ordinary Shares.



We determine beneficial ownership of shares under the rules of the Securities
and Exchange Commission and include any Ordinary Shares over which a person exercises sole or shared voting or investment power, or of which a person has the right to acquire ownership at any time within 60 days of June 1, 2005. Except as otherwise
indicated, and subject to applicable community property laws, the persons named in the table have sole voting and investment power for all Ordinary Shares held by them. Applicable percentage ownership in the following table is based on 6,096,944
Ordinary Shares outstanding as of June 1, 2005



Ordinary
Shares Beneficially Owned



|                                                                                                                                                         |  |           |  |                  |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------- |  | ---------------- | -
|Name and Address                                                                                                                                         |  | Number    |  | Percent of Class |  
|Telvent Investments, S.L. (1) Valgrande 6 28108 Alcobendas Madrid, Spain                                                                                 |  | 1,132,167 |  | 18.5             | %
|                                                                                                                                                         |  |          
|LibertyView Special Opportunities Fund, LP (2) LibertyView Capital Management Neuberger Berman, LLC 111 River Street  Suite 1000 Hoboken, NJ 07030-5776 |  | 870,052   |  | 13.0             | %
|                                                                                                                                                         |  |          
|The Clal Group (3) Kiriat Atidim Ramat Hachayal P.O. Box 61581, Tel Aviv 58177 Israel                                                                    |  | 510,455   |  | 8.3              | %
|                                                                                                                                                         |  |          
|Vertex Venture Capital Israel Funds (4) 1 Hashikma Street Savyon 56530 Israel                                                                            |  | 424,960   |  | 6.9              | %
|                                                                                                                                                         |  |          
|All directors and executive officers as a group (10 persons)(5)                                                                                          |  | 1,584,545 |  | 24.9             | %

---

|(1) | Includes options to purchase 11,250 Ordinary Shares exercisable within 60 days of June 1, 2005, held by Manuel Sanchez Ortega, a director of our company and the chief executive
officer of Telvent, whose rights have been assigned to Telvent.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Includes (i) 259,773 Ordinary Shares, (ii) warrants to purchase 28,830 Ordinary Shares exercisable within 60 days of June 1, 2005, and (iii) 581,449 Ordinary Shares for which the
$2.5 million convertible note issued to LibertyView may be converted at any time at a fixed conversion price of $4.2996 per Ordinary Share.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Includes
|--- | --------

| |  |  | 75,382 Ordinary Shares and warrants to purchase 1,584 Ordinary Shares exercisable within 60 days of June 1, 2005, held by Clal Venture Capital;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Warrants to purchase 1,584 Ordinary Shares exercisable within 60 days of March 1, 2004, held by Clalit;
| | - |  | -------------------------------------------------------------------------------------------------------

| |  |  | 138,301 Ordinary Shares and warrants to purchase 3,661 Ordinary Shares exercisable within 60 days of June 1, 2005, held by Clal Industries and Investments; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 139,851 Ordinary Shares and warrants to purchase 3,661 Ordinary Shares exercisable within 60 days of June 1, 2005, held by Clal Electronics Industries;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 3,635 Ordinary Shares held by Clal Finance Batucha Investment;
| | - |  | --------------------------------------------------------------

| |  |  | 53,709 Ordinary Shares and warrants to purchase 8,198 Ordinary Shares exercisable within 60 days of June 1, 2005, held by FBR Infinity II Venture Israel LP, which may be deemed an
affiliate of the Clal Group;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | 50,511 Ordinary Shares and warrants to purchase 7,711 Ordinary Shares exercisable within 60 days of June 1, 2005, held by FBR Infinity II Venture LP, which may be deemed an
affiliate of the Clal Group;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 19,665 Ordinary Shares and warrants to purchase 3,002 Ordinary Shares exercisable within 60 days of June 1, 2005, held by FBR Infinity II Venture LP, which may be deemed an
affiliate of the Clal Group;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Includes:
|--- | ---------

| |  |  | 49,330 Ordinary Shares and warrants to purchase 7,530 Ordinary Shares exercisable within 60 days of June 1, 2005, held by Vertex Israel II (A) Fund L.P.;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 273,451 Ordinary Shares and warrants to purchase 41,742 Ordinary Shares exercisable within 60 days of June 1, 2005, held by Vertex Israel II (C.I.) Fund L.P.;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 7,558 Ordinary Shares and warrants to purchase 1,153 Ordinary Shares exercisable within 60 days of June 1, 2005, held by Vertex Israel II (B) Fund L.P.;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 34,914 Ordinary Shares and warrants to purchase 5,330 Ordinary Shares exercisable within 60 days of June 1, 2005, held by Vertex Israel II Discount Fund L.P.;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 3,429 Ordinary Shares and warrants to purchase 523 Ordinary Shares exercisable within 60 days of June 1, 2005, held by Vertex Israel II (CI) Executive Fund L.P.;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Also includes options granted to our directors and executive officers which are exercisable within 60 days of June 1, 2005. This number includes Ordinary Shares held by Telvent
since an affiliate of Telvent serves on our Board of Directors and, accordingly, such designee may be deemed to be the beneficial owner of the Ordinary Shares held by Telvent. Such designee disclaims beneficial ownership of such shares. Excludes
Ordinary Shares held by Mark Hosking as a result of our acquisition of e-Wise Solutions.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Our shareholders do not have different voting rights.



Related Party Transactions



Registration Rights



On February 25,
2002 we entered into a Registration Rights Agreement with the former shareholders of iMedeon. Under this agreement, holders of 510,055 Ordinary Shares have the right, starting as of August 25, 2002 and only under certain circumstances, to require us
to register their Ordinary Shares for sale. Under this agreement such shareholders were also granted piggyback rights subject to certain terms and conditions.



On November 4, 2003 we entered into a Registration Rights Agreement with the participants of a private financing that raised
approximately $1.8 million for the Company. Under the terms of this agreement, we have agreed to file a registration statement with the SEC covering the resale of the Ordinary Shares from this transaction within six months following the closing of
the investment, subject to certain terms and conditions.



On
December 5, 2003 we entered into a Registration Rights Agreement with the participants of a private financing that raised approximately $2.2 million for the Company. Under the terms of this agreement, we have agreed to file a registration statement
with the SEC covering the resale of the Ordinary Shares from this transaction within six months following the closing of the investment, subject to certain terms and conditions.



On July 27, 2004, we entered into a Registration Rights Agreement with LibertyView in connection with a Convertible Note
financing that raised approximately $2.5 million for the Company. For discussion of the terms of such registration rights, please see Sources of Cash in Item 5 above.



On July 29, 2004, we entered into a Stockholders Agreement with the former shareholders of Utility Partners. Under this
agreement, we agreed to use best efforts to, within 90 days after the closing date, file with the SEC a registration statement covering all stock consideration. On February 18, 2005, we entered into a Registration Rights Agreement with Telvent
Investments, S.L. in connection with a private financing that raised approximately $1.3 million. Under the terms of this agreement, we have agreed to use best efforts to file a registration statement with the SEC covering the resale of the Ordinary
Shares from this transaction after receipt of a written request from Telvent. We have also provided Telvent with piggyback rights subject to certain terms and conditions.



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Insurances Policies with Clal Credit Insurance and Clal Insurance



During the period 2002 through 2004, we purchased several insurance policies
with Clal Credit Insurance and Clal Insurance, both of which are affiliated wth The Clal Group, which is our shareholder as set forth above. All of these insurance policies were contracted on an arms-length basis and include the following items:



2002  Errors and omissions insurance, fire and general
liability insurance, employers liability insurance, credit insurance, keyman insurance and travel insurance, for payments that total approximately $100,000.



2003  Errors and omissions insurance, fire and general liability insurance, employers liability insurance, and
keyman insurance, for payments that total approximately $70,000.



2004  Fire and general liability insurance, employers liability insurance, and keyman insurance for payments that total approximately $8,000.



Insurance Settlement with Clal Insurance



On March 18, 2003, we entered into a settlement agreement with Clal Insurance, an entity affiliated with The Clal Group
which is our shareholder as set forth above. Under the settlement agreement, Clal Insurance paid us an amount of $350,000 as a final settlement of its liability to us under the insurance provided by it to us in relation to the receivables under a
license transaction that we had with Viasource Communications.



Consulting Agreement with a Director



On July 21, 2003, the Board of Directors and audit committee approved an agreement with Vladimir Morgenstern, a director of our Company, to provide project management services to us in connection with our engagements with high profile
customers and prospects. The compensation provided under the terms of this agreement is based on the average compensation provided to employees providing similar services to us.



Loans



In June 1999, the Board of Directors issued Mr. HaCohen 17,390 Series C-2 Preferred Shares, in consideration of $100,000, which we loaned to Mr. HaCohen.
The loan was approved by the shareholders in June 2000 and bears an annual interest at the rate of 6.5%. As of June 1, 2005, the outstanding loan amount was $149,542. Repayment of the loan is due when Mr. HaCohen sells or otherwise disposes of the
shares subject to the loan. In addition, the Company, at its sole discretion, may call for immediate payment of the loan and the interest thereon in the event that (i) Mr. HaCohen becomes bankrupt or files a motion for bankruptcy, or (ii) Mr.
HaCohen ceases to remain in the employment of the Company for any reason.



On May 28, 2001, we entered into a loan agreement with Mr. Burke for a principal sum of $52,000. Under the loan agreement, as amended, repayment of such loan amount by Mr. Burke (together with an interest equal to the
applicable Federal Rate as published by the IRS on the date of the loan agreement) shall be made upon the earlier to occur of: (i) May 28, 2005, (ii) termination of Mr. Burkes employment with ViryaNet, or (iii) such time as Mr. Burke elects to
repay the loan. In addition, under the loan agreement Mr. Burke shall not be required to repay any outstanding loan amount in the event that his employment with the Company is terminated by the Company without cause. On May 16, 2005, after Mr.
Burkes resignation from the Board and concurrently with the entrance into a part-time employment with Mr. Burke, we extended the repayment date for the loan to May 28, 2006.



Commercial Transactions with Telvent



On June 30, 2004, we entered into a value added reseller agreement with Telvent, under which Telvent became a non-exclusive
reseller of our products at normal reseller terms.



On December
1, 2004, we entered into an agreement with Telvent under which Telvent provides us with certain technical consulting services on a time and materials basis, relating to our agreement with our customer, Las Vegas Valley Water.



Directors and Officers Insurance



We have obtained directors and officers liability insurance for the benefit
of our directors and office holders and intend to continue and obtain such insurance and pay all premiums thereunder to the fullest extent permitted by the Companies Law.



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Indemnification of Office Holders



Our Articles of Association provide that we may indemnify an office holder
against:



| |  |  | a financial liability imposed on him/her in favor of another person by any judgment, including a settlement or an arbitrators award approved by a court concerning an act
performed in his/her capacity as an office holder;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | reasonable litigation expenses, including attorneys fees, expended by the office holder or charged to him/her by a court in proceedings we institute against him/her,
instituted on our behalf, or instituted by another person, in each case relating to an act performed in his/her capacity as an office holder; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | reasonable litigation expenses relating to an act performed in his/her capacity as an office holder, including attorneys fees, expended by the office holder or charged to
him/her by a court in a criminal proceeding from which he/she was acquitted, or a criminal proceeding in which he/she was convicted for a criminal offense that does not require proof of intent.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Our Articles of Association also include:



| |  |  | authorization to undertake, in advance, to indemnify an office holder, provided that the undertaking is limited to specified events which the board of directors believes are
anticipated and limited in amount determined by the board of directors to be reasonable under the circumstances; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | authorization to indemnify retroactively an office holder.
| | - |  | ----------------------------------------------------------



We have agreed to indemnify our office holders under indemnification agreements with each office holder. We have also exempted and agreed to indemnify our
office holders from liabilities resulting from acts performed by them in their capacity as an officer holder to the maximum extent permitted under the Companies Law.



Interests of Experts and Counsel



Not applicable.



Item 8.Financial Information



Consolidated Statements and Other Financial Information



See Item 18 Financial Statements and included herein by reference.



Legal Proceedings



We
are not involved in any legal proceedings that we believe, individually or in the aggregate, will have a material adverse effect on the Company.



Dividend Distribution Policy



We have never declared or paid dividends to our shareholders and we do not intend to pay dividends in the future. We anticipate that we will retain all of
our future earnings, if any, for use in the expansion and operation of our business and, therefore, do not expect to pay any dividends in the future.



Significant Changes



Not
applicable.



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Item 9.The Offer and Listing



Market Price Information



Through
December 31, 2004, the high and low reported sales prices for our Ordinary Shares were as follows:



|                       |  |      |       |     |   |      
|---------------------- |  | ---- | ----- | --- | - | -----
|Period                 |  | High |       | Low
|Year ending            |  |      |       |     |   |      
|December 31, 2004      |  | $    | 6.50  |     | $ | 1.92 
|December 31, 2003      |  |      | 7.80  |     |   | 0.30 
|December 31, 2002      |  |      | 6.90  |     |   | 0.746
|                       |  |     
|Quarters ending:       |  |      |       |     |   |      
|2005                   |  |      |       |     |   |      
|Second Quarter, ending |  |      | 3.10  |     |   | 2.12 
|June 30, 2005          |  |      |       |     |   |      
|First Quarter, ending  |  |      | 3.50  |     |   | 2.06 
|March 31, 2005         |  |      |       |     |   |      
|                       |  |     
|2004                   |  |      |       |     |   |      
|Fourth Quarter, ending |  |      | 3.59  |     |   | 2.11 
|December 31, 2004      |  |      |       |     |   |      
|Third Quarter, ending  |  |      | 4.35  |     |   | 1.92 
|September 30, 2004     |  |      |       |     |   |      
|Second Quarter, ending |  |      | 6.33  |     |   | 4.25 
|June 30, 2004          |  |      |       |     |   |      
|First Quarter, ending  |  |      | 6.50  |     |   | 4.92 
|March 31, 2004         |  |      |       |     |   |      
|                       |  |     
|2003                   |  |      |       |     |   |      
|Fourth Quarter, ending |  |      | 7.80  |     |   | 2.75 
|December 31, 2003      |  |      |       |     |   |      
|Third Quarter, ending  |  |      | 4.15  |     |   | 0.80 
|September 30, 2003     |  |      |       |     |   |      
|Second Quarter, ending |  |      | 1.13  |     |   | 0.30 
|June 30, 2003          |  |      |       |     |   |      
|First Quarter, ending  |  |      | 0.92  |     |   | 0.32 
|March 31, 2003         |  |      |       |     |   |      
|                       |  |     
|2002                   |  |      |       |     |   |      
|Fourth Quarter, ending |  |      | 1.33  |     |   | 0.746
|December 31, 2002      |  |      |       |     |   |      
|Third Quarter, ending  |  |      | 4.339 |     |   | 1.30 
|September 30, 2002     |  |      |       |     |   |      
|Second Quarter, ending |  |      | 6.20  |     |   | 3.00 
|June 30, 2002          |  |      |       |     |   |      
|First Quarter, ending  |  |      | 6.90  |     |   | 4.10 
|March 31, 2002         |  |      |       |     |   |      
|                       |  |     
|Most Recent 6 months   |  | High |       | Low
|June 2005              |  |      | 2.84  |     |   | 2.12 
|May 2005               |  |      | 2.85  |     |   | 2.25 
|April 2005             |  |      | 3.10  |     |   | 2.30 
|March 2005             |  |      | 2.60  |     |   | 2.06 
|February 2005          |  |      | 2.55  |     |   | 2.21 
|January 2005           |  |      | 3.50  |     |   | 2.08 



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Markets on Which Our Ordinary Shares Trade



Our Ordinary Shares were listed on The Nasdaq National Market on September 19, 2000, under the symbol VRYA. Prior to September 19, 2000, there was no public market for our Ordinary Shares. On October 29,
2001 our Ordinary Shares were listed for trading on TASE as well, and were delisted from trading on the TASE on June 3, 2004.



On September 5, 2002, we were notified by The Nasdaq National Market that we were not in compliance with Marketplace Rule 4450(a)(2) by failing to
maintain a minimum market value of $5,000,000 for our publicly held shares and had until December 4, 2002 to regain compliance. Due to the economic and market conditions affecting our valuation, we concluded that we would request a transfer of our
securities listing from The Nasdaq National Market to The Nasdaq SmallCap Market. The transfer was approved on December 20, 2002, and our trading on The Nasdaq SmallCap Market began on December 31, 2002. For further information, see Risk
Factors - We may not be able to maintain compliance with the listing rules of The Nasdaq SmallCap Market in which case our shares would be delisted, which could adversely affect the market price and trading market of our Ordinary Shares.



Item 10.Additional Information



Share Capital



Not applicable.



Memorandum and Articles of Association



Companys Objectives



The
Companys objectives, as set forth in section 3 of our Articles of Association, are to carry on any business and do any act, which is not prohibited by law. We may also make contributions of reasonable sums to worthy purposes even if such
contributions are not made on the basis of business considerations.



Directors



Any director is entitled to
vote in a meeting of our Board of Directors, except that a director who has a personal interest in an extraordinary transaction (as defined below) which is considered at a meeting of our Board of Directors, may not be present at this
meeting or vote on this matter. An extraordinary transaction is defined in the Companies Law as a transaction that is either (i) not in the ordinary course of business; (ii) not on market terms; or (iii) that is likely to have a material
impact on the Companys profitability, assets or liabilities.



Until otherwise decided by our Board of Directors, a quorum at a meeting of our Board of Directors shall be constituted by the presence in person, by alternate or by telephone or similar communication equipment, of a majority of the
directors then in office who are lawfully entitled to participate and vote at the meeting. If within one-half hour (or within such longer time not to exceed one (1) hour, as the Chairman of the meeting, at his discretion, may decide) from the time
appointed for the convening of the board meeting, a quorum is not present, the board meeting shall stand adjourned to the same day in the next week at the same time and place (unless such day shall fall on a public holiday either in Israel or the
United States, in which case the meeting will be adjourned to the first day, not being a Friday, Saturday or Sunday, which follows such public holiday). If, at such adjourned board meeting, a quorum is not present within half an hour from the time
appointed for holding the meeting, the directors present, in person, by alternate or by telephone or similar communication equipment who are lawfully entitled to participate and vote at such meeting, shall be a quorum.



Our business is managed by the Board of Directors, which may exercise all
such company powers and perform on our behalf all such acts as may be exercised and performed by us as are not by the Companies Law or by our Articles of Association required to be exercised or done by us through a general meeting of our
shareholders. Our Articles of Association provide that the board of directors may from time to time, at its discretion, cause us to borrow or secure the payment of any sum or sums of money for the Companys purposes, and may secure or provide
for the repayment of such sum or sums in such manner, at such times and upon such terms and conditions as it deems fit, and, in particular, by the issuance of bonds, perpetual or redeemable debentures, debenture stock, or any mortgages, charges, or
other securities on the undertaking of the whole or any part of our property, both present and future, including its uncalled or called but unpaid capital for the time being.



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There is no age limit as to the ability of individuals to serve as members of our Board of Directors.



A director is not required to hold our shares as a condition
to his nomination or election as a director.



Rights
attached to our shares



All dividends shall be
declared by our Board of Directors and paid in proportion to the amount paid up on account of the nominal value of the Ordinary Shares in respect of which the dividend is being paid. As regards to Ordinary Shares not fully paid throughout the period
in respect of which the dividend is paid, dividends in respect thereto shall be apportioned and paid pro rata according to amounts deemed under our Articles of Association to be paid up on account of the nominal value of such shares during any
portion or portions of the period in respect of which the dividend is paid.



Under our Articles of Association, every shareholder who is present, in person, by proxy, or by written ballot or is deemed under the Companies Law to be present at a general meeting of the shareholders, shall be
entitled to one vote for each ordinary share of which he or she is the holder.



The distribution of dividends is under the discretion of our Board of Directors, which is under no obligation to distribute dividends to our shareholders out of the Companys profits.



Upon liquidation, all available surpluses, after payments of all debts, shall
be distributed to our shareholders on a pro-rata basis.



Changes of rights attached to our shares



Changes to the rights attached to our Ordinary Shares require the approval of shareholders present, in person, by proxy, or by written ballot, or deemed under the Companies Law to be present, holding greater than fifty percent (50%) of the
total voting power attached to the Ordinary Shares whose holders were present, in person, by proxy, or by written ballot, or deemed under the Companies Law to be present, at such general meeting, and voted thereon. If, at any time, the share capital
of the Company is divided into different classes of shares, the right attached to any class (unless otherwise provided by the terms of issue of the shares of that class) may be varied only upon consent of a separate general meeting of the holders of
the shares of that class and the provisions of our Articles of Association relating to general meetings shall apply to every such separate general meeting. The enlargement of an authorized class of shares, or the issuance of additional shares
thereof out of the authorized and unissued share capital, shall not be deemed to vary, modify or abrogate the rights attached to previously issued shares of such class or of any other class of shares.



General Meetings



We are required to hold an annual general shareholders meeting once in every
calendar year within a period of not more than fifteen (15) months after the last preceding annual general shareholders meeting. All general shareholders meetings other than annual general shareholders meeting are deemed to be special shareholders
meetings. Our Board of Directors may call for a general meeting whenever it sees fit, and, under the Companies Law, is required to call a general meeting upon a demand in writing by (i) a shareholder or shareholders holding at least 5% of the
outstanding shares and 1% of the voting rights in the company, or (ii) a shareholder or shareholders holding at least 5% of the voting rights in the company. Subject to applicable law and regulations, prior notice of at least 21 days of any general
shareholders meeting, specifying the place, date and hour of the meeting, shall be given to the shareholders of the Company. No business shall be transacted at any general shareholders meeting unless a quorum is present when the meeting proceeds to
business. For all purposes, the quorum shall not be less than two (2) shareholders present in person, or by proxy, or deemed by the Companies Law to be present at such meeting, holding, in the aggregate, at least, thirty-three and one-third percent
(331/3%) of the voting rights in our issued share capital. If, within half an hour from the time appointed for the meeting, a quorum is not present (or within such longer time not exceeding one (1) hour as
the Chairman of the meeting may decide), the meeting, if convened upon the requisition of the shareholders, shall be dissolved; in any other case, it shall stand adjourned to the same day in the next week at the same place and time (unless such day
shall fall on a public holiday either in Israel or the United States, in which case the meeting will be adjourned to the first day, not being a Friday, Saturday or Sunday, which follows such public holiday), or any other day, hour and/or place as
the directors shall notify the shareholders. If a quorum is not present at the second meeting within half an hour from the time appointed for the meeting, any two shareholders present personally or by proxy or any other valid instrument, shall
constitute a quorum, and shall be entitled to deliberate and to resolve in respect of the matters for which the meeting was convened.



