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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, 2002



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)



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, 2002, the Registrant had
outstanding 2,681,733 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



|ITEM     |  |                                                                              |  | Page No.
|-------- |  | ---------------------------------------------------------------------------- |  | --------
|PART I   |  |                                                                              |  | 3       
|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                                                   |  | 17      
|         |  | History and Development                                                      |  | 17      
|         |  | Business Overview                                                            |  | 17      
|         |  | Organizational Structure                                                     |  | 24      
|         |  | Property, Plants and Equipment                                               |  | 25      
|Item 5.  |  | Operating and Financial Review and Prospects                                 |  | 25      
|         |  | Overview                                                                     |  | 25      
|         |  | Operating Results                                                            |  | 30      
|         |  | Liquidity and