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Ownership of our shares



Our Articles of Association and the laws of the State of Israel do not restrict in anyway the ownership or voting of our
shares by non-residents of Israel.



Change of Control



Our Articles of Association do not contain specific
provisions intended to delay, defer or prevent a change of control.



Material Contracts



We have not
entered into any material contracts other than in the ordinary course of business and other than those discussed in the Property, Plant and Equipment section, the Liquidity and Capital Resources section under Item 5 Operating and Financial
Review and Prospects, and in the Related Party Transactions section under Item 7 Major Shareholders and Related Party Transactions.



Exchange Controls



Until May
1998, Israel imposed restrictions on transactions in foreign currency. These restrictions affected our operations in various ways, and also affected the right of non-residents of Israel to convert into foreign currency amounts they received in
Israeli currency, such as the proceeds of a judgment enforced in Israel. Despite these restrictions, foreign investors who purchased shares with foreign currency were able to repatriate in foreign currency both dividends (after deduction of
withholding tax) and the proceeds from the sale of the shares. In 1998, the Israeli currency control regulations were liberalized significantly, as a result of which Israeli residents generally may freely deal in foreign currency and non-residents
of Israel generally may freely purchase and sell Israeli currency and assets. There are currently no Israeli currency control restrictions on remittances of dividends on the Ordinary Shares or the proceeds from the sale of the shares; however,
legislation remains in effect pursuant to which currency controls can be imposed by administrative action at any time.



Neither our Memorandum of Association nor our Articles of Association nor the laws of the State of Israel restrict in any way the ownership or voting of
Ordinary Shares by non-residents of Israel.



Taxation



United States
Federal Income Tax Consideration



The following
discussion describes the material United States federal income tax consequences to a person from the purchase, ownership, and disposition of our Ordinary Shares. The following discussion is based on the internal revenue code, current and proposed
treasury regulations, judicial decisions and published positions of the Internal Revenue Service, all as in effect on the date of this form, and all of which are subject to change, possibly with retroactive effect. This discussion does not address
all aspects of United States federal income taxation that may be relevant to a person based on particular circumstances. For example, the following discussion does not address the United States federal income tax consequences of the purchase,
ownership and disposition of the Ordinary Shares if the person:



| |  |  | controls or owns, directly, indirectly or through attribution 10% or more of our shares by vote or value;
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | is a broker-dealer, insurance company, tax-exempt organization, or financial institution;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | holds Ordinary Shares as part of an integrated investment comprised of Ordinary Shares and one or more other positions; or
| | - |  | --------------------------------------------------------------------------------------------------------------------------



| |  |  | has a functional currency that is not the United States dollar.
| | - |  | ---------------------------------------------------------------



The following discussion also does not address any aspect of state, local or non-United States tax laws or any aspect of United States estate or gift
taxation and does not address aspects of United States federal income taxation applicable to United States holders holding options, warrants or other rights to acquire our Ordinary Shares, or who otherwise receive our Ordinary Shares as
compensation. Further, this summary generally considers only United States holders that hold their Ordinary Shares as capital assets and does not consider the tax treatment of holders who are partnerships or who hold Ordinary Shares through a
partnership or other



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pass-through entity. This discussion also assumes that we will not be treated as a controlled foreign corporation. Under
the internal revenue code, a controlled foreign corporation generally means any foreign corporation if, on any day during its taxable year, more than fifty percent of either the total combined voting power of all classes of stock of the corporation
entitled to vote, or the total value of the stock of the corporation is owned, directly, indirectly or by attribution, by United States persons who, in turn, own directly, indirectly or by attribution, ten percent or more of the total combined
voting power of all classes of stock of the corporation entitled to vote. This discussion does not apply to any person who is not a United States holder or to any person, which holds shares other than Ordinary Shares.



For purposes of this discussion, a person is a United States holder if such
person holds Ordinary Shares and if such person is:



| |  |  | a citizen or resident of the United States;
| | - |  | -------------------------------------------



| |  |  | a partnership or a corporation or other entity taxable as a corporation organized under the laws of the United States or of any state of the United States or the District of
Columbia;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | an estate the income of which is includible in gross income for United States federal income tax purposes regardless of source; or
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



| |  |  | a trust, if a United States court is able to exercise primary supervision over its administration and one or more United States persons have the authority to control all of its
substantial decisions.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



You should be aware that
this summary is not a comprehensive description of all the tax considerations that may be relevant to your purchase, ownership or disposition of our Ordinary Shares. United States holders of our Ordinary Shares are advised to consult their own tax
advisors concerning the United States federal, state and local tax consequences, as well as the tax consequences in Israel and other jurisdictions, of the purchase, ownership and disposition of our Ordinary Shares in their particular situations.



Distributions



We have never paid dividends, and do not intend to pay dividends in the
future. In general, and subject to the discussion below, if we do make a distribution on the Ordinary Shares, the distribution will be treated as a dividend for United States federal income tax purposes to the extent of our current and accumulated
earnings and profits, as calculated under United States federal income tax principles. If the amount of the distribution exceeds our earnings and profits, the excess will first be treated as a non-taxable return of a United States holders tax
basis in the Ordinary Shares that reduces that United States holders tax basis dollar-for-dollar, and then as gain from the constructive disposition of the Ordinary Shares.



The amount received by a United States holder that is treated as a dividend for United States federal income tax purposes:



| |  |  | will be includible in the United States holders gross income;
| | - |  | --------------------------------------------------------------



| |  |  | will be subject to tax at the rates applicable to ordinary income; and
| | - |  | ----------------------------------------------------------------------



| |  |  | will not qualify for the dividends received deduction applicable in some cases to United States corporations.
| | - |  | -------------------------------------------------------------------------------------------------------------



The amount of dividend income will include the amount of Israeli taxes, if
any, withheld by us on the dividends we paid, as described below in this filing under Israeli Taxation and Investment Programs. Thus, if withholding taxes are imposed, a United States holder will be required to report income in an amount greater
than the cash or the value of other property it receives on the Ordinary Shares. However, a United States holder may be eligible to claim as a credit against its United States federal income tax liability the amount of tax withheld by us on the
dividends we paid.



The amount of foreign income taxes, which
may be claimed as a credit in any year, is subject to complex limitations and restrictions, which must be determined on an individual basis by each United States holder. In general, the total amount of allowable foreign tax credits in any year
cannot exceed the pre- credit United States tax liability for the year attributable to each of nine categories of foreign source taxable income. Dividends received by a United States holder on stock of a foreign corporation, such as our Ordinary
Shares, are generally treated as foreign source income within the category of passive income for this purpose, but are subject to being reclassified as United States source income in specific circumstances. Because distributions in excess of our
current and accumulated earnings and profits generally will not give rise to foreign source income, a person may be unable to claim a foreign



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tax credit for Israeli withholding tax imposed on the excess amount unless, subject to applicable limitations, such
person has other foreign source income. A United States holders foreign tax credit may be further limited or restricted based on that United States holders particular circumstances, including the length of time the United States holder
owned our Ordinary Shares and whether the alternative minimum tax provisions of the internal revenue code apply. If a United States holders foreign tax credit is restricted in one taxable year, the excess foreign tax credit generally can be
carried back for two taxable years and forward for five taxable years, subject to the limitations described above.



If a United States holder receives a dividend in NIS or other non-United States currency, the amount of the distribution for United States federal income
tax purposes will be the United States dollar value of the distribution determined by the spot rate of exchange on the date the distribution is received, or is treated as received. A United States holder will have a tax basis in the foreign currency
for United States federal income tax purposes equal to the United States dollar value of the foreign currency as determined under the preceding sentence. A United States holder generally will recognize exchange gain or loss upon the subsequent
disposition of the foreign currency equal to the difference between the amount realized on the disposition and the United States holders tax basis in the foreign currency. The gain or loss generally will be ordinary gain or loss and will
generally be treated as United States source gain or loss for United States federal income tax purposes.



Alternatively, a United States holder may elect to claim a United States federal income tax deduction for the Israeli tax paid or withheld, but only for a
taxable year in which the United States holder elects to deduct all foreign income taxes. A non-corporate United States holder, however, may not elect to deduct Israeli taxes if that United States holder does not itemize deductions.



Because the tax rules that limit the availability or use of foreign tax
credits are complex, we are unable to provide United States holders with any assurance as to the effect of limitations on United States foreign tax credits and deductions for foreign taxes, and United States holders should consult with, and rely
solely upon, their personal tax advisors with respect to such matters.



Sale, Exchange or Other Disposition



Subject to the discussion below, a United States holder generally will recognize capital gain or loss for United States federal income tax purposes upon the sale or other disposition of the United States holders Ordinary Shares equal
to the difference between the amount realized on the sale or other disposition and the United States holders tax basis in its Ordinary Shares. The capital gain or loss will be long-term capital gain or loss if the Ordinary Shares have been
held for more than one year at the time of sale or other disposition. In general, any gain or loss recognized by a United States holder on the sale or other disposition of Ordinary Shares will be United States source income or loss for foreign tax
credit purposes. In some cases, however, losses upon the sale or other disposition of Ordinary Shares may be required to be allocated to foreign source income.



Personal Holding Companies



A foreign corporation may be classified as a personal holding company for United States federal income tax purposes if both of the following two tests are
satisfied:



| |  |  | if at any time during the last half of the companys taxable year, five or fewer individuals without regard to their citizenship or residency actually or constructively own,
under attribution rules, more than 50% of the stock of the corporation by value; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 60% or more of the foreign corporations gross income derived from United States sources or effectively connected with a United States trade or business, as specifically
adjusted, is from passive sources like dividends and royalty payments.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



A personal holding company generally is taxed at a rate of 38.6% of its undistributed personal holding company income, which is generally calculated based on the corporations taxable income, after making
adjustments including deducting dividends paid and income taxes. We cannot provide any assurance that either test will not be satisfied in 2003 or future years because it is difficult to make accurate predictions of future income and the amount of
stock an individual will actually or constructively own in us.



Foreign Personal Holding Companies



A
foreign corporation will be classified as a foreign personal holding company for United States federal income tax purposes if both of the following two tests are satisfied:



| |  |  | five or fewer individuals who are United States citizens or residents actually or constructively own, under attribution rules, more than 50% of all classes of the corporations
stock measured by voting power or value at any time during the corporations taxable year; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | the corporation receives at least 60%, 50% if previously a foreign personal holding company, of its gross income regardless of source, as specifically adjusted, from passive
sources.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



If a corporation is classified as a
foreign personal holding company, a portion of its undistributed foreign personal holding company income, as defined for United States federal income tax purposes, would be imputed to all of its shareholders who are United States holders on the last
day of the corporations taxable year, or, if earlier, the last day on which the United States ownership test set forth above is met. The imputed income would be taxable as a dividend, even if no cash dividend is actually paid. United States
holders who dispose of their shares before that date would not be subject to United States federal income tax under these rules. We cannot provide any assurance that we will not qualify as a foreign personal holding company because it is difficult
to make accurate predictions of future income and the amount of stock a United States citizen or resident will actually or constructively own in us.



Foreign Investment Companies



A foreign corporation may be classified as a foreign investment company if, at any time during a taxable year when 50% or more by vote or value of the
corporations outstanding stock is owned, directly or indirectly, by United States holders, it is:



| |  |  | registered under the Investment Company Act of 1940 as a management company or unit investment trust; or
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | engaged, or holding itself out as being engaged, primarily in the business of investing, reinvesting, or trading in securities, commodities, or any interest, including a futures or
forward contract or option, in securities or commodities.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In general, if a corporation is classified as a foreign investment company at any time during the period a United States holder holds the corporations stock, any gain from the sale or exchange, or distribution treated as an exchange,
of stock in that corporation by the United States holder will be taxable as ordinary income to the extent of the United States holders ratable share of the corporations accumulated earnings and profits. We cannot provide any assurance
that we will not qualify as a foreign investment company because it is difficult to make accurate predictions of the amount of stock United States holders will directly or indirectly own in us.



Passive Foreign Investment Company Rules



In general, a foreign corporation will be a passive foreign investment
company if:



| |  |  | 75% or more of its gross income, including the pro rata share of the gross income of any United States or foreign company in which the corporation is considered to own 25% or more
of the shares by value, in a taxable year is passive income; or
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | at least 50% of the average value of the assets of the corporation, including the pro rata share of the assets of any United States or foreign company in which the corporation is
considered to own 25% or more of the shares by value, in a taxable year are held for the production of, or produce, passive income. If the foreign corporation is a publicly traded corporation for its entire taxable year, this 50% test is based on
the average value of its assets. This 50% test may instead be based on the adjusted bases of the foreign corporations assets, rather than value, if the foreign corporation is not a publicly traded corporation for a portion of its taxable year
and either the foreign corporation is a controlled foreign corporation or elects to use the adjusted bases of its assets for purposes of this test.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



If we were a passive foreign investment company, and a United States holder did not make a qualifying election either to
treat us as a qualified electing fund or mark our shares to market:



| |  |  | excess distributions by us to a United States holder would be taxed in a special way. Excess distributions are amounts received by a United States holder concerning our Ordinary
Shares in any taxable year that exceed 125% of the average distributions received by the United States holder from us in the shorter of either the three previous years or the United States holders holding period for Ordinary Shares before the
current taxable year. Excess distributions must be allocated ratably to each day that a United States holder has held our Ordinary Shares. A United States holder must include amounts allocated to the current taxable year and to pre-passive foreign
investment company years in its gross income as ordinary income for the
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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current taxable year. A United States holder must pay tax on amounts allocated to each prior taxable year
for which we were a passive foreign investment company at the highest rate in effect for that year on ordinary income and the tax is subject to an interest charge at the rate applicable to deficiencies for income tax.



| |  |  | the entire amount of gain that is recognized by a United States holder upon the sale or other disposition of Ordinary Shares will also be considered an excess distribution and will
be subject to tax as described above.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | if a corporation is a passive foreign investment company, a United States holder who acquires Ordinary Shares in the corporation from a decedent who was a United States shareholder
is denied the normally available step-up in the tax basis of the Ordinary Shares to fair market value at the date of death and instead will hold the Ordinary Shares with a tax basis equal to the decedents basis, if lower than the fair market
value. A United States holder cannot avoid this result, however, by electing to mark our Ordinary Shares to market.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



If a United States holder has made a qualified electing fund election for all taxable years during which the United States holder owned our Ordinary
Shares and we were a passive foreign investment company, the passive foreign investment company rules described above will not apply to the United States holder. Instead, a United States holder of a qualified electing fund is required for each
taxable year to include in income a pro rata share of the ordinary earnings of the qualified electing fund as ordinary income and a pro rata share of the net capital gain of the qualified electing fund as long-term capital gain, subject to a
separate election to defer payment of taxes and incur an interest charge. The qualified electing fund election is made on a shareholder-by-shareholder basis and can be revoked only with the consent of the Internal Revenue Service. A United States
holder generally makes a qualified electing fund election by obtaining and retaining the passive foreign investment company annual information statement, attaching a completed Internal Revenue Service Form 8621 to a timely filed United States
federal income tax return and by filing the form with the Internal Revenue Service center in Philadelphia, Pennsylvania. Even if a qualified electing fund election is not made, a shareholder in a passive foreign investment company who is a United
States holder generally must file a completed Internal Revenue Service Form 8621 every year.



A United States holder of publicly traded passive foreign investment company stock could elect to mark the stock to market annually and generally could be subject to specific rules for each of the United States
holders taxable years, including:



| |  |  | if the fair market value of the United States holders passive foreign investment company stock exceeds the United States holders adjusted tax basis in that stock as of
the close of the United States holders taxable year, the United States holder will recognize the amount of the excess as ordinary income;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | if the fair market value of the United States holders passive foreign investment company stock is less than the United States holders adjusted tax basis in that stock as
of the close of the United States holders taxable year, the United States holder may recognize the amount of the difference as ordinary loss. Losses would be allowed only for the amount of net gain previously included by the United States
holder under the election for prior taxable years; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | if the United States holder has elected to mark our Ordinary Shares to market for all taxable years during which the United States holder owned our Ordinary Shares and we were a
passive foreign investment company, the passive foreign investment company rules generally will not apply to the United States holder.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



United States holders who hold Ordinary Shares during a period when we are a passive foreign investment company will be subject to the preceding rules,
even if we cease to be a passive foreign investment company, subject to exceptions for United States holders who made a qualified electing fund election. United States holders are urged to consult their tax advisors about the passive foreign
investment company rules, including the specific rules and requirements applicable to making qualified electing fund and other elections.



Status of ViryaNet as a Passive Foreign Investment Company (PFIC)



Although we do not believe that we were a PFIC in 2004, there can be no assurance that the IRS will agree with that
conclusion or that we will not become a PFIC in 2005 or in a subsequent year. Passive foreign investment company status is determined as of the end of each taxable year and is dependent upon a number of factors, including the value of a
corporations assets and the amount and type of its gross income. The determination of whether we are or will become a passive foreign investment company will be affected by how rapidly we use our cash and investment assets in our business.
Also, a significant decline in the market price of our Ordinary Shares may result in our being classified as a passive foreign investment company.



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Backup Withholding and Information Reporting



Dividends on our Ordinary Shares, and payments of the proceeds of a sale of
our Ordinary Shares, paid within the United States or through certain United States-related financial intermediaries are subject to information reporting and may be subject to backup withholding at a 30% rate unless (i) the payer is entitled to, and
does in fact, presume the United States holder of our Ordinary Shares is a corporation or other exempt recipient or (ii) the United States holder provides a taxpayer identification number on a properly completed Form W-9 and certifies that no loss
of exemption from backup withholding has occurred. The amount of any backup withholding will be allowed as a credit against a United States holders United States federal income tax liability and may entitle that United States holder to a
refund, provided that required information is furnished to the Internal Revenue Service.



Israeli Taxation and Investment Programs



The following is a summary of the principal tax laws applicable to companies in Israel, with special reference to their effect on us, and Israeli government programs benefiting us. This section also contains a
discussion of Israeli tax consequences to you if you acquire Ordinary Shares of our company. This summary does not discuss all the acts of Israeli tax law that may be relevant to you in light of your personal investment circumstances or if you are
subject to special treatment under Israeli law. To the extent that the discussion is based on new tax legislation which has not been subject to judicial or administrative interpretation, we cannot assure you that the views expressed in this
discussion will be accepted by the tax authorities. The discussion should not be understood as legal or professional tax advice and is not exhaustive of all possible tax considerations.



General Corporate Tax Structure



On June 29, 2004, the Israeli Government passed the Amendment to the Income Tax Ordinance (No. 140 and Temporary Provision), 2004, which
progressively reduces the tax rates applicable to companies from 36% to 35% in 2004 and to a rate of 30% in 2007. The amendment had no impact on our financial statements. However, the effective tax rate payable by a company that derives income from
an approved enterprise may be considerably less.



Law for
the Encouragement of Industry, Taxes, 1969



We qualify
as an industrial company under the Law for the Encouragement of Industry (Taxes), 1969, otherwise known as the industry encouragement law. A company qualifies as an industrial company under the industry encouragement law if it resides in Israel and
at least 90% of its income in a given tax year, exclusive of income from specified loans, capital gains, interest and dividends, is derived from an industrial enterprise owned by it. An industrial enterprise is defined as an enterprise whose major
activity in a given tax year is industrial manufacturing.



Under the industry encouragement law, an industrial company is entitled to deduct the purchase price of know how, patents or rights over a period of eight years beginning with the year in which the rights were first used.



The tax laws and regulations dealing with the adjustment of taxable income
for inflation in Israel also provide that industrial enterprises, like ours, are eligible for special rates of depreciation deductions. These rates vary in the case of plant and machinery according to the number of shifts in which the equipment is
operated and range from 20% to 40% on a straight-line basis, or from 30% to 50% on a declining balance basis for equipment first put into operation on or after June 1, 1989, instead of the regular rates, which are applied on a straight-line basis.



Industrial enterprises which are approved enterprises can also
choose between



| |  |  | the special rates referred to above; and
| | - |  | ----------------------------------------



| |  |  | accelerated rates of depreciation applied on a straight-line basis on property and equipment, generally ranging from 200% on equipment to 400% of the ordinary depreciation rates on
buildings during the first five years of service of the assets subject to a ceiling of 20% per year on depreciation of buildings.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Qualification as an industrial company under the industrial encouragement law is not conditioned upon the receipt of prior approval from any Israeli
government authority. No assurance can be given that we will continue to qualify as an industrial company or will in the future be able to avail ourselves of any benefits available to companies so qualifying.



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Law for the Encouragement of Capital Investments, 1959



The Law for Encouragement of Capital Investments, 1959, which is referred to
below as the capital investments law, provides that capital investments in a production facility or other eligible assets may, upon application to the Israeli Investment Center of the Ministry of Industry and Commerce, be designated as an approved
enterprise. Each certificate of approval for an approved enterprise relates to a specific investment program in the approved enterprise, delineated both by the financial scope of the investment and by the physical characteristics of the facility or
the asset. An approved enterprise is entitled to benefits, including Israeli government cash grants and tax benefits.



A recent amendment to the Investment Law (the Amendment), which has been officially published and effected since of April 1, 2005, has
significantly changed the provisions of the Investment Law. The Amendment limits the scope of enterprises, which may be approved by the Investment Center by setting criteria for the approval of a facility as an Approved Enterprise. Additionally, the
Amendment enacted major changes in the manner in which tax benefits are awarded under the Investment Law so that companies no longer require Investment Center approval in order to qualify for tax benefits. However, the Amendment provides that terms
and benefits included in any certificate of approval already granted will remain subject to the provisions of the law as they were on the date of such approval.



Tax Benefits



Taxable income derived from an approved enterprise is subject to a reduced corporate tax rate of 25%. That income is eligible for further reductions in
tax rates depending on the percentage of the foreign investment in our share capital and the percentage of our combined share and loan capital owned by non-Israeli residents. The tax rate is 20% if the foreign investment is 49% or more but less than
74%, 15% if the foreign investment is 74% or more but less than 90% and 10% if the foreign investment is 90% or more. The lowest level of foreign investment during the year will be used to determine the relevant tax rate for that year. These tax
benefits described above are granted for a limited period of time and begin when a company is operational and profitable. The benefits are granted for up to 7 years, or 10 years for a company that has 25% or more of its shares owned by non-Israeli
shareholders, from the first year in which the approved enterprise has taxable income, other than income subject to capital gains tax. The period of benefits may not, however, exceed the lesser of 12 years from the year in which the production began
or 14 years from the year of receipt of approved enterprise status.



An approved enterprise approved after April 1, 1986, may elect to forego any entitlement to the grants otherwise available under the capital investments law or may participate in an alternative benefits program, under which the
undistributed income from the approved enterprise is fully exempt from corporate tax for a defined period of time. The period of tax exemption ranges between two and ten years, depending upon the location within Israel of the approved enterprise and
the type of the approved enterprise. Alternatively, approved enterprises approved after January 1, 1997 in national priority region A, may elect to receive grants and a two-year tax exemption for undistributed profits derived from the approved
enterprise program. We cannot assure you that the current benefit programs will continue to be available or that we will continue to qualify for benefits under the current programs.



We have two approved enterprise programs under the capital investments law, which entitle us to some tax benefits. The tax
benefit period for these programs has not yet begun. Income derived from these alternative benefit programs is exempt from tax for a period of ten years, starting in the first year in which we generate taxable income from the approved enterprise,
subject to certain conditions.



If dividends are paid out of
tax-exempt profit derived from our approved enterprise, we will be liable for corporate tax on the gross amount of distributed profits before company tax at the rate that would have been applied if we had not elected the alternative tax benefit.
This rate is generally 10% to 25%, depending on the percentage of a companys shares held by foreign shareholders. We will also be required to withhold on behalf of the dividend recipients 15% of the amount distributed as dividends. Cash
dividends paid by an Israeli company are normally subject to a withholding tax, except for dividends that are paid to an Israeli company, in which case no tax is withheld unless the dividend is paid from earnings from an approved enterprise. Since
we have received some benefits under Israeli laws relating to approved enterprises, payment of dividends may subject us to some Israeli taxes to which we would not otherwise be subject.



The benefits available to an approved enterprise are conditional upon the fulfillment of conditions stipulated in the
capital investments law and its regulations and the criteria in the specific certificate of approval, as described above. If these conditions are violated, in whole or in part, we would be required to refund the amount of tax benefits and linkage
differences to the Israeli consumer price index and interest.



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Our approved enterprise program and the tax benefits thereunder may not continue in the future at their
current levels or at any level. The termination or reduction of these tax benefits would likely increase our taxes. The amount, if any, by which our taxes would increase will depend upon the rate of the tax increase, the amount of any tax benefit
reduction, and the amount of any taxable income that we may earn in the future.



Taxation Under Inflationary Conditions



The Income Tax, Inflationary Adjustment, Law, 1985, which is referred to below as the inflationary adjustments law, attempts to overcome some of the problems presented to a traditional tax system by an economy
experiencing rapid inflation, which was the case in Israel at the time the law was enacted. Generally, the inflationary adjustments law provides significant tax adjustments, based on net equity less fixed assets, to depreciation methods and tax loss
carry forwards to compensate for loss of value resulting from an inflationary economy. Our taxable income is subject to the provisions of this law.



Tax Benefits of Research and Development



Israeli tax law permits, under some conditions, a tax deduction in the year incurred for expenditures, including capital expenditures, in scientific
research and development projects, if the expenditures are approved by the relevant government ministry and if the research and development is for the promotion of the enterprise and is carried out by, or on behalf of, a company seeking the
deduction.



The OCS has approved some of our research and
development programs and we have been able to deduct, for tax purposes, a portion of our research and development expenses net of the grants received. Other research and development expenses that are not approved may be deducted for tax purposes in
3 equal installments during a 3-year period.



Withholding
and Capital Gains Taxes Applicable to Non-Israeli Shareholders



Nonresidents of Israel are subject to income tax on income accrued or derived from sources in Israel or received in Israel. These sources of income include passive income like dividends, royalties and interest, as well as non-passive income
from business conducted or services rendered in Israel. We are generally required to withhold income tax at the rate of 25%, 15% for dividends generated by an approved enterprise, on all distributions of dividends.



Israeli law generally imposes a capital gains tax on the sale of publicly
traded securities. Pursuant to changes made to the Israeli Income Tax Ordinance in January 2003, capital gains on the sale of our Ordinary Shares will be subject to Israeli capital gains tax, generally at a rate of 15%. However, as of January 1,
2003 nonresidents of Israel will be exempt from capital gains tax in relation to the sale of our Ordinary Shares for so long as (a) our Ordinary Shares are listed for trading on a stock exchange outside of Israel, (b) the capital gains are not
accrued or derived by the nonresident shareholders permanent enterprise in Israel, (c) the Ordinary Shares in relation to which the capital gains are accrued or derived were acquired by the nonresident shareholder after the initial listing of
the Ordinary Shares on a stock exchange outside of Israel, and (d) neither the shareholder nor the particular capital gain is otherwise subject to certain sections of the Israeli Income Tax Ordinance. As of January 1, 2003 nonresidents of Israel are
also exempt from Israeli capital gains tax resulting from the sale of securities on TASE provided that the capital gains are not accrued or derived by the nonresident shareholders permanent enterprise in Israel.



The convention between the United States and the government of the State of
Israel on taxes on income, which shall be referred to as the treaty, is generally effective as of January 1, 1995.



Under the treaty, the following entities or individuals generally are exempt from Israeli capital gains tax on income derived from the sale, exchange or
disposition of Ordinary Shares if these entities or individuals own, directly or indirectly, less than 10% of the voting power in our Company during the twelve month period preceding the sale, exchange or disposition of their Ordinary Shares:



| |  |  | individuals that are residents of the United States;
| | - |  | ----------------------------------------------------



| |  |  | corporations, or entities taxable as corporations, that are not residents of Israel and that are organized under the laws of the United States or of any state of the United States
or the District of Columbia; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | other entities, to the extent that the other entities income is taxable in the United States as the income of residents of the United States.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------



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The application of the treaty provisions applying to dividends and capital gains described above and
below is conditioned upon the fact that this income is not effectively connected with a permanent establishment maintained by the non-Israeli residents in Israel. Under the treaty, a permanent establishment generally means a fixed place of business
through which industrial or commercial activity is conducted, directly or indirectly through agents.



Unless an exemption applies under domestic Israeli law, residents of the United States who own the requisite 10% or more of our outstanding voting shares
are subject to Israeli tax on any gain realized on the sale, exchange or disposition of those shares but would generally be permitted under the treaty to claim a credit for those taxes against the United States income tax imposed on any gain from
the sale, exchange or disposition, subject to the limitations applicable to foreign tax credits.



Under the treaty, the maximum tax on dividends paid to a holder of Ordinary Shares who is a resident of the United States under the treaty generally is
25%. However, dividends generally paid to a United States corporation by an Israeli company that does not enjoy the benefits of an approved enterprise will generally be subject to a 12.5% dividend withholding tax if:



| |  |  | the recipient corporation owns at least 10% of the outstanding voting shares of the Israeli company during the portion of the current taxable year and during the whole of the prior
taxable year of the Israeli company preceding the date of the dividend; and not more than 25% of the gross income of the Israeli company during the prior taxable year of the Israeli company preceding the date of the dividend consists of interest or
dividends.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



If the Israeli company is entitled to
the Israeli tax benefits applicable to an approved enterprise and the requirements listed above are met, the withholding tax rate on dividends paid to a United States corporation is 15%.



Documents on Display



The documents concerning ViryaNet referred to in this document and required to be made available to the public are available at our offices located at
8 HaMarpe Street, Science Based Industries Campus, Har Hotzvim, Jerusalem, Israel 91450.



Item 11.Quantitative And Qualitative Disclosures About Market Risk



Revenues generated and costs incurred outside of the United States are generally denominated in non-dollar currencies. Costs not effectively denominated
in United States dollars are translated to United States dollars, when recorded, at the prevailing exchange rates for the purposes of the our financial statements. Consequently, fluctuations in the rates of exchange between the dollar and non-dollar
currencies will affect our results of operations. An increase in the value of a particular currency relative to the dollar will increase the dollar reporting value for transactions in that particular currency, and a decrease in the value of that
currency relative to the dollar will decrease the dollar reporting value for those transactions. This effect on the dollar reporting value for transactions is generally only partially offset by the impact that currency fluctuations may have on
costs. We do not generally engage in currency hedging transactions to offset the risks associated with variations in currency exchange rates. Consequently, significant foreign currency fluctuations and other foreign exchange risks may have a
material adverse effect on our business, financial condition and results of operations. Since the our revenues are generated in United States dollars and currencies other than NIS, and a substantial portion of our expenses are incurred and will
continue to be incurred in NIS, we are exposed to risk by the amount that the rate of inflation in Israel exceeds the rate of devaluation of the NIS in relation to the dollar and other currencies or if the timing of the devaluation lags behind
inflation in Israel. We do not engage in any hedging or other transactions intended to manage risks relating to foreign currency exchange rate or interest rate fluctuations. We also do not own any market risk sensitive instruments. However, we may
in the future undertake hedging or other transactions or invest in market risk sensitive instruments if we determine that it is necessary to offset these risks.



Item 12.Description Of Securities Other Than Equity Securities



Not applicable.



PART II



Item 13.Defaults, Dividend Arrearages And Delinquencies



None.



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Item 14.Material Modifications To The Rights Of Security Holders And Use Of Proceeds



Use of Proceeds



On September 19, 2000, we commenced an IPO of 400,000 of our Ordinary Shares, pursuant to our final prospectus dated September 19, 2000 (the
Prospectus). The Prospectus was contained in our Registration Statement on Form F-1, which was declared effective by the Securities and Exchange Commission (SEC File No. 333-42158) on September 19, 2000. The IPO closed on September 22,
2000 upon the sale of 400,000 Ordinary Shares to the underwriters. Chase Securities Inc., Salomon Smith Barney, Inc., and Dain Rauscher Incorporated acted as the representatives of the underwriters in the IPO.



The aggregate offering price of the IPO to the public was $32,000,000, with
proceeds to us, after deduction of the underwriting discount, of $29,760,000 (before deducting offering expenses payable by us). The aggregate amount of expenses incurred by us in connection with the issuance and distribution of Ordinary Shares
offered and sold in the IPO was approximately $6,376,000, including $2,240,000 in underwriting discounts and commissions, $428,000 in payments to directors and officers and $3,708,000 in other expenses.



The net proceeds to us from the IPO, after deducting underwriting discounts
and commissions and other expenses, were approximately $25,624,000. Through December 31, 2004, these net proceeds have been used for the purchase of equipment and software in the amount of approximately $2,339,000, and approximately $23,285,000 have
been used for working capital purposes.



Item 15.Controls and Procedures



(a) Disclosure Controls and Procedures. We performed an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of
the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of December 31, 2004. After giving consideration to the
circumstances surrounding the restatement of our consolidated financial statements for the years ended December 31, 2000, 2001, 2002 and 2003 reported in our Report on Form 20-F/A dated March 25, 2005, management has reevaluated our disclosure
controls and procedures. Solely as a result of the material weakness of internal control over financial reporting described below, we have concluded that our disclosure controls and procedures were not effective as of December 31, 2004.



The restatement caused us to determine that a material weakness of
internal control over financial reporting existed as of December 31, 2003. Specifically, there were ineffective controls to identify errors in the application of complex accounting standards to our software licensing transactions. Subsequent to
December 31, 2004, we completed a comprehensive review of our software licensing transactions entered into between 1999 and 2003. As a result of this review and related remediation efforts, which we also describe below, in our best judgment, we have
also eliminated the aforementioned material weakness.



The
specific circumstances which led to the restatement and our reevaluation of our disclosure controls and procedures were as follows: On April 15, 2004, we filed a registration statement on Form F-3 with the SEC for the purpose of registering Ordinary
Shares we had previously issued. On May 14, 2004, we received an initial comment letter from Staff that requested further information about the Form F-3 and our annual report on Form 20-F for the year ended December 31, 2003, filed on April 9, 2004.
We provided our response to these comments on June 3, 2004. Subsequently, we and the Staff continued to correspond. Among its other comments, the Staff inquired about our revenue recognition for software license transactions with extended payment
term arrangements. The Staff queried whether we had established normal payment terms with our customers and had a sufficient history of successful collections in past extended payment term arrangements with similar payment terms. At our request, on
February 10, 2005, we held a phone conference with the Staff and representatives of Ernst & Young, our independent auditors, with the intent of clarifying our response to these concerns.



During the phone conference and in response to the Staffs concerns, it
became evident to us that in order to recognize revenue in license transactions according to SOP 97-2 for extended payment term arrangements, we needed to demonstrate that we had established normal payment terms with our customers and a sufficient
history of successful collections in past extended payment term arrangements with similar payment terms. It also became evident to us that our interpretation of SOP 97-2, which did not require a sufficient history of successful collections in prior
arrangements in determining revenue recognition for software license transactions with payment terms of less than twelve months, did not coincide with the Staffs position. Our position took into consideration other factors such as the length
of the product lifecycle, the low risk of technical obsolescence within the payment period, the importance of the software to the customer, and the low frequency of major software upgrades.



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Subsequent to that phone conference, we conducted a review of all software license transactions we had
entered into during 1999 through 2003 to determine whether we could demonstrate that we had a sufficient history of successful collections in similar extended payment term arrangements in order to support revenue recognition for 2000 through 2003.
The factors we considered in this review included (i) the life cycle of its software which was released in 1998, (ii) the limited number of licensing arrangements underlying the software, especially in the earlier years, (iii) the nature of the
arrangements, and (iv) the diverse payment terms agreed to with the customers.



As a result of this review process, we determined that for 2000 through 2002, we did not have normal payment terms as the payment terms for all arrangements varied significantly, ranging from 30 days to eleven months
and we were not able to establish a sufficient historical basis of successful collections in similar extended payment term arrangements. For 2003, we determined that we did not have any payment arrangements where revenue was recognized upon delivery
of our software with payment terms greater than three months, but that a sufficient historical basis of successfully collecting on licensing transactions with payment terms of three months or less had been attained. Prior to February 10, 2005, we
did not monitor historical payment arrangements for the purpose of examining their effects on our revenue recognition policy because our interpretation of SOP 97-2 did not consider a sufficient history of successful collections as a factor in
determining revenue recognition for software license transactions with payment terms of less than twelve months. In addition, our payment terms with customers varied significantly and we were unable to establish normal payment terms as the basis for
revenue recognition.



Accordingly, we concluded that, and with
our auditors concurrence, in hindsight, for license transactions in 2000 through 2002 where revenue was recognized upon delivery of our software, we should have recognized revenues as payments were due provided collectibility was deemed probable, or
as payments were collected. We restated our financial statements accordingly. For 2003, we concluded, and with our auditors concurrence, in hindsight, to restate three transactions whose payment was not collected when due but was subsequently
collected during 2004.



As a result of this review and the
restatement, we have strengthened our internal controls relating to revenue recognition to improve compliance with applicable revenue recognition accounting guidance by (i) documenting normal payment terms with our customers, so as to be able to
identify payment terms under which upfront revenue recognition would not be appropriate, (ii) monitoring compliance of payment terms with our revenue recognition policy at the time of each transaction, and (iii) analyzing all new payment
arrangements for software licenses transactions against our historical basis and examining their effect, if any, on our revenue recognition policy on a quarterly basis.



(b) Not yet applicable



(c) Not yet applicable



(d) Changes in Internal Control Over Financial Reporting. There has been no change in the Companys internal control over financial reporting (as
defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during 2004, that has materially affected, or is reasonably likely to materially affect, the Companys internal control over financial reporting. However, as
discussed in Item 15(a) above, we strengthened our internal controls relating to revenue recognition to improve compliance with applicable revenue recognition accounting guidance as a response to the circumstances which led to the restatement of our
financial statements for the years 2000 through 2003.



Item 16.



Item 16A. Audit
Committee Financial Expert



Our Board of Directors has determined that we
have at least one audit committee financial expert, Ms. Ronit Lerner.



Item 16B. Code of Ethics



We have adopted a
written code of ethics that applies to all of our employees, including our principal executive officer, principal financial officer and principal accounting officer.



You may request a copy of our code of ethics, at no cost, by writing to or telephoning us as follows:



ViryaNet, Inc.

2 Willow Street

Southborough

MA 01745-1027

Telephone: 508-490-8600



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Item 16C. Principal Accountant Fees and Services



During each of the last two fiscal years, Kost Forer Gabbay & Kasierer, a member of Ernst and Young Global, has acted as the Companys independent auditors.



Audit fees



Ernst & Young billed the Company approximately $120,000 for audit services for 2004, including fees associated with the annual audit and reviews of the Companys
quarterly financial results submitted on Form 6-K, and consultations on various accounting issues. Ernst & Young billed the Company approximately $126,000 for audit services for fiscal 2003.



Audit-related fees



Ernst & Young billed the Company approximately $60,000 for audit-related services for fiscal 2004. Audit-related services principally
include due diligence examinations as well as assistance with certain requirements of the SEC regulations. Ernst & Young billed the Company approximately $30,000 for audit-related services for fiscal 2003.



Tax fees



Ernst & Young billed the Company approximately $66,000 for tax advice, including fees associated with tax compliance services, tax
planning services and other tax consulting services for fiscal 2004. Ernst & Young billed the Company approximately $59,000 for tax advice in fiscal 2003.



All other fees



We did not pay Ernst & Young for any fees other than the Audit Fees, Audit-Related Fees and Tax Fees described above for fiscal 2004 and 2003.



Pre-Approval Policies for Non-Audit Services



Prior to the engagement of Ernst & Young each year, the engagement is approved by the Audit Committee of the Board of Directors and by
vote of the Companys shareholders at the Companys Annual General Meeting of Shareholders. The Companys Audit Committee has also adopted its own rules of procedure. The Audit Committees rules of procedure provide for a process
with respect to the prior approval of all services, including non-audit services, to be performed by the independent auditors for the Company. In fiscal 2004, the Companys Audit Committee approved all of the services provided by Ernst &
Young.



Item 16D. Exemption From The Listing Standards For Audit Committees



Not applicable.



Item 16E. Purchases of Equity Securities By The Issuer And Affiliated Purchasers



Not applicable.



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PART III



Item 17.Financial Statements



Not applicable.



Item 18.Financial Statements



See the Index to Consolidated Financial Statements and related Financial Statements accompanying this report-beginning page F-1.



Item 19. Exhibits



|             |  |                         |  |                                                                                                                                  |  |                                                                                                                                
|------------ |  | ----------------------- |  | -------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------
|ExhibitIndex |  | Description of Document |  |                                                                                                                                 
|1            |  | 1)                      |  | Memorandum of Association of Registrant (English translation) dated March 8, 1988                                                |  | Filed as Exhibit 3.1 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference.  
|             |  |                         | 
|             |  | 2)                      |  | Amended Articles of Association of ViryaNet                                                                                      |  | Filed as Exhibit 1(2) of the Companys 20-F for the year ending December 31, 2001 and incorporated herein by reference.        
|             |  |                         | 
|4(a)         |  | 1)                      |  | The 2000 Amendment and Restatement to the Investors Rights Agreement among ViryaNet and the Investors dated April 5, 2000        |  | Filed as Exhibit 10.5 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference. 
|             |  |                         | 
|             |  | 2)                      |  | The Registration Rights Agreement, among ViryaNet and the previous shareholders of iMedeon, Inc. dated February 25, 2002.        |  | Filed as Exhibit 4(a) of the Companys 20-F for the year ending December 31, 2001 and incorporated herein by reference.        
|             |  |                         | 
|             |  | 3)                      |  | The Agreement and Plan of Merger among ViryaNet, iMedeon, Inc. and the stockholders of iMedeon, Inc, dated February 25, 2002.    |  | Filed as Exhibit 4(a) of the Companys 20-F for the year ending December 31, 2001 and incorporated herein by reference.        
|             |  |                         | 
|             |  | 4)                      |  | Warrant issued by ViryaNet to Hapoalim Nechasim (Menayot) Ltd. to purchase Ordinary Shares.                                      |  | Filed as Exhibit 10.10 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference.
|             |  |                         | 
|             |  | 5)                      |  | Warrant issued by ViryaNet to Hapoalim Nechasim (Menayot) Ltd. to purchase Ordinary Shares.                                      |  | Filed as Exhibit 10.11 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference.
|             |  |                         | 
|             |  | 6)                      |  | Form of warrant issued by ViryaNet to customers prior to July 1, 2000 to purchase Ordinary Shares.                               |  | Filed as Exhibit 10.12 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference.
|             |  |                         | 
|             |  | 7)                      |  | Form of warrant issued by ViryaNet to customers after July 1, 2000 to purchase Ordinary Shares.                                  |  | Filed as Exhibit 10.17 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference 
|             |  |                         | 
|             |  | 8)                      |  | Warrant issued by ViryaNet to Bank Hapoalim Ltd. to purchase Ordinary Shares dated effective February 13, 2002.                  |  | Filed as Exhibit 4(a) of the Companys 20-F for the year ending December 31, 2001 and incorporated herein by reference.        
|             |  |                         | 
|             |  | 9)                      |  | Warrant issued by ViryaNet to GE Capital Equity Investments, Inc. to purchase Ordinary Shares dated effective February 21, 2002. |  | Filed as Exhibit 4(a) of the Companys 20-F for the year ending December 31, 2001 and incorporated herein by reference.        
|             |  |                         | 
|             |  | 10)                     |  | Letter of Credit issued by Bank Hapoalim B.M. to ViryaNet dated February 10, 2002.                                               |  | Filed as Exhibit 4(a) of the Companys 20-F for the year ending December 31, 2001 and incorporated herein by reference.        



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|             |  |                         |  |                                                                                                                                                                                                                              |  |                                                                                                                                   
|------------ |  | ----------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------------------------------------------------------------------------------------------------------------------
|ExhibitIndex |  | Description of Document |  |                                                                                                                                                                                                                             
|             |  | 11)                     |  | Letter from Bank Hapoalim B.M. to ViryaNet dated July 14, 2003.                                                                                                                                                              |  | Translation. Filed as exhibit 11 of the Companys 20-F for the year ending December 31, 2002 and incorporated herein by reference.
|             |  |                         | 
|             |  | 12)                     |  | Share Purchase Agreement dated July 28, 2003, by and among the company and Telvent GIT, S.A., and exhibits thereof                                                                                                           |  | Filed as Exhibit 4(a) of the Companys 20-F for the year ending December 31, 2003 and incorporated herein by reference.           
|             |  |                         | 
|             |  | 13)                     |  | Share Purchase Agreement dated October 30, 2003, among ViryaNet and the investors identified in such agreement, and exhibits thereof                                                                                         |  | Filed as Exhibit 4(a) of the Companys 20-F for the year ending December 31, 2003 and incorporated herein by reference.           
|             |  |                         | 
|             |  | 14)                     |  | Agreements dated November 6, 2003, among ViryaNet and the investors identified in such agreements                                                                                                                            |  | Filed as Exhibit 4(a) of the Companys 20-F for the year ending December 31, 2003 and incorporated herein by reference.           
|             |  |                         | 
|             |  | 15)                     |  | Agreement and Plan of Merger dated July 9, 2004, among Utility Partners, Inc., ViryaNet and ViryaNet Acquisition Inc., and exhibit thereof.                                                                                  |  |                                                                                                                                   
|             |  |                         | 
|             |  | 16)                     |  | Note Purchase Agreement dated July 27, 2004, between ViryaNet and LibertyView Special Opportunities Fund LP, and exhibits thereof                                                                                            |  |                                                                                                                                   
|             |  |                         | 
|             |  | 17)                     |  | Share Purchase Agreement dated February 7, 2005, between ViryaNet and Telvent Investments, S.L. and exhibits thereof                                                                                                         |  |                                                                                                                                   
|             |  |                         | 
|             |  | 18)                     |  | Letter dated March 14, 2005, between ViryaNet and Bank Hapoalim Ltd.                                                                                                                                                         |  | Translated from the Hebrew original.                                                                                              
|             |  |                         | 
|             |  | 19)                     |  | Warrant dated March 14, 2005, issued by ViryaNet to Bank Hapoalim Ltd. to purchase Ordinary Shares                                                                                                                           |  |                                                                                                                                   
|             |  |                         | 
|             |  | 20)                     |  | Asset Purchase Agreement dated June 1, 2005, between ViryaNet and e-Wise Solutions as amended.                                                                                                                               |  |                                                                                                                                   
|             |  |                         | 
|4(b)         |  | 1)                      |  | Lease for approximately 16,950 square feet of office space in Jerusalem, Israel.                                                                                                                                             |  | Filed as Exhibit 10.14 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference.   
|             |  |                         | 
|             |  | 2)                      |  | A new Lease agreement reducing the current Company premises leased in Jerusalem, Israel, to an area of approximately 7,600 square feet of office space, dated February 25, 2002 (as summarized and
translated into English). |  | Filed as Exhibit 4(a) of the Companys 20-F for the year ending December 31, 2001 and incorporated herein by reference.           
|             |  |                         | 
|             |  | 3)                      |  | Lease for approximately 13,807 square feet in Southborough, Massachusetts.                                                                                                                                                   |  | Filed as Exhibit 10.15 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference.   
|             |  |                         | 
|             |  | 4)                      |  | Lease for approximately 20,000 square feet located in Alpharetta, Georgia.                                                                                                                                                   |  | Filed as Exhibit 4(a) of the Companys 20-F for the year ending December 31, 2001 and incorporated herein by reference.           



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|             |  |                         |  |                                                                                                                                  |  |                                                                                                                                
|------------ |  | ----------------------- |  | -------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------
|ExhibitIndex |  | Description of Document |  |                                                                                                                                 
|             |  | 5)                      |  | Consent of Kost, Forer, Gabbay & Kasierer, a member of Ernst and Young Global                                                    |  |                                                                                                                                
|             |  |                         | 
|             |  | 6)                      |  | First Amendment to the Lease Agreement by and between the Company and Three and 400 Northwinds Center L.P., dated June 10, 2003. |  | Filed as Exhibit 4(b) of the Companys 20-F for the year ending December 31, 2002.                                             
|             |  |                         | 
|             |  | 7)                      |  | Promissory Notes by and between the Company and Three and 400 Northwinds Center L.P., dated June 10, 2003.                       |  | Filed as Exhibit 4(b) of the Companys 20-F for the year ending December 31, 2002.                                             
|             |  |                         | 
|4(c)         |  | 1)                      |  | The Companys 1996 Stock Option and Incentive Plan.                                                                              |  | Filed as Exhibit 10.1 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference. 
|             |  |                         | 
|             |  | 2)                      |  | The Companys 1997 Stock Option and Incentive Plan.                                                                              |  | Filed as Exhibit 10.2 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference. 
|             |  |                         | 
|             |  | 3)                      |  | The Companys 1998 Stock Option and Incentive Plan.                                                                              |  | Filed as Exhibit 10.3 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference. 
|             |  |                         | 
|             |  | 4)                      |  | The Companys 1999 Stock Option and Incentive Plan.                                                                              |  | Filed as Exhibit 10.4 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference. 
|             |  |                         | 
|             |  | 5)                      |  | Form of Indemnification Agreement entered into with directors and officers of the Company.                                       |  | Filed as Exhibit 10.16 to the Companys Registration Statement on Form F-1, No. 333-42158 and incorporated herein by reference.
|             |  |                         | 
|             |  | 6)                      |  | Tender Offer Statement under Section 13(e)(1) of the Securities Exchange Act of 1934.                                            |  | Filed on Form SC TO-I, No. 005-60313 and incorporated herein by reference.                                                     
|             |  |                         | 
|99.1         |  | 1)                      |  | Certification of Paul V. Brooks and Albert A. Gabrielli pursuant to 18 U.S.C. Section 1350                                       |  |                                                                                                                                



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SIGNATURES



Pursuant to the requirements of the Securities Act of 1933, the Registrant certifies that it has reasonable grounds to believe that it meets all of
the requirements for filing on Form 20-F and has duly caused this Form 20-F to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Southborough, Massachusetts, on this 15th day of July, 2005.



VIRYANET LTD.By:

/s/ Paul V. BrooksPaul V. Brooks President and Chief Executive Officer




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VIRYANET LTD. AND ITS SUBSIDIARIES



CONSOLIDATED FINANCIAL STATEMENTS



AS OF DECEMBER 31, 2004



IN U.S. DOLLARS



INDEX



|                                                           |  |           
|---------------------------------------------------------- |  | ----------
|                                                           |  | Page      
|Report of Independent Registered Public Accounting Firm    |  | F-2       
|                                                           | 
|Consolidated Balance Sheets                                |  | F-3 - F-4 
|                                                           | 
|Consolidated Statements of Operations                      |  | F-5       
|                                                           | 
|Statements of Changes in Shareholders Equity (deficiency) |  | F-6       
|                                                           | 
|Consolidated Statements of Cash Flows                      |  | F-7 - F-8 
|                                                           | 
|Notes to Consolidated Financial Statements                 |  | F-9 - F-43



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##### Table of Contents

|     |  |                                                                           |  |                                               
|---- |  | ------------------------------------------------------------------------- |  | ----------------------------------------------
|LOGO |  | n      Kost Forer Gabbay &
Kasierer 3 Aminadav St. Tel-Aviv 67067, Israel |  | n      Phone: 972-3-6232525 Fax: 972-3-5622555



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



To the shareholders of



VIRYANET LTD.



We have audited the accompanying
consolidated balance sheets of ViryaNet Ltd. (the Company) and its subsidiaries as of December 31, 2003 and 2004, and the related consolidated statements of operations, changes in shareholders equity (deficiency) and cash flows for
each of the three years in the period ended December 31, 2004. 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 the standards of
the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to
perform an audit of the Companys internal control over financial reporting. Our audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but
not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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 consolidated financial statements referred to above, present fairly, in all material respects, the consolidated financial position of the Company and its subsidiaries as of December 31, 2003 and 2004, and the consolidated results of
their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.





|                 |  |                                 
|---------------- |  | --------------------------------
|Tel-Aviv, Israel |  | KOST FORER GABBAY & KASIERER    
|June 29, 2005    |  | A Member of Ernst & Young Global



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



CONSOLIDATED BALANCE SHEETS

U.S. dollars in thousands



|                                                                                     |  |              |        |      |   |       
|------------------------------------------------------------------------------------ |  | ------------ | ------ | ---- | - | ------
|                                                                                     |  | December 31,
|                                                                                     |  | 2003         |        | 2004
|ASSETS                                                                               |  |              |        |      |   |       
|                                                                                     |  |             
|CURRENT ASSETS:                                                                      |  |              |        |      |   |       
|Cash and cash equivalents                                                            |  | $            | 5,087  |      | $ | 2,943 
|Trade receivables (net of allowance for doubtful accounts of $ 52 for 2003 and 2004) |  |              | 1,792  |      |   | 1,288 
|Unbilled receivables                                                                 |  |              | 255    |      |   | 158   
|Other accounts receivable and prepaid expenses (Note 3)                              |  |              | 986    |      |   | 918   
|                                                                                     |  |              |        |      |   |       
|Total current assets                                                                 |  |              | 8,120  |      |   | 5,307 
|                                                                                     |  |              |        |      |   |       
|SEVERANCE PAY FUND                                                                   |  |              | 638    |      |   | 735   
|                                                                                     |  |              |        |      |   |       
|PROPERTY AND EQUIPMENT, NET (Note 4)                                                 |  |              | 630    |      |   | 310   
|                                                                                     |  |              |        |      |   |       
|GOODWILL (Notes 1b, 1c)                                                              |  |              | 2,772  |      |   | 6,516 
|                                                                                     |  |              |        |      |   |       
|CUSTOMER RELATIONSHIP, NET (Notes 1c, 5c)                                            |  |              |       |      |   | 898   
|                                                                                     |  |              |        |      |   |       
|OTHER INTANGIBLE ASSETS, NET (Notes 1b, 1c, 5)                                       |  |              | 70     |      |   | 632   
|                                                                                     |  |              |        |      |   |       
|Total assets                                                                         |  | $            | 12,230 |      | $ | 14,398
|                                                                                     |  |              |        |      |   |       



The accompanying notes are an integral
part of the consolidated financial statements.



F-3



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



CONSOLIDATED BALANCE SHEETS

U.S. dollars in thousands, except share and per share data



|                                                                                                                                                                                                              |  |              |          |   |      |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | -------- | - | ---- | - | -------- | -
|                                                                                                                                                                                                              |  | December 31, |         
|                                                                                                                                                                                                              |  | 2003         |          |   | 2004 |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                                                                          |  |              |          |   |      |   |          |  
|                                                                                                                                                                                                              |  |             
|CURRENT LIABILITIES:                                                                                                                                                                                          |  |              |          |   |      |   |          |  
|Short-term bank credit (Note 6)                                                                                                                                                                               |  | $            | 908      |   |      | $ | 1,513    |  
|Current maturities of long-term bank loan (Note 8)                                                                                                                                                            |  |              | 1,036    |   |      |   | 1,045    |  
|Trade payables                                                                                                                                                                                                |  |              | 905      |   |      |   | 1,118    |  
|Deferred revenues                                                                                                                                                                                             |  |              | 1,304    |   |      |   | 2,729    |  
|Other accounts payable and accrued expenses (Note 7)                                                                                                                                                          |  |              | 2,907    |   |      |   | 2,334    |  
|                                                                                                                                                                                                              |  |              |          |   |      |   |          |  
|Total current liabilities                                                                                                                                                                                     |  |              | 7,060    |   |      |   | 8,739    |  
|                                                                                                                                                                                                              |  |              |          |   |      |   |          |  
|LONG-TERM LIABILITIES:                                                                                                                                                                                        |  |              |          |   |      |   |          |  
|Long-term bank loan (Note 8)                                                                                                                                                                                  |  |              | 1,307    |   |      |   | 261      |  
|Convertible note (Note 9)                                                                                                                                                                                     |  |              |         |   |      |   | 2,500    |  
|Accrued severance pay                                                                                                                                                                                         |  |              | 1,077    |   |      |   | 1,220    |  
|                                                                                                                                                                                                              |  |              |          |   |      |   |          |  
|Total long-term liabilities                                                                                                                                                                                   |  |              | 2,384    |   |      |   | 3,981    |  
|                                                                                                                                                                                                              |  |              |          |   |      |   |          |  
|COMMITMENTS AND CONTINGENT LIABILITIES (Note 10)                                                                                                                                                              |  |              |          |   |      |   |          |  
|                                                                                                                                                                                                              |  |             
|SHAREHOLDERS EQUITY:                                                                                                                                                                                         |  |              |          |   |      |   |          |  
|Share capital (Note 11):                                                                                                                                                                                      |  |              |          |   |      |   |          |  
|Ordinary Shares of NIS 1.0 par value - Authorized: 6,500,000 and 11,000,000 at December 31, 2003 and 2004; Issued and outstanding: 4,490,872
and 5,413,892 shares at December 31, 2003 and 2004, respectively |  |              | 1,108    |   |      |   | 1,312    |  
|Additional paid-in capital                                                                                                                                                                                    |  |              | 105,725  |   |      |   | 108,511  |  
|Deferred stock compensation                                                                                                                                                                                   |  |              | (102     | ) |      |   | (50      | )
|Accumulated other comprehensive loss                                                                                                                                                                          |  |              | (353     | ) |      |   | (348     | )
|Accumulated deficit                                                                                                                                                                                           |  |              | (103,592 | ) |      |   | (107,747 | )
|                                                                                                                                                                                                              |  |              |          |   |      |   |          |  
|Total shareholders equity                                                                                                                                                                                    |  |              | 2,786    |   |      |   | 1,678    |  
|                                                                                                                                                                                                              |  |              |          |   |      |   |          |  
|Total liabilities and shareholders equity                                                                                                                                                                    |  | $            | 12,230   |   |      | $ | 14,398   |  
|                                                                                                                                                                                                              |  |              |          |   |      |   |          |  



The accompanying notes are an integral
part of the consolidated financial statements.



F-4



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



CONSOLIDATED STATEMENTS OF OPERATIONS

U.S. dollars in thousands, except share and per share data



|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|------------------------------------------------------------------------------------------------- |  | ----------------------- | --------- | - | ---- | - | --------- | ---- |  | - | --------- | -
|                                                                                                  |  | Year ended December 31, |          
|                                                                                                  |  | 2002                    |           |   | 2003 |   |           | 2004 | 
|Revenues (Notes 13a,15):                                                                          |  |                         |           |   |      |   |           |      |  |   |           |  
|Software licenses                                                                                 |  | $                       | 6,611     |   |      | $ | 4,102     |      |  | $ | 3,114     |  
|Maintenance and services                                                                          |  |                         | 5,190     |   |      |   | 7,857     |      |  |   | 8,806     |  
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|Total revenues                                                                                    |  |                         | 11,801    |   |      |   | 11,959    |      |  |   | 11,920    |  
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|Cost of revenues:                                                                                 |  |                         |           |   |      |   |           |      |  |   |           |  
|Software licenses                                                                                 |  |                         | 361       |   |      |   | 482       |      |  |   | 288       |  
|Maintenance and services                                                                          |  |                         | 4,380     |   |      |   | 4,996     |      |  |   | 6,741     |  
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|Total cost of revenues                                                                            |  |                         | 4,741     |   |      |   | 5,478     |      |  |   | 7,029     |  
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|Gross profit                                                                                      |  |                         | 7,060     |   |      |   | 6,481     |      |  |   | 4,891     |  
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|Operating expenses:                                                                               |  |                         |           |   |      |   |           |      |  |   |           |  
|Research and development                                                                          |  |                         | 3,813     |   |      |   | 2,194     |      |  |   | 2,069     |  
|Less - royalty bearing grants                                                                     |  |                         | 461       |   |      |   | 96        |      |  |   |          |  
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|Research and development, net                                                                     |  |                         | 3,352     |   |      |   | 2,098     |      |  |   | 2,069     |  
|Selling and marketing                                                                             |  |                         | 6,598     |   |      |   | 4,109     |      |  |   | 4,367     |  
|General and administrative                                                                        |  |                         | 2,261     |   |      |   | 1,947     |      |  |   | 2,149     |  
|In-process research and development write-off                                                     |  |                         | 480       |   |      |   |          |      |  |   |          |  
|Stock compensation expenses (1)                                                                   |  |                         | 36        |   |      |   | 20        |      |  |   | 98        |  
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|Total operating expenses                                                                          |  |                         | 12,727    |   |      |   | 8,174     |      |  |   | 8,683     |  
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|Operating loss                                                                                    |  |                         | (5,667    | ) |      |   | (1,693    | )    |  |   | (3,792    | )
|Financial expenses, net (Note 14)                                                                 |  |                         | (189      | ) |      |   | (311      | )    |  |   | (363      | )
|Other income                                                                                      |  |                         |          |   |      |   | 350       |      |  |   |          |  
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|Net loss                                                                                          |  | $                       | (5,856    | ) |      | $ | (1,654    | )    |  | $ | (4,155    | )
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|Basic and diluted net loss per share                                                              |  | $                       | (2.26     | ) |      | $ | (0.55     | )    |  | $ | (0.85     | )
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|Weighted average number of shares used in computing basic and diluted net loss per Ordinary Share |  |                         | 2,587,948 |   |      |   | 3,048,319 |      |  |   | 4,888,062 |  
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|                                                                                                  |  |                         |          
|(1)     Stock compensation relates to the following:                                              |  |                         |           |   |      |   |           |      |  |   |           |  
|                                                                                                  |  |                         |          
|Cost of revenues                                                                                  |  | $                       |          |   |      | $ |          |      |  | $ | 2         |  
|Selling and marketing                                                                             |  |                         | 32        |   |      |   |          |      |  |   | 31        |  
|General and administrative                                                                        |  |                         | 4         |   |      |   | 20        |      |  |   | 65        |  
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  
|Total                                                                                             |  | $                       | 36        |   |      | $ | 20        |      |  | $ | 98        |  
|                                                                                                  |  |                         |           |   |      |   |           |      |  |   |           |  



The accompanying notes are an integral
part of the consolidated financial statements.



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY (DEFICIENCY)

U.S. dollars in thousands, except share data



|                                                                                           |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------------------------ |  | --------------- |  | ------------------------- | ----- |  | --------------------------- | ------- | - | ---------------------------------- | - | ---- | ------------------- |  | - | ----------------------- | - |  | ------------------------------------- | -------- | - |  | - | ------ | - |  | - | ------ | -
|                                                                                           |  | Ordinary Shares |  | Additionalpaid-in capital |       |  | Deferred stock compensation |         |   | Accumulatedothercomprehensive Loss |   |      | Accumulated deficit |  |   | Totalcomprehensive loss |   |  | Totalshareholdersequity (deficiency) |         
|                                                                                           |  | Number          |  | Amount                    |       |  |                             |         |   |                                   
|Balance as of January 1, 2002                                                              |  | 2,171,678       |  | $                         | 611   |  | $                           | 97,962  |   |                                    | $ | (43  | )                   |  | $ | (436                    | ) |  | $                                     | (96,082  | ) |  |   |        |   |  | $ | 2,012  |  
|Issuance of shares in connection with the acquisition of iMedeon, Inc.                     |  | 510,055         |  |                           | 110   |  |                             | 2,843   |   |                                    |   |     |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 2,953  |  
|Amortization of deferred stock compensation                                                |  |                |  |                           |      |  |                             |        |   |                                    |   | 36   |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 36     |  
|Stock based Compensation related to warrants to a related party                            |  |                |  |                           |      |  |                             | 136     |   |                                    |   |     |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 136    |  
|Forfeiture of stock options to employees                                                   |  |                |  |                           |      |  |                             | (7      | ) |                                    |   | 7    |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   |       |  
|Comprehensive loss:                                                                        |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  |   |        |   |  |   |        |  
|Foreign currency translation adjustments                                                   |  |                |  |                           |      |  |                             |        |   |                                    |   |     |                     |  |   | 68                      |   |  |                                       |         |   |  | $ | 68     |   |  |   | 68     |  
|Net loss                                                                                   |  |                |  |                           |      |  |                             |        |   |                                    |   |     |                     |  |   |                        |   |  |                                       | (5,856   | ) |  |   | (5,856 | ) |  |   | (5,856 | )
|                                                                                           |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  |   |        |   |  |   |        |  
|Total comprehensive loss                                                                   |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  | $ | (5,788 | ) |  |   |        |  
|                                                                                           |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  |   |        |   |  |   |        |  
|Balance as of December 31, 2002                                                            |  | 2,681,733       |  |                           | 721   |  |                             | 100,934 |   |                                    |   |     |                     |  |   | (368                    | ) |  |                                       | (101,938 | ) |  |   |        |   |  |   | (651   | )
|Issuance of shares, net of issuance expenses                                               |  | 1,611,089       |  |                           | 361   |  |                             | 4,232   |   |                                    |   |     |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 4,593  |  
|Exercise of stock options                                                                  |  | 112,962         |  |                           | 26    |  |                             | 158     |   |                                    |   |     |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 184    |  
|Exercise of warrants to a bank by way of cashless exercise                                 |  | 85,088          |  |                           |      |  |                             |        |   |                                    |   |     |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   |       |  
|Deferred stock compensation to employees                                                   |  |                |  |                           |      |  |                             | 106     |   |                                    |   | (106 | )                   |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   |       |  
|Amortization of deferred stock compensation                                                |  |                |  |                           |      |  |                             |        |   |                                    |   | 4    |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 4      |  
|Compensation related to warrants granted to a bank                                         |  |                |  |                           |      |  |                             | 71      |   |                                    |   |     |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 71     |  
|Compensation related to warrants granted to consultants                                    |  |                |  |                           |      |  |                             | 101     |   |                                    |   |     |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 101    |  
|Compensation related to warrants granted in regard to settlement agreement with a customer |  |                |  |                           |      |  |                             | 123     |   |                                    |   |     |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 123    |  
|Comprehensive loss:                                                                        |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  |   |        |   |  |   |        |  
|Foreign currency translation adjustments                                                   |  |                |  |                           |      |  |                             |        |   |                                    |   |     |                     |  |   | 15                      |   |  |                                       |         |   |  | $ | 15     |   |  |   | 15     |  
|Net loss                                                                                   |  |                |  |                           |      |  |                             |        |   |                                    |   |     |                     |  |   |                        |   |  |                                       | (1,654   | ) |  |   | (1,654 | ) |  |   | (1,654 | )
|                                                                                           |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  |   |        |   |  |   |        |  
|Total comprehensive loss                                                                   |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  | $ | (1,639 | ) |  |   |        |  
|                                                                                           |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  |   |        |   |  |   |        |  
|Balance as of December 31, 2003                                                            |  | 4,490,872       |  |                           | 1,108 |  |                             | 105,725 |   |                                    |   | (102 | )                   |  |   | (353                    | ) |  |                                       | (103,592 | ) |  |   |        |   |  |   | 2,786  |  
|Issuance of shares in connection with the acquisition of Utility Partners, Inc.            |  | 898,485         |  |                           | 198   |  |                             | 2,738   |   |                                    |   |     |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 2,936  |  
|Exercise of stock options                                                                  |  | 24,535          |  |                           | 6     |  |                             | 34      |   |                                    |   |     |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 40     |  
|Compensation related to warrants granted to consultants                                    |  |                |  |                           |      |  |                             | 14      |   |                                    |   |     |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 14     |  
|Amortization of deferred stock compensation                                                |  |                |  |                           |      |  |                             |        |   |                                    |   | 52   |                     |  |   |                        |   |  |                                       |         |   |  |   |        |   |  |   | 52     |  
|Comprehensive loss:                                                                        |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  |   |        |   |  |   |        |  
|Foreign currency translation adjustments                                                   |  |                |  |                           |      |  |                             |        |   |                                    |   |     |                     |  |   | 5                       |   |  |                                       |         |   |  | $ | 5      |   |  |   | 5      |  
|Net loss                                                                                   |  |                |  |                           |      |  |                             |        |   |                                    |   |     |                     |  |   |                        |   |  |                                       | (4,155   | ) |  |   | (4,155 | ) |  |   | (4,155 | )
|                                                                                           |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  |   |        |   |  |   |        |  
|Total comprehensive loss                                                                   |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  | $ | (4,150 | ) |  |   |        |  
|                                                                                           |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  |   |        |   |  |   |        |  
|Balance as of December 31, 2004                                                            |  | 5,413,892       |  | $                         | 1,312 |  | $                           | 108,511 |   |                                    | $ | (50  | )                   |  | $ | (348                    | ) |  | $                                     | (107,747 | ) |  |   |        |   |  | $ | 1,678  |  
|                                                                                           |  |                 |  |                           |       |  |                             |         |   |                                    |   |      |                     |  |   |                         |   |  |                                       |          |   |  |   |        |   |  |   |        |  



The accompanying notes are an integral
part of the consolidated financial statements.



F-6



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



CONSOLIDATED STATEMENTS OF CASH FLOWS

U.S. dollars in thousands



|                                                                                           |  |                         |        |   |      |   |        |      |  |   |        |  
|------------------------------------------------------------------------------------------ |  | ----------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                           |  | Year ended December 31, |       
|                                                                                           |  | 2002                    |        |   | 2003 |   |        | 2004 | 
|Cash flows from operating activities:                                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|Net loss                                                                                   |  | $                       | (5,856 | ) |      | $ | (1,654 | )    |  | $ | (4,155 | )
|Adjustments to reconcile net loss to net cash used in operating activities:                |  |                         |        |   |      |   |        |      |  |   |        |  
|Depreciation and amortization                                                              |  |                         | 1,306  |   |      |   | 974    |      |  |   | 763    |  
|In-process research and development write-off                                              |  |                         | 480    |   |      |   |       |      |  |   |       |  
|Accrued severance pay, net                                                                 |  |                         | (202   | ) |      |   | 28     |      |  |   | 46     |  
|Amortization of deferred stock compensation to employees                                   |  |                         | 36     |   |      |   | 4      |      |  |   | 52     |  
|Compensation related to warrants to a bank                                                 |  |                         |       |   |      |   | 14     |      |  |   | 28     |  
|Compensation related to warrants granted in regard to settlement agreement with a customer |  |                         |       |   |      |   | 123    |      |  |   |       |  
|Compensation related to warrants to a related party                                        |  |                         | 136    |   |      |   |       |      |  |   |       |  
|Compensation related to warrants to consultants                                            |  |                         |       |   |      |   | 16     |      |  |   | 46     |  
|Decrease (increase) in trade receivables and unbilled receivables                          |  |                         | 460    |   |      |   | (134   | )    |  |   | 674    |  
|Decrease (increase) in other accounts receivable and prepaid expenses                      |  |                         | 366    |   |      |   | (141   | )    |  |   | 114    |  
|Increase (decrease) in trade payables                                                      |  |                         | (1,086 | ) |      |   | 50     |      |  |   | 122    |  
|Increase (decrease) in deferred revenues                                                   |  |                         | 91     |   |      |   | (136   | )    |  |   | 861    |  
|Decrease in other accounts payable and accrued expenses                                    |  |                         | (2,481 | ) |      |   | (512   | )    |  |   | (1,242 | )
|Other                                                                                      |  |                         | 38     |   |      |   | 2      |      |  |   |       |  
|                                                                                           |  |                         |        |   |      |   |        |      |  |   |        |  
|Net cash used in operating activities                                                      |  |                         | (6,712 | ) |      |   | (1,366 | )    |  |   | (2,691 | )
|                                                                                           |  |                         |        |   |      |   |        |      |  |   |        |  
|Cash flows from investing activities:                                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|Purchase of property and equipment                                                         |  |                         | (71    | ) |      |   | (14    | )    |  |   | (195   | )
|Proceeds from sale of property and equipment                                               |  |                         | 6      |   |      |   |       |      |  |   |       |  
|Decrease in restricted cash                                                                |  |                         |       |   |      |   | 30     |      |  |   |       |  
|Cash provided in connection with the acquisition of iMedeon (a)                            |  |                         | 1,804  |   |      |   |       |      |  |   |       |  
|Cash used in connection with the acquisition of Utility Partners (b)                       |  |                         |       |   |      |   |       |      |  |   | (1,107 | )
|                                                                                           |  |                         |        |   |      |   |        |      |  |   |        |  
|Net cash provided by (used in) investing activities                                        |  |                         | 1,739  |   |      |   | 16     |      |  |   | (1,302 | )
|                                                                                           |  |                         |        |   |      |   |        |      |  |   |        |  
|Cash flows from financing activities:                                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|Short-term bank credit, net                                                                |  |                         |       |   |      |   | 898    |      |  |   | 605    |  
|Repayment of short-term bank credit and long term loan                                     |  |                         | (534   | ) |      |   | (2,613 | )    |  |   | (1,065 | )
|Proceeds from issuance of convertible note                                                 |  |                         |       |   |      |   |       |      |  |   | 2,500  |  
|Issuance costs for convertible note                                                        |  |                         |       |   |      |   |       |      |  |   | (29    | )
|Proceeds from issuance of share capital, net                                               |  |                         |       |   |      |   | 4,816  |      |  |   |       |  
|Issuance expenses paid in connection with issuance of share capital from prior year        |  |                         |       |   |      |   |       |      |  |   | (193   | )
|Proceeds from exercise of stock options                                                    |  |                         |       |   |      |   | 184    |      |  |   | 40     |  
|                                                                                           |  |                         |        |   |      |   |        |      |  |   |        |  
|Net cash provided by (used in) financing activities                                        |  |                         | (534   | ) |      |   | 3,285  |      |  |   | 1,858  |  
|                                                                                           |  |                         |        |   |      |   |        |      |  |   |        |  
|Effect of exchange rate on cash and cash equivalents                                       |  |                         | 178    |   |      |   | (59    | )    |  |   | (9     | )
|                                                                                           |  |                         |        |   |      |   |        |      |  |   |        |  
|Increase (decrease) in cash and cash equivalents                                           |  |                         | (5,329 | ) |      |   | 1,876  |      |  |   | (2,144 | )
|Cash and cash equivalents at the beginning of the year                                     |  |                         | 8,540  |   |      |   | 3,211  |      |  |   | 5,087  |  
|                                                                                           |  |                         |        |   |      |   |        |      |  |   |        |  
|Cash and cash equivalents at the end of the year                                           |  | $                       | 3,211  |   |      | $ | 5,087  |      |  | $ | 2,943  |  
|                                                                                           |  |                         |        |   |      |   |        |      |  |   |        |  



The accompanying notes are an integral
part of the consolidated financial statements.



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VIRYANET LTD. AND ITS SUBSIDIARIES



CONSOLIDATED STATEMENTS OF CASH FLOWS

U.S. dollars in thousands



|                                                                                                       |  |                         |       |      |   |      |  |   |   
|------------------------------------------------------------------------------------------------------ |  | ----------------------- | ----- | ---- | - | ---- |  | - | --
|                                                                                                       |  | Year ended December 31,
|                                                                                                       |  | 2002                    |       | 2003 |   | 2004
|Supplemental disclosure of cash flows activities:                                                      |  |                         |       |      |   |      |  |   |   
|Cash paid during the year for:                                                                         |  |                         |       |      |   |      |  |   |   
|Interest                                                                                               |  | $                       | 204   |      | $ | 169  |  | $ | 87
|                                                                                                       |  |                         |       |      |   |      |  |   |   
|Supplemental disclosure of non-cash investing and financing activities:                                |  |                         |       |      |   |      |  |   |   
|Refinancing of short-term loan on a long-term basis                                                    |  | $                       | 2,400 |      | $ |     |  | $ |  
|                                                                                                       |  |                         |       |      |   |      |  |   |   
|Issuance expenses to be paid                                                                           |  | $                       |      |      | $ | 223  |  | $ |  
|                                                                                                       |  |                         |       |      |   |      |  |   |   
|Compensation related to warrants to a bank                                                             |  | $                       |      |      | $ | 71   |  | $ |  
|                                                                                                       |  |                         |       |      |   |      |  |   |   
|Compensation related to options and warrants to consultants and a settlement agreement with a customer |  | $                       |      |      | $ | 224  |  | $ | 14
|                                                                                                       |  |                         |       |      |   |      |  |   |   



|(a) | Acquisition of iMedeon, Inc.
|--- | ----------------------------



In February 2002, the Company and its subsidiaries acquired assets and assumed liabilities of iMedeon, Inc., The estimated net fair value of the assets
acquired and liabilities assumed as of the date of acquisition was as follows:



|                                                                |  |                              |        |  
|--------------------------------------------------------------- |  | ---------------------------- | ------ | -
|                                                                |  | Year ended December 31, 2002 |       
|Working capital deficiency, excluding cash and cash equivalents |  | $                            | 2,378  |  
|Property and equipment                                          |  |                              | (95    | )
|Current technology                                              |  |                              | (180   | )
|In process research and development                             |  |                              | (480   | )
|Goodwill                                                        |  |                              | (2,772 | )
|Less - amounts acquired by issuance of shares                   |  |                              | 2,953  |  
|                                                                |  |                              |        |  
|                                                                |  | $                            | 1,804  |  
|                                                                |  |                              |        |  



|(b) | Acquisition of Utility Partners, Inc.
|--- | -------------------------------------



In July 2004, the Company and its subsidiaries acquired assets and assumed liabilities of Utility Partners, Inc., The estimated net fair value of the
assets acquired and liabilities assumed as of the date of acquisition was as follows:



|                                                                |  |                              |        |  
|--------------------------------------------------------------- |  | ---------------------------- | ------ | -
|                                                                |  | Year ended December 31, 2004 |       
|Working capital deficiency, excluding cash and cash equivalents |  | $                            | 1,408  |  
|Property and equipment                                          |  |                              | (21    | )
|Current technology                                              |  |                              | (590   | )
|Customer relationship                                           |  |                              | (965   | )
|Database                                                        |  |                              | (21    | )
|Trademark and tradename                                         |  |                              | (110   | )
|Goodwill                                                        |  |                              | (3,744 | )
|Less - amounts acquired by issuance of shares                   |  |                              | 2,936  |  
|                                                                |  |                              |        |  
|                                                                |  | $                            | (1,107 | )
|                                                                |  |                              |        |  



The accompanying notes are an integral
part of the consolidated financial statements.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data



NOTE 1:- GENERAL



| | a. | ViryaNet Ltd. (the Company), an Israeli corporation, was established in 1988. The Company develops, markets and supports integrated mobile and Web-based software
applications for workforce management and the automation of field service delivery. The Company also provides additional software applications for spare parts logistics, contract management, and depot repair operations. The Companys mission is
to provide companies with solutions that improve the quality and efficiency of their complex service business processes.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



ViryaNet Ltd. has five wholly-owned subsidiaries: three in the United States (ViryaNet Inc. and its subsidiaries iMedeon Inc. and
Utility Partners Inc., collectively ViryaNet US) one in the United Kingdom (ViryaNet UK), and one in Japan (ViryaNet Japan). See also Note 16c.



The Companys sales are generated in the United States, Europe and the
Middle East and the, Far East. In 2002, 2003 and 2004, sales to major customers constituted 12%, 41% and 25% of the total revenues, respectively. As for major customers, see Note 13b.



The Ordinary Shares of the Company are traded on the Nasdaq SmallCap Market. See also Note 16d.



| | b. | Acquisition of iMedeon, Inc.:
| | -- | -----------------------------



In February 2002, the Company acquired all the outstanding shares of iMedeon, a United States based company, in a stock-for-stock transaction. iMedeon was
a provider of mobile workforce management solutions to the utilities sector. The aggregate purchase price for this transaction was approximately $ 3,650, and consisted of 510,055 of the Companys Ordinary Shares (estimated fair value of $
2,953) and transaction expenses of approximately $ 700.



The
Company acquired iMedeon in order to accelerate its penetration into the utilities sector, to strengthen its delivery teams and to further strengthen its product offerings.



The Company determined the fair value of the issued shares using Emerging Issues Task Force No. 99-12 Determination of
the Measurement Date For the Market Price of Acquirer Securities Issued in a Purchase Business Combination (EITF No. 99-12). According to EITF No. 99-12 the fair value is determined based on the average market price of the
Companys Ordinary Shares two days before and after the announcement date.



The operations of iMedeon are included in the consolidated statements from the date of acquisition.



The acquisition was accounted for under the purchase method of accounting, in accordance with SFAS No. 141, and accordingly, the purchase price has been
allocated to the assets acquired and the liabilities assumed based on their estimated fair value at the date of acquisition. The excess of the purchase price over the estimated fair value of the net assets acquired has been recorded as goodwill.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands, except share data



NOTE 1:- GENERAL (Cont.)



The following table summarizes the estimated fair value of assets acquired and liabilities assumed at the date of
acquisition:



|                                        |  |   |        |  
|--------------------------------------- |  | - | ------ | -
|Current assets                          |  | $ | 2,595  |  
|Property and equipment                  |  |   | 95     |  
|Technology (1)                          |  |   | 180    |  
|In process research and development (2) |  |   | 480    |  
|Goodwill                                |  |   | 2,772  |  
|                                        |  |   |        |  
|Total assets acquired                   |  |   | 6,122  |  
|                                        |  |   |        |  
|Current liabilities                     |  |   | (2,472 | )
|                                        |  |   |        |  
|Total liabilities assumed               |  |   | (2,472 | )
|                                        |  |   |        |  
|Net assets acquired                     |  | $ | 3,650  |  
|                                        |  |   |        |  

---

|(1) | See also Note 5.
|--- | ----------------

|(2) | In connection with the acquisition, the Company recorded in the year 2002 a one time expense of $ 480 to write-off in-process research and development acquired from iMedeon for
which technological feasibility has not yet been established and for which no alternative future use exists.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The following represents the unaudited pro-forma results of operations for the year ended December 31, 2002 assuming that the iMedeon acquisition had been
consummated as of January 1, 2001 and 2002, respectively:



|                                     |  |                         |        |      |   |       
|------------------------------------ |  | ----------------------- | ------ | ---- | - | ------
|                                     |  | Year ended December 31,
|                                     |  | 2001                    |        | 2002
|Revenues                             |  | $                       | 16,209 |      | $ | 12,043
|                                     |  |                         |        |      |   |       
|Net loss                             |  | $                       | 26,106 |      | $ | 7,614 
|                                     |  |                         |        |      |   |       
|Basic and diluted net loss per share |  | $                       | 12.02  |      | $ | 2.94  
|                                     |  |                         |        |      |   |       



| | c. | Acquisition of Utility Partners, Inc.:
| | -- | --------------------------------------



In July 2004, the Company acquired all the outstanding shares of Utility Partners Inc. (UP or Utility Partners), a United States
based company, for an aggregate purchase price of $ 4,573. Utility Partners was a provider of mobile workforce management solutions to the utilities sector. The aggregate purchase price for this transaction consisted of a cash payment of $ 1,430,
issuance of 898,485 of the Companys Ordinary Shares (estimated fair value of $ 2,936), and transaction expenses of approximately $ 207.



The Company acquired UP in order to solidify its position within the utilities sector, to strengthen its delivery teams and to further strengthen its
product offerings



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data



NOTE 1:- GENERAL (Cont.)



The Company determined the fair value of the issued shares using EITF No. 99-12. According to EITF No. 99-12 the fair value
is determined based on the average market price of the Companys Ordinary Shares two days before and after the transaction date.



The operations of UP are included in the consolidated statements from the date of acquisition.



The acquisition was accounted for under the purchase method of accounting,
in accordance with SFAS No. 141, and accordingly, the purchase price has been allocated to the assets acquired and the liabilities assumed based on their estimated fair value at the date of acquisition. The excess of the purchase price over the
estimated fair value of the net assets acquired has been recorded as goodwill.



The following table summarizes the estimated fair value of assets acquired and liabilities assumed at the date of acquisition:



|                            |  |   |        |  
|--------------------------- |  | - | ------ | -
|Current assets              |  | $ | 640    |  
|Property and equipment      |  |   | 21     |  
|Technology (1)              |  |   | 590    |  
|Customer relationship (1)   |  |   | 965    |  
|Database (1)                |  |   | 21     |  
|Trademark and tradename (1) |  |   | 110    |  
|Goodwill                    |  |   | 3,744  |  
|                            | 
|Total assets acquired       |  |   | 6,091  |  
|                            |  |   |        |  
|Current liabilities         |  |   | (1,518 | )
|                            |  |   |        |  
|Total liabilities assumed   |  |   | (1,518 | )
|                            |  |   |        |  
|Net assets acquired         |  | $ | 4,573  |  
|                            |  |   |        |  

---

|(1) | See also Note 5.
|--- | ----------------



The following represents the unaudited pro-forma results of operations for the year ended December 31, 2004 assuming that the UP acquisition had been
consummated as of January 1, 2003 and 2004, respectively:



|                                     |  |                         |        |      |   |       
|------------------------------------ |  | ----------------------- | ------ | ---- | - | ------
|                                     |  | Year ended December 31,
|                                     |  | 2003                    |        | 2004
|Revenues                             |  | $                       | 15,625 |      | $ | 13,741
|                                     |  |                         |        |      |   |       
|Net loss                             |  | $                       | 1,869  |      | $ | 5,131 
|                                     |  |                         |        |      |   |       
|Basic and diluted net loss per share |  | $                       | 0.61   |      | $ | 1.05  
|                                     |  |                         |        |      |   |       



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data



NOTE 1:- GENERAL (Cont.)



The pro-forma financial information is not necessarily indicative of the consolidated results that would have been attained
had the acquisition taken place at the beginning of 2004, nor is it necessarily indicative of future results.



| | d. | Restructuring charges:
| | -- | ----------------------



During the fourth quarter of 2002, the Company restructured its sale and support strategy in Europe, changing from a direct to an indirect selling model.
This resulted in the termination of personnel and contractors employed directly by ViryaNet U.K.



In connection with the 2002 restructuring plan, Emerging Issues Task Force 94-3 (EITF 94-3) Liability Recognition for Certain Employee
Termination Benefits and Other Cost to Exit an Activity (including certain cost in restructuring) and Staff Accounting Bulletin No. 100 Restructuring and Impairment Charges (SAB No. 100) were applied and accordingly,
the Company incurred expenses of $ 439, out of which $ 185 were included in cost of maintenance and services, $ 150 in selling and marketing expenses and $ 104 in general and administrative expenses.



NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES



Basis of presentation:



The consolidated financial statements have been prepared in accordance with
United States generally accepted accounting principles (U.S. GAAP).



Use of estimates:



The
preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results
could differ from those estimates.



Financial statements in
U.S. dollars:



Substantially all of the revenues of the
Company and ViryaNet U.S. are generated in U.S. dollars (dollars). In addition, a substantial portion of the costs of the Company and its subsidiaries is incurred in dollars. The Companys management believes that the dollar is the
primary currency of the economic environment in which the Company and its U.S. subsidiaries operate. Thus, the functional and reporting currency of the Company and its U.S. subsidiaries is the dollar. Accordingly, amounts in currencies other than
U.S. dollars have been translated as follows:



Monetary
balances - at the exchange rate in effect on the balance sheet date.



Nonmonetary balances  at the historical rate in effect as of the date of recognition of the transaction.



Revenues and cost - at the exchange rate in effect as of the date of recognition of the transaction.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES



All the exchange gain and losses from the remeasurement mentioned above are reflected in the statement of operations in
financial expenses (income), net.



The functional currency of
ViryaNet UK and ViryaNet Japan has been determined to be their local currency. Assets and liabilities are translated at year-end exchange rates and statement of operations items are translated at average exchange rates prevailing during the year.
Such translation adjustments are recorded as a separate component of accumulated other comprehensive loss in shareholders equity.



Principles of consolidation:



The consolidated financial statements include the accounts of the Company and its subsidiaries (the Group). Intercompany balances and
transactions including profit from intercompany sales not yet realized outside the group, have been eliminated upon consolidation.



Cash equivalents:



Cash equivalents are short-term, highly liquid investments that are readily convertible to cash, with original maturities of three months or less.



Property and equipment:



Property and equipment are stated at cost, net of accumulated depreciation.
Depreciation is calculated by the straight-line method over the estimated useful lives of the assets at the following annual rates:



|                                             |  |                                                
|-------------------------------------------- |  | -----------------------------------------------
|                                             |  | %                                              
|Computers, peripheral equipment and software |  | 33                                             
|Office furniture and equipment               |  | 6 - 25                                         
|Leasehold improvements                       |  | Over the lesser term of thelease or useful life



Intangible assets:



Intangible assets are presented at cost. The intangible
assets amortized over their useful lives on the straight-line method for the following periods:



|                        |  |                            
|----------------------- |  | ---------------------------
|                        |  | Amortization period inyears
|Technology              |  | 3                          
|Customer relationship   |  | 6                          
|Database                |  | 2                          
|Trademark and tradename |  | 4                          



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)



Impairment of long-lived assets:



The Company and its subsidiaries long-lived assets, including identifiable intangible assets, are reviewed for
impairment in accordance with Statement of Financial Accounting Standard No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS No. 144), whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. During 2002, 2003 and 2004, no impairment losses have been identified.



Goodwill:



Under Financial Accounting Standards No. 142 Goodwill and Other Intangible Assets (SFAS No. 142) goodwill is not amortized but
instead is tested for impairment at least annually (or more frequently if impairment indicators arise).



SFAS No. 142 prescribes a two phase process for impairment testing of goodwill. The first phase screens for impairment; while the second phase (if
necessary) measures impairment.



In the first phase of
impairment testing, goodwill attributable to each of the reporting units is tested for impairment by comparing the fair value of each reporting unit with its carrying value. During 2002, 2003 and 2004, no instances of impairment were found.



Income taxes:



The Company and its subsidiaries account for income taxes in accordance with
Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS No. 109). This statement prescribes the use of the liability method whereby deferred tax assets and liability account balances are
determined based on the differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company and its
subsidiaries provide a valuation allowance, if necessary, to reduce deferred tax assets to their estimated realizable value.



Revenue recognition:



The Company generates revenues from licensing the rights to use its software products directly to end-users and through indirect channels such as
resellers and system integrators. The Company also generates revenues from rendering professional services, including consulting, customization, implementation, training and maintenance.



All of the Companys software licenses sold through reseller agreements are non-exchangeable, non-refundable and
non-returnable. Accordingly, the resellers are considered end users.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)



Revenues from software license agreements are recognized, in accordance with Statement Of Position No. 97-2, Software
Revenue Recognition, as amended (SOP No. 97-2). SOP No. 97-2 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair value of the elements.
The Company has adopted Statement of Position No. 98-9, Modification of SOP No. 97-2, Software Revenue Recognition with Respect to Certain Transactions, (SOP No. 98-9). SOP No. 98-9 requires that revenue be recognized under
the residual method when vendor specific objective evidence (VSOE) of fair value exists for all undelivered elements and VSOE does not exist for all of the delivered elements. Under the residual method any discount in the
arrangement is allocated to the delivered element.



Generally,
Revenue from license fees is recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, no significant obligations with regard to implementation remain, the fee is fixed or determinable and collectibility is
probable. The Company does not grant a right of return to its customers.



The Company recognized revenues during 2002 on licensing transactions as payments were due, provided collectibility of the amount was deemed probable, or as payments were collected.



For 2003 and 2004, the Company believes that it has attained a sufficient
history of successfully collecting on licensing transactions with payments terms of three months or less without making a concession. As a result, the Company recognized revenues on such arrangements upfront on the date of the delivery, provided
collectibility was deemed probable at the date of the transaction.



Maintenance and support revenue included in multiple element arrangements is deferred and recognized on a straight-line basis over the term of the maintenance and support agreement, which is, in most cases, one year. Revenue from rendering
services such as consulting, implementation and training are recognized as work is performed. The VSOE of fair value of the undelivered elements is determined based on the price charged for the undelivered element when sold separately.



Arrangements that include services are evaluated to determine whether
those services are essential to the functionality of other elements of the arrangement. Services that are considered essential consist primarily of significant production, customization, or modification when such services are provided, revenue under
the arrangement is recognized using contract accounting. When services are not considered essential, the revenue allocable to the software services is recognized as the services are performed.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)



Revenues from software licenses that require significant production, customization, or modification are recognized in
accordance with Statement of Position No. 81-1, Accounting for Performance of Construction - Type and Certain Production - Type Contracts (SOP No. 81-1), using contract accounting on a percentage of completion method, based
on the relationship of actual labor days incurred to total labor days estimated to be incurred over the duration of the contract and in accordance with the Input Method. Provisions for estimated losses on uncompleted contracts are made
in the period in which such losses are first determined, in the amount of the estimated loss on the entire contract. As of December 31, 2004, no such estimated losses were identified.



Estimated gross profit or loss from long-term contracts may change due to changes in estimates resulting from differences
between actual performance and original forecasts. Such changes in estimated gross profit are recorded in results of operations when they are reasonably determinable by management, on a cumulative catch-up basis.



Deferred revenue:



Deferred revenue is comprised of deferred maintenance and support, and
professional services. Deferred maintenance and support revenue is not recorded until it has been collected and is recognized as revenue over the term of the arrangement. Deferred professional services revenue is not recorded unless it has been paid
in advance of performance and is recognized as revenue when the services have been performed.



The following table describes the allocation of deferred revenue for the periods ended on December 31:



|                        |  |      |       |      |   |      
|----------------------- |  | ---- | ----- | ---- | - | -----
|                        |  | 2003 |       | 2004
|Maintenance and support |  | $    | 1,277 |      | $ | 2,378
|Professional services   |  |      | 27    |      |   | 351  
|                        |  |      |       |      |   |      
|Total deferred revenue  |  | $    | 1,304 |      | $ | 2,729
|                        |  |      |       |      |   |      



Research and
development costs:



Research and development costs, net of
grants received, are charged to the statement of operations as incurred.



Statement of Financial Accounting Standards No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed (SFAS No. 86), requires capitalization of certain
software development costs subsequent to the establishment of technological feasibility.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)



Based on the Companys product development process, technological feasibility is established upon completion of a
working model. Costs incurred by the Company between the completion of the working model and the point at which the product is ready for general release have been insignificant. Due to the relatively short time between the date the products achieve
technological feasibility and the date they generally become available to customers, costs subject to capitalization under SFAS No. 86 have been immaterial and have been expensed as incurred.



Concentrations of credit risk:



Financial instruments that potentially subject the Company and its
subsidiaries to concentrations of credit risk consist principally of cash and cash equivalents, trade receivables and unbilled receivables.



The majority of the Companys cash and cash equivalents is invested in dollar instruments with major banks in the United States and Israel. Such cash
and cash equivalents in the United States may be in excess of insured limits and are not insured in other jurisdictions. Management believes that the financial institutions that hold the Companys investments are financially sound and
accordingly, minimal credit risk exists with respect to these investments.



The Companys trade receivables and unbilled receivables are derived from sales to customers located primarily in the United States, Europe, Far East and Middle East. The Company and its subsidiaries perform
ongoing credit evaluations of their customers and has insured itself against credit associated with some of its trade receivables. In managements opinion, the allowance for doubtful accounts adequately covers anticipated losses with respect to
its accounts receivable. An allowance for doubtful accounts is established when the Company has determined that the account is doubtful of collection.



The Company and its subsidiaries had no significant off-balance-sheet concentration of credit risk, such as foreign exchange contracts, option contracts
or other foreign hedging arrangements.



Convertible
note:



The Company presents the outstanding principal
amount of its convertible note as a long-term liability, in accordance with APB No. 14 Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants (APB 14). The debt is classified as a long-term liability
until the date of conversion on which it would be reclassified to equity, or at the first contractual redemption date, on which it would be reclassified as a short-term liability. Accrued interest on the convertible note is included in other
payables and accrued expenses.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data



NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)



Stock-based compensation:



The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25)
and FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation (FIN 44), in accounting for its employee stock option plans. According to APB 25, compensation expense is measured under the
intrinsic value method, whereby compensation expense is equal to the excess, if any, of the quoted market price of the stock over the exercise price at the grant date of the award.



The Company adopted the disclosure provisions of Statement of Financial Accounting Standards No. 148 Accounting for
Stock-Based Compensation (SFAS No. 148), which amended certain provisions of SFAS 123. The Company continues to apply the provisions of APB No. 25 in accounting for stock-based compensation.



The expenses related to stock-based employee compensation included in the
determination of net loss for 2002, 2003 and 2004 is less than that which would have been recognized if the fair value method had been applied to all awards granted after the original effective date of SFAS No. 123. If the Company and its
subsidiaries had elected to adopt the fair value recognition provisions of SFAS No. 123 as of its original effective date, pro-forma net loss and pro-forma basic and diluted net loss per share would be as follows:



Pro-forma information under SFAS No. 123 is as follows:



|                                                  |  |                         |        |   |      |   |        |      |  |   |        |  
|------------------------------------------------- |  | ----------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                  |  | Year ended December 31, |       
|                                                  |  | 2002                    |        |   | 2003 |   |        | 2004 | 
|Net loss as reported                              |  | $                       | (5,856 | ) |      | $ | (1,654 | )    |  | $ | (4,155 | )
|Add - stock based compensation - intrinsic value  |  |                         | 36     |   |      |   | 4      |      |  |   | 52     |  
|Deduct - stock-based compensation - fair value    |  |                         | (179   | ) |      |   | (301   | )    |  | $ | (433   | )
|                                                  |  |                         |        |   |      |   |        |      |  |   |        |  
|Pro forma net loss                                |  | $                       | (5,999 | ) |      | $ | (1,951 | )    |  | $ | (4,536 | )
|                                                  |  |                         |        |   |      |   |        |      |  |   |        |  
|Basic and diluted net loss per share, as reported |  | $                       | (2.26  | ) |      | $ | (0.55  | )    |  | $ | (0.85  | )
|                                                  |  |                         |        |   |      |   |        |      |  |   |        |  
|Pro forma basic and diluted loss per share        |  | $                       | (2.32  | ) |      | $ | (0.64  | )    |  | $ | (0.93  | )
|                                                  |  |                         |        |   |      |   |        |      |  |   |        |  



For purposes of pro
forma disclosure, the estimated fair value of the options is amortized to expenses over the options vesting period.



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)



The fair value of stock options was estimated at the date of grant using a Black-Scholes options pricing model with the
following weighted average assumptions for 2002, 2003 and 2004:



|                       |  |         |   |  |         |   |  |         |  
|---------------------- |  | ------- | - |  | ------- | - |  | ------- | -
|                       |  | 2002    |   |  | 2003    |   |  | 2004    |  
|Dividend yield         |  | 0       | % |  | 0       | % |  | 0       | %
|Expected volatility    |  | 0.5     |   |  | 1.65    |   |  | 0.8     |  
|Risk-free interest     |  | 3       | % |  | 2       | % |  | 3.5     | %
|Expected life of up to |  | 4 years |   |  | 2 years |   |  | 4 years |  



The Company applies
SFAS No. 123 and Emerging Issues Task Force No. 96-18 Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services (EITF 96-18), with respect to
options issued to non-employees. SFAS No. 123 requires the use of an option valuation model to measure the fair value of the options at the date of grant.



Royalty-bearing grants:



Royalty-bearing grants from the Office of the Chief Scientist (OCS) and from the Binational Industrial Research and Development Foundation
(BIRD-F) for funding approved research and development projects are recognized at the time the Company is entitled to such grants, on the basis of the costs incurred and included as a deduction of research and development costs. Research
and development grants amounted to $ 461, $ 96 and $ 0 in 2002, 2003 and 2004, respectively.



Severance pay:



The
Companys liability for severance pay of its Israeli employees is calculated pursuant to Israeli severance pay law based on the most recent salary of the employees multiplied by the number of years of employment, as of the balance sheet date.
Employees are entitled to one months salary for each year of employment or a portion thereof. The Companys liability for all of its employees in Israel, is fully provided by monthly deposits with insurance policies and by an accrual. The
value of these policies is recorded as an asset in the Companys balance sheet.



The deposited funds for the Companys Israeli employees include profits accumulated up to the balance sheet date. The deposited funds may be withdrawn only upon the fulfillment of the obligation pursuant to
Israeli severance pay law or labor agreements. The value of the deposited funds is based on the cash surrendered value of these policies, and includes immaterial profits.



Severance expenses for the years ended December 31, 2002, 2003 and 2004 amounted to approximately $ 753, $ 117 and $ 138,
respectively.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands



NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)



Fair value of financial instruments:



The following methods and assumptions were used by the Company and its subsidiaries in estimating their fair value
disclosures for financial instruments:



The carrying amount
reported in the balance sheet for cash and cash equivalents, trade receivables, unbilled receivables, other accounts receivable, short-term bank credit, trade payables and other accounts payable approximate their fair values due to the short-term
maturity of such instruments.



Value of long-term bank loan
approximates fair value due to the variable interest rate on this loan.



Convertible note is estimated by discounting the future cash flows using current interest rates for loans of similar terms and maturities. The carrying amount of the convertible note approximates its fair value.



Net loss per share:



Basic net loss per share is computed based on the weighted average number of
Ordinary Shares outstanding during each year. Diluted net loss per share is computed based on the weighted-average number of Ordinary Shares outstanding during each year, plus dilutive potential Ordinary Shares considered outstanding during the
year, in accordance with Statement of Financial Accounting Standard No. 128, Earnings Per Share (SFAS No. 128).



All outstanding stock options, warrants and shares issuable upon conversion of the convertible note have been excluded from the calculation of the diluted
net loss per Ordinary Share because all such securities are anti-dilutive for all periods presented. The total weighted-average number of shares related to the outstanding options, warrants and shares issuable upon conversion of the convertible note
excluded from the calculations of diluted net loss per share, was 738,200, 662,776 and 1,361,486 for the years ended December 31, 2002, 2003 and 2004, respectively.



Reclassification:



Certain amounts from prior years have been reclassified to conform to the current years presentation.



The reclassification had no effect on previously reported net loss,
shareholders equity or cash flows.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)



Impact of recently issued accounting standards:



On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004),
Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends
FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants
of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. Early adoption will be permitted in periods in which financial statements have not yet been issued. The
Company expects to adopt Statement 123(R) on January 1, 2006 (the effective date).



Statement 123(R) permits public companies to adopt its requirements using one of two methods:



A modified-prospective method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of
Statement 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement 123(R) that remain unvested on the
effective date.



A modified-retrospective method
which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under Statement 123 for purposes of pro forma disclosures either (a) all prior
periods presented or (b) prior interim periods of the year of adoption.



As permitted by Statement 123, the Company currently accounts for share-based payments to employees using Opinion 25s intrinsic value method and, as such, generally recognizes no compensation cost for employee
stock options. In addition, non-compensatory plans under APB 25 will be considered compensatory for FAS 123(R) purposes. Accordingly, the adoption of Statement 123(R)s fair value method will have a significant impact on the Company result of
operations, although it will have no impact on the Company overall financial position. The impact of adoption of Statement 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future.
However, had the Company adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note 2 to the
consolidated financial statements.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 3:- OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES



|                           |  |              |     |      |   |    
|-------------------------- |  | ------------ | --- | ---- | - | ---
|                           |  | December 31,
|                           |  | 2003         |     | 2004
|Prepaid expenses           |  | $            | 541 |      | $ | 726
|Employees                  |  |              | 52  |      |   | 58 
|Government authorities     |  |              | 93  |      |   | 134
|Due from insurance company |  |              | 202 |      |   |   
|Other                      |  |              | 98  |      |   |   
|                           |  |              |     |      |   |    
|                           |  | $            | 986 |      | $ | 918
|                           |  |              |     |      |   |    



NOTE 4:- PROPERTY AND EQUIPMENT,
NET



| | a. | Composition:
| | -- | ------------



|                                             |  |              |       |      |   |      
|-------------------------------------------- |  | ------------ | ----- | ---- | - | -----
|                                             |  | December 31,
|                                             |  | 2003         |       | 2004
|Cost:                                        |  |              |       |      |   |      
|Computers, peripheral equipment and software |  | $            | 5,342 |      | $ | 5,532
|Office furniture and equipment               |  |              | 929   |      |   | 956  
|Leasehold improvements                       |  |              | 535   |      |   | 535  
|                                             |  |              |       |      |   |      
|                                             |  |              | 6,806 |      |   | 7,023
|Accumulated depreciation                     |  |              | 6,176 |      |   | 6,713
|                                             |  |              |       |      |   |      
|Depreciated cost                             |  | $            | 630   |      | $ | 310  
|                                             |  |              |       |      |   |      



Depreciation expenses
for the years ended December 31, 2002, 2003 and 2004 were approximately $ 1,256, $ 914 and $ 537, respectively.



| | b. | As for charges, see Note 10c.
| | -- | -----------------------------



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 5:- OTHER INTANGIBLE ASSETS, NET



| | a. | Cost:
| | -- | -----



|                          |  |              |     |      |   |    
|------------------------- |  | ------------ | --- | ---- | - | ---
|                          |  | December 31,
|                          |  | 2003         |     | 2004
|Technology                |  | $            | 180 |      | $ | 770
|Database                  |  |              |    |      |   | 21 
|Trademark and tradename   |  |              |    |      |   | 110
|                          |  |              |     |      |   |    
|                          |  |              | 180 |      |   | 901
|                          |  |              |     |      |   |    
|Accumulated amortization: |  |              |     |      |   |    
|Technology                |  |              | 110 |      |   | 254
|Database                  |  |              |    |      |   | 4  
|Trademark and tradename   |  |              |    |      |   | 11 
|                          |  |              |     |      |   |    
|                          |  |              | 110 |      |   | 269
|                          |  |              |     |      |   |    
|Amortized cost            |  | $            | 70  |      | $ | 632
|                          |  |              |     |      |   |    



See also Notes 1b, 1c.



| | b. | Amortization expenses amounted to $ 50, $ 60 and $ 159 for the years ended December 31, 2002, 2003 and 2004, respectively.
| | -- | --------------------------------------------------------------------------------------------------------------------------



| | c. | Customer relationship acquired as part of the acquisition of UP (see also Note 1c). Amortization expenses amounted to $ 0, $ 0 and $ 67 for the years ended December 31, 2002, 2003
and 2004, respectively.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | d. | Following is the estimated amortization expenses with respect to identifiable intangible assets for the years ended:
| | -- | --------------------------------------------------------------------------------------------------------------------



|     |  |              |    
|---- |  | ------------ | ---
|     |  | December 31,
|2005 |  | $            | 406
|2006 |  |              | 391
|2007 |  |              | 303
|2008 |  |              | 177
|2009 |  |              | 161



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 6:- SHORT-TERM BANK CREDIT



In February 2002, Bank Hapoalim (the Bank) agreed to extend the line of credit, which allowed the Company to
borrow up to $ 6,000 until January 31, 2003.



In connection
with the credit line, the Company granted warrants to the Bank (see also Note 11c).



On December 31, 2002, short and long-term borrowings under the line of credit were $ 5,023 in total. In January 2003, the line of credit was terminated and replaced by (i) a short-term loan in the amount of $ 3,450
which was subject to repayment by July 21, 2003, and (ii) short-term debt in the amount of $ 1,573 which was reduced by $ 665 during the year to an ending balance of $ 908 (comprised of $ 898 in short-term bank debt and $ 10 used in the overdraft
facility with the Bank, as detailed below).



In July 2003, the
Bank agreed to convert $ 2,400 out of the $ 3,450 short-term loan into a long-term loan (see also Note 8) and the remaining loan balance of $ 1,050 was repaid by November of 2003. In total, $ 1,715 of bank debts was repaid during the year.



As of December 31, 2004, the Company has an overdraft
facility with the Bank of up to $ 137 out of which the Company used $ 13 and a short-term loan in the amount of $1,500. The weighted-average interest on the credit line and on the short-term loan was approximately 4% and 5%, respectively.



NOTE 7:- OTHER ACCOUNTS PAYABLE AND ACCRUED EXPENSES



|                               |  |              |       |      |   |      
|------------------------------ |  | ------------ | ----- | ---- | - | -----
|                               |  | December 31,
|                               |  | 2003         |       | 2004
|Accrued expenses               |  | $            | 1,838 |      | $ | 923  
|Employees and payroll accruals |  |              | 1,069 |      |   | 1,411
|                               |  |              |       |      |   |      
|                               |  | $            | 2,907 |      | $ | 2,334
|                               |  |              |       |      |   |      



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

U.S. dollars in thousands, except share and per share data



NOTE 8:- LONG-TERM BANK LOAN



| | a. | Composed as follows:
| | -- | --------------------



|                          |  |          |  |               |   |      |              |       |  |   |      
|------------------------- |  | -------- |  | ------------- | - | ---- | ------------ | ----- |  | - | -----
|                          |  | Currency |  | Interest rate |   |      | December 31,
|                          |  |          |  | 2003          |   | 2004
|Loan from a bank (1)(2)   |  | U.S. $   |  | Libor + 2.75  | % |      | $            | 2,343 |  | $ | 1,306
|Less - current maturities |  |          |  |               |   |      |              | 1,036 |  |   | 1,045
|                          |  |          |  |               |   |      |              |       |  |   |      
|                          |  |          |  |               |   |      | $            | 1,307 |  | $ | 261  
|                          |  |          |  |               |   |      |              |       |  |   |      

---

|(1) | In July 2003, the Company entered into a financing agreement with Bank Hapoalim, in which $ 2,400 short-term loan was converted into a long-term loan. The loan is payable quarterly
in equal installments over a two and a half years period beginning on January 1, 2004, with interest payable quarterly at a rate of Libor + 2.75%. The debt restructure was subject to certain conditions. As of December 31, 2004, the Company did not
comply with one condition set under the long-term loan agreement. The Company received a written waiver from the Bank, under which, the Bank agreed not to act upon their contractual rights on the Companys default. Additionally, subsequent to
the balance sheet date, the Bank agreed to replace such conditions with new conditions starting on January 1, 2006 (See Note 16a). The Company applied the guidelines of Emerging Issues Task Force No. 86-30, Classification of Obligations When a
Violation is Waived by the Creditor (EITF No. 86-30), for classifying the obligation as long-term loan. As part of the agreement, the warrant previously issued to the Bank was amended to cover 100,000 Ordinary Shares of the Company
and the exercise price for all such shares was repriced to $ 1.00 per share (see also Note 11). Under the financing agreement with Bank Hapoalim, as the bank has a floating charge on all of the Companys assets, the Company may require the
consent of the Bank to effect a funding if it is structured as a secured debt financing.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | In accordance with APB No. 14 Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants (APB 14), the Company allocated a portion of the
proceeds to the warrants, based on their applicable fair values. Amounts allocated to the warrants totaling $ 71, were recorded as additional paid in capital against a discount on the Loan. The discount related to the loan is amortized as financial
expenses over the term of the Loan.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The fair
value of the warrants was estimated at the grant date using a Black-Scholes option pricing model with the following assumptions: risk-free interest rate of 3%, dividend yield of 0%, volatility factors of the expected market price of the
Companys Ordinary Shares of 1.65 and an expected life of four years.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands, except share and per share data



NOTE 8:- LONG-TERM BANK LOAN (Cont.)



| | b. | The aggregate annual maturities of the long-term loan are as follows:
| | -- | ---------------------------------------------------------------------



|     |  |                   |      
|---- |  | ----------------- | -----
|     |  | December 31, 2004
|2005 |  | $                 | 1,045
|2006 |  |                   | 261  
|     |  |                   |      
|     |  | $                 | 1,306
|     |  |                   |      



An amount of $ 29,
which relates to the discount, was deducted from the principal amount of the loan.



| | c. | As for charges, see Note 10c(1).
| | -- | --------------------------------



NOTE 9:- CONVERTIBLE NOTE



On July 28, 2004, the Company issued to LibertyView Special Opportunities Fund, L.P. (LibertyView) $ 2,500 aggregate principal amount of 7.5%
Convertible Note (the Note) due July 28, 2014. The Company is obligated to pay interest on the Note on a quarterly basis commencing October 15, 2004, with interest to be paid either in cash or registered Ordinary Shares of the Company,
at the discretion of the Company.



The Note is convertible, at
the option of LibertyView at any time before the maturity date, into Ordinary Shares of the Company at a fixed conversion price of $ 4.2996 per Ordinary Share. LibertyView also has an option to require the Company to purchase the Note for an amount
equal to 100% of the principal amount plus accrued and unpaid interest, on July 15, 2008, July 15, 2009 and July 15, 2011. If LibertyView elects to require the Company to purchase the Note, the Company can elect to pay the repurchase price in cash,
Ordinary Shares or a combination thereof. The Note is also subject to repurchase for cash, at LibertyViews option and at a repurchase price equal to 100% of the principal amount plus accrued and unpaid interest, on the occurrence of certain
events, including the following: (i) an acquisition of the Company for cash only, (ii) an acquisition of the Company by another company whose market value is less than $ 25,000, (iii) if the Company ceases to be traded on The Nasdaq SmallCap Market
(see also Note 16e), and (iv) if the Company is subject to bankruptcy or similar proceedings.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

U.S. dollars in thousands, except share and per share data



NOTE 9:- CONVERTIBLE NOTE (Cont.)



As of December 31, 2004, the Note is presented as a long-term liability. The Note was issued with a conversion price equal
to $ 4.2996 per share. In accordance with Emerging Issues Task Force No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, (EITF No. 98-5) and Emerging
Issues Task Force No. 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments, (EITF No. 00-27), no beneficial conversion features was recognized nor recorded.



In connection with the Note, the Company agreed to file an F-3 Registration
Statement covering the Ordinary Shares which may be issued upon conversion of the Note within the earlier of (i) 60 days from the date of the Note, and (ii) 5 business days after the registration statement that was filed with the SEC prior to the
date of the Note is declared effective by the SEC. In that respect, the Company has also agreed that in the event that the F-3 is not filed on time or not declared effective by the SEC within 90 days after it is filed, the Company shall pay
LibertyView a cash compensation equal to 1% of the loan under the Note per each month of delay (on a pro-rated basis).



Subsequent to the balance sheet date, on May 27, 2005, the Company entered into a letter agreement with LibertyView under which the Company has agreed to
issue to LibertyView 50,000 Ordinary Shares and pay it a cash amount of $ 40 as sole and complete remedy for the Companys inability to meet such registration deadlines.



NOTE 10:- COMMITMENTS AND CONTINGENT LIABILITIES



| | a. | Royalty commitments:
| | -- | --------------------



Under the Companys research and development agreements with the OCS and BIRD-F, and pursuant to applicable laws, the Company is required to pay
royalties at the rate of between 3% to 5% on revenues derived from products developed with royalty-bearing grants provided by the OCS and BIRD-F, in an amount of up to 100% of the grants received from the OCS and 150% of the research and development
grants received from the BIRD-F. The obligation to pay these royalties is contingent on actual sales of the products and, in the absence of such sales, no payment is required.



Royalties payable with respect to grants received under programs approved by the OCS after January 1, 1999, are subject to
interest on the U.S. dollar-linked value of the total grants received at the annual rate of LIBOR applicable to U.S. dollar deposits. Royalties payable with respect to grants received from BIRD-F are linked to the Consumer Price Index in the United
States.



Through December 31, 2004, the Company has paid or
accrued royalties to the OCS and BIRD-F in the amounts of $ 13 and $ 0, respectively. As of December 31, 2004, the aggregate contingent liability to the OCS and BIRD-F amounted to $ 372 and $ 868, respectively. The Company has notified the BIRD-F
that the project supported by the BIRD-F has failed and that consequently it believes that it will not be required to pay the BIRD-F any royalties from the sale of any of its products. Therefore, as of December 31, 2004, the Company has not paid or
accrued royalties relating to the repayment of BIRD-F grants.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands, except share and per share data



NOTE 10:- COMMITMENTS AND CONTINGENT LIABILITIES (Cont.)



| | b. | Lease commitments:
| | -- | ------------------



The Companys facilities, its subsidiaries facilities and its vehicles are leased under various operating lease agreements, which expire on
various dates, the latest of which is in 2008.



Future minimum
rental payments under non-cancelable operating leases are as follows:



|      |  |            |       |          |   |       |  |   |      
|----- |  | ---------- | ----- | -------- | - | ----- |  | - | -----
|      |  | Facilities |       | Vehicles |   | Total
|2005  |  | $          | 651   |          | $ | 231   |  | $ | 882  
|2006  |  |            | 432   |          |   | 227   |  |   | 659  
|2007  |  |            | 252   |          |   | 235   |  |   | 487  
|2008  |  |            | 126   |          |   |      |  |   | 126  
|      |  |            |       |          |   |       |  |   |      
|Total |  | $          | 1,461 |          | $ | 693   |  | $ | 2,154
|      |  |            |       |          |   |       |  |   |      



Facilities lease
expenses for the years ended December 31, 2002, 2003 and 2004 were approximately $ 845, $ 571 and $ 661, respectively.



Vehicles lease expenses for the years ended December 31, 2002, 2003 and 2004 were approximately $ 226, $ 204 and $ 203, respectively.



| | c. | Charges and guarantees:
| | -- | -----------------------



| | 1. | The Company has a floating charge on all of its assets in favor of the Bank.
| | -- | ----------------------------------------------------------------------------



| | 2. | The Company obtained bank guarantees in the amount of $ 94, in order to secure an office lease agreement.
| | -- | ---------------------------------------------------------------------------------------------------------



NOTE 11:- SHAREHOLDERS EQUITY



The Ordinary Shares of the Company are traded on the Nasdaq SmallCap Market. (See also Note 16d).



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)

U.S. dollars in thousands, except share and per share data



NOTE 11:- SHAREHOLDERS EQUITY (Cont.)



General:



| | 1. | The Ordinary Shares confer upon the holders the right to receive notice to participate and vote in general meetings of the Company, the right to receive dividends, if declared, and
the right to receive any remaining assets of the Company upon liquidation, if any, after full payment is made to any creditors.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 2. | In November 2003 and July 2004, the Companys shareholders approved in the annual general meeting an increase in the Companys authorized share capital by 2,300,000 and
4,500,000 Ordinary Shares, respectively.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 3. | In August 2003, the Company issued to a private investor 539,258 Ordinary Shares at a price per share of $ 1.854 in a consideration of $ 1,000 (issuance expenses amounted to $ 83).
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 4.     a) | In November 2003, the Company issued to financial institutions and a group of private investors 517,322 Ordinary Shares at a price per share of $ 3.406 for the consideration of $
1,762.
| | --------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As part of the investment agreement,
the Company granted the investors warrants to purchase 93,723 Ordinary Shares of the Company at an exercise price of $ 4.70 per share. The warrants are exercisable no later than November 2006, or, at the time of a change of control. As of December
31, 2004, all of the above warrants are outstanding.



| | b) | In December 2003, the Company issued to venture capital firms and private investors 554,509 Ordinary Shares at a price per share of $ 4.036 for the consideration of $ 2,238.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As part of the investment agreement, the
Company granted the investors warrants to purchase 84,644 Ordinary Shares of the Company at an exercise price of $ 6.61 per share. The warrants are exercisable no later than December 2006, or, at the time of a change of control. As of December 31,
2004, all of the above warrants are outstanding.



Aggregate
issuance expenses in both rounds described above, amounted to $ 324.



| | c) | In connection with the November and December 2003 investment agreements, the Company paid its investment consultants a commission of $ 143 (recorded as issuance expenses) and
granted to the consultant warrants to purchase:
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (1) | 5,872 Ordinary Shares of the Company at an exercise price of $ 3.046 per share. The warrants are exercisable no later than November 2006, or at the time of a change of control.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands, except share and per share data



NOTE 11:- SHAREHOLDERS EQUITY (Cont.)



| | (2) | 10,301 Ordinary Shares of the Company at an exercise price of $ 6.61 per share. The warrants are exercisable no later than December 2006, or at the time of change of control.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (3) | 18,580 Ordinary Shares of the Company at an exercise price of $ 4.89 per share. The warrants are exercisable no later than December 2006, or at the time of change of control.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As of December 31, 2004, all of the above
warrants are outstanding.



| | 5. | In July 2004, the Company issued a total of 898,485 Ordinary Shares related to the acquisition of Utility Partners Inc. (see also Note 1d).
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------



Stock options:



| | 1. | Under the Companys 1996, 1997, 1998 and 1999 Stock Option Plans (the Plans), options may be granted to officers, directors, employees and consultants of the
Company or its subsidiaries.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Pursuant to the
Plans, the Company reserved for issuance 140,000, 50,000, 150,000 and 300,000 Ordinary Shares, respectively. In 2002, 2003 and 2004, the Company increased the number of shares reserved for issuance under the 1999 Stock Option Plan by additional
300,000, 200,000 and 350,000 shares, respectively.



As of
December 31, 2004, an aggregate of 237,204 Ordinary Shares of the Company were available for future grant.



Each option granted under the Plans is exercisable until the earlier of seven years from the date of the grant of the option or the expiration dates of
the respective option plans. The 1996, 1997, 1998 and 1999 option plans will expire on December 31, 2005, 2006, 2007, and 2008, respectively. The exercise price of the options granted under the plans may not be less than the nominal value of the
shares into which such options are exercised. The options vest primarily over periods of two to four years. Any options which are canceled or forfeited before expiration become available for future grants.



| | 2. | During 2003, the Company decided to extend the exercise period for certain grants. The extension was accounted for in accordance with FIN 44, by applying a new measurement date,
which resulted in no additional compensation expenses.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands, except share and per share data



NOTE 11:- SHAREHOLDERS EQUITY (Cont.)



| | 3. | The following is a summary of the Companys employees and directors stock option activity under the Plans and related information:
| | -- | ------------------------------------------------------------------------------------------------------------------------------------



|                                    |  |                         |   |      |                              |       |                   |          |   |                              |   |                   |  |           |                              |  |   |     
|----------------------------------- |  | ----------------------- | - | ---- | ---------------------------- | ----- | ----------------- | -------- | - | ---------------------------- | - | ----------------- |  | --------- | ---------------------------- |  | - | ----
|                                    |  | Year ended December 31,
|                                    |  | 2002                    |   | 2003 |                              | 2004 
|                                    |  | Number of options       |   |      | Weightedaverageexerciseprice |       | Number of options |          |   | Weightedaverageexerciseprice |   | Number of options |  |           | Weightedaverageexerciseprice
|Outstanding - beginning of the year |  | 547,130                 |   |      | $                            | 26.06 |                   | 520,554  |   |                              | $ | 7.85              |  | 665,434   |                              |  | $ | 4.13
|Granted                             |  | 520,798                 |   |      | $                            | 2.87  |                   | 336,750  |   |                              | $ | 1.59              |  | 418,000   |                              |  | $ | 2.12
|Exercised                           |  |                        |   |      | $                            |      |                   | (89,962  | ) |                              | $ | 1.64              |  | (19,535   | )                            |  | $ | 1.61
|Forfeited/canceled                  |  | (547,374                | ) |      | $                            | 21.31 |                   | (101,908 | ) |                              | $ | 8.96              |  | (53,656   | )                            |  | $ | 5.15
|                                    |  |                         |   |      |                              |       |                   |          |   |                              |   |                   |  |           |                              |  |   |     
|Outstanding - end of the year       |  | 520,554                 |   |      | $                            | 7.85  |                   | 665,434  |   |                              | $ | 4.13              |  | 1,010,243 |                              |  | $ | 3.33
|                                    |  |                         |   |      |                              |       |                   |          |   |                              |   |                   |  |           |                              |  |   |     
|Options exercisable                 |  | 423,029                 |   |      | $                            | 5.82  |                   | 327,082  |   |                              | $ | 6.56              |  | 461,275   |                              |  | $ | 4.93
|                                    |  |                         |   |      |                              |       |                   |          |   |                              |   |                   |  |           |                              |  |   |     



The options
outstanding as of December 31, 2004, under the Plans, have been separated into ranges of exercise price, as follows:



|                        |  |                                          |  |                                                 |  |                              |       |                                          |         |                                                   |   |      
|----------------------- |  | ---------------------------------------- |  | ----------------------------------------------- |  | ---------------------------- | ----- | ---------------------------------------- | ------- | ------------------------------------------------- | - | -----
|Range of exercise price |  | Optionsoutstandingas ofDecember 31, 2004 |  | Weightedaverageremainingcontractuallife (years) |  | Weightedaverageexerciseprice |       | Optionsexercisableas ofDecember 31, 2004 |         | Weightedaverageexerciseprice ofoptionsexercisable
|$ 1.59-1.64             |  | 470,280                                  |  | 5.51                                            |  | $                            | 1.61  |                                          | 339,313 |                                                   | $ | 1.62 
|$ 2.00-2.33             |  | 418,000                                  |  | 6.71                                            |  | $                            | 2.12  |                                          |        |                                                   | $ |     
|$ 4.10-6.11             |  | 105,113                                  |  | 3.89                                            |  | $                            | 5.38  |                                          | 105,112 |                                                   | $ | 5.38 
|$ 23.00-57.50           |  | 8,450                                    |  | 1.84                                            |  | $                            | 38.11 |                                          | 8,450   |                                                   | $ | 38.11
|$ 80.00-110.00          |  | 8,400                                    |  | 2.53                                            |  | $                            | 99.52 |                                          | 8,400   |                                                   | $ | 99.52
|                        |  |                                          |  |                                                 |  |                              |       |                                          |         |                                                   |   |      
|$ 1.59-110.00           |  | 1,010,243                                |  |                                                 |  | $                            | 3.33  |                                          | 461,275 |                                                   | $ | 4.93 
|                        |  |                                          |  |                                                 |  |                              |       |                                          |         |                                                   |   |      



The Company has
recorded deferred compensation for options issued with an exercise price below the market price of the Ordinary Shares at the date of grant. The deferred compensation is amortized and recorded as compensation expense ratably over the vesting period
of the option. Compensation expenses of approximately $ 20 and $ 92, were recognized during the years ended December 31, 2003 and 2004, respectively.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands, except share and per share data



NOTE 11:- SHAREHOLDERS EQUITY (Cont.)



The weighted average fair values of options granted for the years ended December 31, 2002, 2003 and 2004, were:



|                                           |  |                                            |      |                         |   |                           |  |      |      |      |   |      |  |      |   |      |   |      |  |   |   |  |   |      |  |   |  
|------------------------------------------ |  | ------------------------------------------ | ---- | ----------------------- | - | ------------------------- |  | ---- | ---- | ---- | - | ---- |  | ---- | - | ---- | - | ---- |  | - | - |  | - | ---- |  | - | -
|                                           |  | For exercise price on the grant date that:
|                                           |  | Equals market price                        |      | Exceeds market price    |   | Is less than market price
|                                           |  | Year ended December 31,                    |      | Year ended December 31, |   | Year ended December 31,  
|                                           |  | 2002                                       |      | 2003                    |   | 2004                      |  | 2002 |      | 2003 |   | 2004 |  | 2002 |   | 2003 |   | 2004
|Weighted average exercise prices           |  | $                                          | 2.83 |                         | $ | 1.59                      |  | $    | 2.12 |      | $ |     |  | $    |  |      | $ |     |  | $ |  |  | $ | 1.59 |  | $ | 
|                                           |  |                                            |      |                         |   |                           |  |      |      |      |   |      |  |      |   |      |   |      |  |   |   |  |   |      |  |   |  
|Weighted average fair values on grant date |  | $                                          | 1.02 |                         | $ | 1.10                      |  | $    | 1.01 |      | $ |     |  | $    |  |      | $ |     |  | $ |  |  | $ | 4.36 |  | $ | 
|                                           |  |                                            |      |                         |   |                           |  |      |      |      |   |      |  |      |   |      |   |      |  |   |   |  |   |      |  |   |  



| | 4. | Options issued to consultants:
| | -- | ------------------------------



| | a) | The Companys outstanding options to consultants as of December 31, 2004, are as follows:
| | -- | -----------------------------------------------------------------------------------------



|               |  |                             |  |                          |        |                    |        |                    |                  
|-------------- |  | --------------------------- |  | ------------------------ | ------ | ------------------ | ------ | ------------------ | -----------------
|Issuance date  |  | Options for Ordinary Shares |  | Exercise price per share |        | Optionsexercisable |        | Exercisablethrough
|December 1996  |  | 8,000                       |  | $                        | 11.24  |                    | 8,000  |                    | December 2006 (*)
|September 1998 |  | 4,000                       |  | $                        | 37.50  |                    | 4,000  |                    | January 2006     
|November 1998  |  | 1,000                       |  | $                        | 37.50  |                    | 1,000  |                    | December 2006    
|November 1999  |  | 1,200                       |  | $                        | 57.50  |                    | 1,200  |                    | November 2006    
|March 2000     |  | 200                         |  | $                        | 120.00 |                    | 200    |                    | March 2007       
|December 2000  |  | 100                         |  | $                        | 25.70  |                    | 100    |                    | December 2007    
|January 2002   |  | 5,000                       |  | $                        | 4.10   |                    | 5,000  |                    | January 2009     
|September 2002 |  | 19,060                      |  | $                        | 1.64   |                    | 19,060 |                    | September 2009   
|August 2003    |  | 25,250                      |  | $                        | 1.59   |                    | 25,250 |                    | August 2010      
|August 2004    |  | 2,500                       |  | $                        | 2.00   |                    | 2,500  |                    | August 2011      
|               |  |                             |  |                          |        |                    |        |                    |                  
|Total          |  | 66,310                      |  |                          |        |                    | 66,310 |                    |                  
|               |  |                             |  |                          |        |                    |        |                    |                  

---

|(*) | The options were exercisable through December 2002. If not exercised, they are automatically renewed for one additional year, each time, for up to four years, through December 2006.
The exercise price will be increased by 6% compounded each year.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) | The Company had accounted for its options to consultants under the fair value method of SFAS No. 123. EITF 96-18 and EITF 00-18. The fair value for these options was estimated using
a Black-Scholes option pricing model with the following weighted-average assumptions for 2002, 2003 and 2004: risk-free interest rates of 3%, 2% and 2%, respectively, dividend yields of 0% for each year, volatility factors of the expected market
price of the Companys Ordinary Shares of 0.5, 1.65 and 0.85, respectively, and a contractual life of the options of approximately 2 years for each year.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c) | During 2004, one of the consultants exercised 5,000 options for Ordinary Shares of the Company at an exercise price of $ 1.59 per share.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands, except share and per share data



NOTE 11:- SHAREHOLDERS EQUITY (Cont.)



Warrants:



| | 1. | Warrants issued for financing transactions:
| | -- | -------------------------------------------



| | a) | In connection with an additional credit line received in April 2001, which was extended in February 2002, the Company issued to a subsidiary of Bank Hapoalim, a warrant to purchase
an additional 60,000 Ordinary Shares of the Company for an aggregate exercise price of $ 5.00 per share. This warrant was later amended and repriced as explained in note 1(b) below.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



During 2001, the Company recorded a compensation of approximately $ 87,
which was included in the financial expenses. This transaction was accounted for according to APB 14.



The fair value of this warrant was determined using the Black-Scholes pricing model, assuming a risk free interest rate of 3%, a volatility factor of
0.68, dividend yield of 0% and a contractual life of the warrants of two years.



| | b) | In July 2003, the Company entered into a refinancing agreement with Bank Hapoalim, in which $ 2,400 out of the line of credit was converted into a long-term loan (also see Note 8).
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As part of the agreement, the warrant issued
in February 2002 was amended to cover 100,000 Ordinary Shares of the Company at an exercise price of $ 1.00 per each of the shares covered under the warrant. The warrant was exercisable during a period of four years from the date of grant. In
November 2003, the bank exercised the warrant into 85,088 Ordinary Shares, in a cashless exercise.



During 2003 and 2004, the Company recorded a compensation of approximately $ 14 and $ 28, respectively, which was included in the financial expenses.
This transaction was accounted for according to APB 14.



| | 2. | Warrants issued to customers:
| | -- | -----------------------------



In October 2003, the Company signed a settlement agreement with one of its customers. As part of the agreement, the Company granted the customer warrants
to purchase 52,000 Ordinary Shares of the Company at an exercise price of $ 1.59 per share (exercise no later than October 2006).



The estimated fair value of the warrants was $ 123. The fair value of these warrants was determined using the Black-Scholes pricing model, assuming a
risk-free interest rate of 2%, a volatility factor of 1.2, dividend yields of 0%, and a contractual life of three years.



This transaction was accounted for according to SFAS No. 123 and EITF 96-18.



As of December 31, 2004, all of the above warrants are outstanding.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands, except share and per share data



NOTE 11:- SHAREHOLDERS EQUITY (Cont.)



| | 3. | Warrants to others:
| | -- | -------------------



| | a) | In February 2002, the Company granted to a related party, at that time, with respect to marketing activities, a warrant to purchase 67,223 Ordinary Shares of the Company, at an
exercise price of $ 5.15 per share. The Company accounted for its warrant under the fair value method of SFAS No. 123 and according to EITF 96-18. At the grant date, the fair value of the warrant was determined using the Black-Scholes option pricing
model, assuming a risk-free rate of 3%, a volatility of 0.5, dividend yield of 0% and a contractual life of 3 years. In relation to the warrants, the Company recorded $ 136 as sales and marketing expenses.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As of December 31, 2004, all of the above warrants are outstanding.



| | b) | In May 2003, the Company reached an agreement with a provider of marketing service, in which the provider received a warrant to purchase 119,336 Ordinary Shares of the Company at an
exercise price of $ 0.58 per share. The warrant may be exercised in whole or in part no later than May 2006.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The fair value of the warrant in the amount of $ 50, was estimated using the Black- Scholes model, assuming a risk-free interest rate of 2%, a volatility
factor of 1.2, dividend yields of 0%, and a contractual life of three years, and was recorded as prepaid expenses and is amortized ratably over the service period.



As of December 31, 2004, all of the above warrants are outstanding.



| | c) | In June 2004, the Company granted to a third party with respect to marketing activities, a warrant to purchase 4,000 Ordinary Shares of the Company at an exercise price of $ 4.48
per share. The warrant may be exercised in whole or in part no later than June 2007. The fair value of the warrant in the amount of $ 14, was estimated using the Black-Scholes model, assuming a risk-free interest rate of 3%, a volatility factor of
1.4, dividend yields of 0%, and a contractual life of three years, and was recorded as prepaid expenses and is amortized ratably over the service period.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The transactions were accounted for according to EITF 00-18 Accounting for Certain Transactions Involving Equity
Instruments Granted to Other Than Employees.



As of
December 31, 2004, all of the above warrants are outstanding.



Dividends:



Dividends, if any, may be paid in
NIS or in non-Israeli currency. Dividends paid to shareholders in non-Israeli currency may be converted into dollars, on the basis of the exchange rate prevailing at the time of payment. The Company does not intend to pay cash dividends in the
foreseeable future.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 12:- TAXES ON INCOME



Tax benefits under the Law for the Encouragement of Capital Investments, 1959 (the law):



The Companys production facilities have been granted an Approved
Enterprise status under the law, for three separate investment programs, which were approved in February 1989, March 1995 and April 1998.



The status of Approved Enterprise granted for the February 1989 investment program has expired.



Pursuant to the Capital Investment law, the Company has elected for its
other two investment programs the alternative benefits track and has waived Government grants in return for a tax exemption. Accordingly, income derived from these programs will be tax-exempt for a period of ten years commencing with the
year in which it first earns taxable income, subject to certain conditions.



The period of tax benefits described above is subject to limits of 12 years from the commencement of production, or 14 years from the approval date, whichever is earlier. Accordingly, the period of the benefit
relating to these investment programs will expire between 2009 to 2012.



As the Company currently has no taxable income, the benefits from all these programs have not been yet utilized.



If the retained tax-exempt income were distributed in a manner other than in the complete liquidation of the Company, it would be taxed at the corporate
tax rate applicable to such profits as if the Company had not chosen the alternative tax benefits (tax rate of 10% - 25% on the amount distributed). In addition, these dividends will be subject to a 15% withholding tax. The Companys Board of
Directors has determined that such tax-exempted income will not be distributed as dividends.



In the event of failure to comply with the conditions stipulated by the above law and the instruments of approval for the specific investments in approved enterprises, maintain the development and
production nature of its facilities, and finance of at least 30% of the investment program by equity, may be subject to corporate tax in Israel at the regular corporation tax rate of 35% in 2004, and 34%, 32% and 30% in 2005, 2006 and 2007,
respectively and the Company may be required to refund the amount of the benefits, in whole or in part, including interest.



The law also grants entitlement to accelerated depreciation claim on equipment used by the Approved Enterprise during five tax years.



Income from sources other than the Approved
Enterprise, during the benefit period, will be subject to tax at the regular rate prevailing at that time.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 12:- TAXES ON INCOME (Cont.)



A recent amendment to the Investment Law (the Amendment), which has been officially published and effected since
of April 1, 2005, has significantly changed the provisions of the Investment Law. The Amendment limits the scope of enterprises, which may be approved by the Investment Center by setting criteria for the approval of a facility as an Approved
Enterprise. Additionally, the Amendment enacted major changes in the manner in which tax benefits are awarded under the Investment Law so that companies no longer require Investment Center approval in order to qualify for tax benefits.



However, the Amendment provides that terms and benefits included in any
certificate of approval already granted will remain subject to the provisions of the law as they were on the date of such approval.



Tax benefits under Israels Law for the Encouragement of Industry (Taxation), 1969:



The Company is an industrial company, as defined by this law
and, as such, is entitled to certain tax benefits, mainly amortization of costs relating to know-how and patents over eight years, the right to claim public issuance expenses and accelerated depreciation.



Measurement of results for tax purposes under the Income Tax Law
(Inflationary Adjustments), 1985:



Results for tax
purposes are measured and reflected in real terms in accordance with the change in the Israeli Consumer Price Index (CPI). As explained in Note 2b, the consolidated financial statements are presented in U.S. dollars. The difference between the
change in the Israeli CPI and in the NIS/dollar exchange rate causes a difference between taxable income or loss and the income or loss before taxes reflected in the consolidated financial statements. In accordance with paragraph 9(f) of SFAS No.
109 the Company has not provided deferred income taxes on this difference between the reporting currency and the tax bases of assets and liabilities.



Net operating losses carryforward:



The Company has accumulated losses for tax purposes as of December 31, 2004, in the amount of approximately $ 16,000, which may be carried forward and
offset against taxable income in the future for an indefinite period.



Through December 31, 2004, ViryaNet UK had accumulated losses for income tax purposes of approximately $ 17,500, which can be carried forward and offset against taxable income in the future for an indefinite period.



Through December 31, 2004, ViryaNet Japan had accumulated losses for income
tax purposes of approximately $ 1,500, which can be carried forward and offset against taxable income for 10 years and expire from 2008 to 2014.



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 12:- TAXES ON INCOME (Cont.)



As of December 31, 2004, the U.S. subsidiary had U.S. federal net operating loss carryforward for income tax purposes in the
amount of approximately $ 62,500. Net operating loss carryforward arising in taxable years beginning before August 6, 1997, can be carried forward and offset against taxable income for 15 years and expiring between 2010 and 2012. Net operating loss
carryforward arising in taxable years beginning after August 6, 1997 can be carried forward and offset against taxable income for 20 years and expiring between 2017 and 2024.



Utilization of U.S. net operating losses may be subject to substantial annual limitations due to the change in
ownership provisions of the Internal Revenue Code of 1986 and similar state provisions. The annual limitation may result in the expiration of net operating losses before utilization.



Deferred income taxes:



Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Companys deferred tax assets are as follows:



|                                                     |  |              |         |   |      |   |         |  
|---------------------------------------------------- |  | ------------ | ------- | - | ---- | - | ------- | -
|                                                     |  | December 31, |        
|                                                     |  | 2003         |         |   | 2004 |  
|Deferred tax assets:                                 |  |              |         |   |      |   |         |  
|US net operating loss carryforward                   |  | $            | 21,388  |   |      | $ | 21,861  |  
|UK net operating loss carryforward                   |  |              | 5,243   |   |      |   | 5,245   |  
|Japan net operating loss carryforward                |  |              | 465     |   |      |   | 531     |  
|                                                     |  |              |         |   |      |   |         |  
|Total deferred tax assets before valuation allowance |  |              | 27,096  |   |      |   | 27,637  |  
|Valuation allowance                                  |  |              | (27,096 | ) |      |   | (27,637 | )
|                                                     |  |              |         |   |      |   |         |  
|Net deferred tax asset                               |  | $            |        |   |      | $ |        |  
|                                                     |  |              |         |   |      |   |         |  



As of December 31,
2004, ViryaNet UK, ViryaNet US and ViryaNet Japan have provided valuation allowances in respect of deferred tax assets resulting from tax loss carryforward and other temporary differences, since they have a history of operating losses and current
uncertainty concerning its ability to realize these deferred tax assets in the future. Management currently believes that it is more likely than not that the deferred tax regarding the loss carryforward and other temporary differences will not be
realized in the foreseeable future.



The Company expects that
during the period these tax losses are utilized, its income would be substantially tax-exempt. Accordingly, there will be no tax benefit available from such losses and therefore no deferred income taxes or valuation allowances have been included in
these financial statements.



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 12:- TAXES ON INCOME (Cont.)



Loss before taxes consists of the following:



|         |  |                         |       |      |   |       |  |   |      
|-------- |  | ----------------------- | ----- | ---- | - | ----- |  | - | -----
|         |  | Year ended December 31,
|         |  | 2002                    |       | 2003 |   | 2004 
|Domestic |  | $                       | 2,741 |      | $ | 434   |  | $ | 2,101
|Foreign  |  |                         | 3,115 |      |   | 1,220 |  |   | 2,054
|         |  |                         |       |      |   |       |  |   |      
|         |  | $                       | 5,856 |      | $ | 1,654 |  | $ | 4,155
|         |  |                         |       |      |   |       |  |   |      



Tax rates:



On June 29, 2004, the Israeli Government passed the
Amendment to the Income Tax Ordinance (No. 140 and Temporary Provision), 2004, which progressively reduces the tax rates applicable to companies from 36% to 35% in 2004 and to a rate of 30% in 2007. The amendment had no impact on the Companys
financial statement.



Reconciliation of the theoretical tax
expense (benefit) to the actual tax expense (benefit):



In
2002, 2003 and 2004, the main reconciling item of the statutory tax rate of the Company (36% - in 2002 and 2003, 35% - in 2004) to the effective tax rate (0%) is tax loss carryforwards and other deferred tax assets for which a full valuation
allowance was provided.



NOTE 13:- SEGMENTS, CUSTOMERS AND GEOGRAPHIC
INFORMATION



| | a. | Summary information about geographical areas:
| | -- | ---------------------------------------------



The Company adopted Statement of Financial Accounting Standard No. 131, Disclosures About Segments of an Enterprise and Related Information,
(SFAS No. 131). The Company operates in a single reportable segment, the Field Service business segment (see Note 1 for a brief description of the Companys business). The total revenues are attributable to geographic areas based on
the location of the end customer.



The following presents
total revenues for the years ended December 31, 2002, 2003 and 2004 and long-lived assets as of December 31, 2002, 2003 and 2004:



|                       |  |                              |        |                              |   |                              |  |                   |        |               |   |                   |  |   |        |  |   |      
|---------------------- |  | ---------------------------- | ------ | ---------------------------- | - | ---------------------------- |  | ----------------- | ------ | ------------- | - | ----------------- |  | - | ------ |  | - | -----
|                       |  | Year ended December 31, 2002 |        | Year ended December 31, 2003 |   | Year ended December 31, 2004
|                       |  | Total revenues               |        | Long-lived assets            |   | Totalrevenues                |  | Long-lived assets |        | Totalrevenues |   | Long-lived assets
|United States          |  | $                            | 6,690  |                              | $ | 1,324                        |  | $                 | 8,367  |               | $ | 559               |  | $ | 9,409  |  | $ | 1,635
|Europe and Middle East |  |                              | 3,373  |                              |   | 314                          |  |                   | 1,509  |               |   | 126               |  |   | 1,261  |  |   | 195  
|Far East               |  |                              | 1,738  |                              |   | 21                           |  |                   | 2,083  |               |   | 15                |  |   | 1,250  |  |   | 10   
|                       |  |                              |        |                              |   |                              |  |                   |        |               |   |                   |  |   |        |  |   |      
|                       |  | $                            | 11,801 |                              | $ | 1,659                        |  | $                 | 11,959 |               | $ | 700               |  | $ | 11,920 |  | $ | 1,840
|                       |  |                              |        |                              |   |                              |  |                   |        |               |   |                   |  |   |        |  |   |      



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 13:- SEGMENTS, CUSTOMERS AND GEOGRAPHIC INFORMATION (Cont.)



| | b. | Major customers data as a percentage of total revenues:
| | -- | -------------------------------------------------------



|           |  |                         |   |  |      |   |  |     
|---------- |  | ----------------------- | - |  | ---- | - |  | ----
|           |  | Year ended December 31,
|           |  | 2002                    |   |  | 2003 |   |  | 2004
|           |  | %                      
|Customer A |  |                        |   |  |     |   |  | 15  
|Customer B |  | *                       | ) |  | 16   |   |  | 10  
|Customer C |  |                        |   |  | 13   |   |  |    
|Customer D |  | 12                      |   |  | 12   |   |  |    
|Customer E |  | *                       | ) |  | *    | ) |  |    

---

|*) | Represents less than 10% of total revenues.
|-- | -------------------------------------------



NOTE 14:- SELECTED STATEMENTS OF OPERATIONS DATA



Financial expenses, net:



|                                                             |  |                         |      |   |      |   |      |      |  |   |      |  
|------------------------------------------------------------ |  | ----------------------- | ---- | - | ---- | - | ---- | ---- |  | - | ---- | -
|                                                             |  | Year ended December 31, |     
|                                                             |  | 2002                    |      |   | 2003 |   |      | 2004 | 
|Financial expenses:                                          |  |                         |      |   |      |   |      |      |  |   |      |  
|                                                             |  |                         |     
|Interest                                                     |  | $                       | (229 | ) |      | $ | (146 | )    |  | $ | (256 | )
|Other expenses                                               |  |                         | (85  | ) |      |   | (69  | )    |  |   | (48  | )
|Foreign currency translation adjustments                     |  |                         | (32  | ) |      |   | (118 | )    |  |   | (130 | )
|Stock-based compensation related to options to Bank Hapoalim |  |                         |     |   |      |   | (14  | )    |  |   | (28  | )
|                                                             |  |                         |      |   |      |   |      |      |  |   |      |  
|                                                             |  |                         | (346 | ) |      |   | (347 | )    |  |   | (462 | )
|                                                             |  |                         |      |   |      |   |      |      |  |   |      |  
|Financial income:                                            |  |                         |      |   |      |   |      |      |  |   |      |  
|                                                             |  |                         |     
|Interest                                                     |  |                         | 59   |   |      |   | 22   |      |  |   | 11   |  
|Foreign currency translation adjustments                     |  |                         | 98   |   |      |   | 14   |      |  |   | 88   |  
|                                                             |  |                         |      |   |      |   |      |      |  |   |      |  
|                                                             |  |                         | 157  |   |      |   | 36   |      |  |   | 99   |  
|                                                             |  |                         |      |   |      |   |      |      |  |   |      |  
|                                                             |  | $                       | (189 | ) |      | $ | (311 | )    |  | $ | (363 | )
|                                                             |  |                         |      |   |      |   |      |      |  |   |      |  



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands, except share and per share data



NOTE 15:- RELATED PARTIES TRANSACTIONS



| | a. | In June 1999, the board of directors approved the issuance of 17,390 Series C-2 Preferred shares, to its chairman in consideration of $ 100, which the Company loaned to him. The
loan was approved by the shareholders in June 2000 and bears an annual interest at the rate of 6.5%. Repayment of the loan is due when the chairman sells or otherwise disposes of the shares, subject to the loan. In addition, the Company, at its sole
discretion, may call for immediate repayment of the loan and the interest thereon in the event that (i) the chairman becomes bankrupt or files a motion for bankruptcy, or (ii) the chairman ceases to remain in the employment of the Company for any
reason.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b. | On May 28, 2001, the Company entered into a loan agreement with its former Chief Executive Officer for a principal sum of $ 52. Under the loan agreement, as amended, repayment of
such loan amount by the officer (together with an interest equal to the applicable Federal Rate as published by the IRS on the date of the loan agreement) shall be made upon the earlier to occur of: (i) May 28, 2005 (ii) termination of the
officers employment with the Company, or (iii) such time as the officer elects to repay the loan. In addition, under the loan agreement the officer shall not be required to repay any outstanding loan amount in the event that his employment
with the Company is terminated by the Company without cause. On May 16, 2005, after the officer has resigned from the Board of Directors and concurrently with the entering into a part-time employment with the former officer, the Company extended the
repayment date of the loan to May 28, 2006.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c. | On July 21, 2003, the board of directors and audit committee approved an agreement with a director of the Company, to provide project management services to the Company in
connection with its engagements with customers and prospects. The compensation provided under the terms of this agreement is based on the average compensation provided to employees providing similar services to the Company.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | d. | Insurances policies with Clal Credit Insurance and Clal Insurance:
| | -- | ------------------------------------------------------------------



During the period from 2002 through 2004, the Company purchased several insurance policies from Clal Credit Insurance and Clal Insurance, both of which
are affiliated with The Clal Group, which is the Companys shareholder. All of these insurance policies include the following items:



2002 - Errors and omissions insurance, fire and general liability insurance, employers liability insurance, credit insurance, keyman insurance and
travel insurance, for payments that total approximately $ 100.



2003 - Errors and omissions insurance, fire and general liability insurance, employers liability insurance, and keyman insurance, for payments that total approximately $ 70.



2004 - Fire and general liability insurance, employers liability
insurance, and keyman insurance, for payments that total approximately $ 8.



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 15:- RELATED PARTY TRANSACTIONS (Cont.)



| | e. | Insurance settlement with Clal Insurance:
| | -- | -----------------------------------------



On March 18, 2003, the Company entered into a settlement agreement with Clal Insurance, an entity affiliated with The Clal Group which is a significant
shareholder as set forth above. Under the settlement agreement, Clal Insurance paid the company an amount of $ 350 as a final settlement of its liability to the Company under the insurance provided by it to the receivables under a license
transaction that the Company had with Viasource Communications. This amount has been classified as other income in the accompanying statements of operations.



| | f. | Transactions with Telvent Interactive S.A. (Telvent):
| | -- | -------------------------------------------------------



On June 30, 2004, the Company entered into a value added reseller agreement with Telvent, under which Telvent became a non-exclusive reseller of the
Companys products at normal reseller terms.



On December
1, 2004, the Company entered into an agreement with Telvent, under which, Telvent provides the Company with certain technical consulting services relating to one of the Companys customers.



The following is a summary of the transactions with Telvent:



|                         |  |              |   |      |   |    
|------------------------ |  | ------------ | - | ---- | - | ---
|                         |  | December 31,
|                         |  | 2003         |   | 2004
|Revenues:                |  |              |   |      |   |    
|Software license         |  | $            |  |      | $ | 650
|Maintenance and services |  |              |  |      |   | 23 
|                         |  |              |   |      |   |    
|Total                    |  | $            |  |      | $ | 673
|                         |  |              |   |      |   |    
|Cost of revenues:        |  |              |   |      |   |    
|Maintenance and services |  | $            |  |      | $ | 48 
|                         |  |              |   |      |   |    



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands, except share and per share data



NOTE 16:- SUBSEQUENT EVENTS



| | a. | Credit line and covenants with Bank Hapaolim:
| | -- | ---------------------------------------------



During March 2005, Bank Hapoalim agreed to provide the Company with an additional credit line in the amount of $1,000. The credit line can be denominated
in either USD or in NIS. The interest rates on the credit line range between Libor + 2.25% in USD and 8% in NIS. In addition, the bank agreed to cancel the existing covenants and to replace them in their entirety with the following covenants: (i)
the Companys shareholders equity, on a quarterly basis, starting on January 1, 2006, shall be at least the higher of (a) 17% of its total assets, or (b) $3,000, (ii) the Companys cash balance, on January 1, 2006 and on a quarterly
basis thereafter, shall not be less than $ 2,000.



In
consideration for the additional credit line, the Company issued the Bank a warrant to purchase 50,000 Ordinary Shares of the Company at an exercise price of $2.06 per Ordinary Share.



The fair value of this warrant was determined using Black-Scholes pricing model, assuming a risk free interest rate of 3%, a
volatility factor of 1.13, dividend yield of 0% and an expected life of the warrant of two years. This resulted in an amount of $ 61. In accordance with APB 14, the Company allocated a portion of the proceeds to the warrant, based on their
applicable fair values. Amounts allocated to the warrants were recorded as additional paid-in capital against a discount on the loan. The discount related to this loan will be amortized as financial expenses over the term of the loan.



| | b. | In February 2005, the Company issued to Telvent Investments S.L., an existing shareholder of the Company, in a private placement, 581,659 Ordinary Shares at a price per share of $
2.29, for the total consideration of $ 1,332.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | c. | On June 1, 2005, the Company established a subsidiary in Australia, ViryaNet Pty Ltd. (ViryaNet Australia), and on June 15, 2005, acquired substantially all of the
assets of privately-held e-Wise Solutions (e-Wise) e-Wise based in Melbourne, Australia, develops and implements front-office automation solutions for mobile and desktop platforms, for large organizations in the utility, government, and
oil and gas services market segments, across Australia, New Zealand, and the Asia Pacific region. Through ViryaNet Australia, the Company acquired substantially all of the assets of e-Wise, including intellectual property rights, and will assume
certain customer and partnership agreements, for an initial consideration of $ 700 payable in 273,267 unregistered Ordinary Shares of ViryaNet and the assumption of approximately $ 300 of unsecured debt. Additional consideration of up to $ 700 in
unregistered Ordinary Shares may be paid to e-Wise in 2006 based on the achievement of certain performance objectives for 2005 (the Contingent Consideration). On July 5, 2005, the Company signed an amendment to the agreement with e-Wise
under which the Company received an option to pay 90% of the Contingent Consideration at any time before October 15, 2005, as satisfaction of our payment obligation in connection with such Contingent Consideration.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | d. | On June 2, 2005, the Company was notified by the Nasdaq that it is not in compliance with the listing standards for shareholders equity. On July 5, 2005, the Company submitted
a plan to Nasdaq to regain compliance.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

U.S. dollars in thousands



NOTE 16:- SUBSEQUENT EVENTS (Cont.)



| | e. | On June 29, 2005, the Company entered into an additional letter agreement with LibertyView under which LibertyView agreed, for the period ending on January 1, 2006, to waive its
right to require the Company to repurchase the convertible note if it ceases to be traded on the Nasdaq SmallCap Market. In connection with such waiver, the Company issued 10,000 Ordinary Shares to LibertyView.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



F-43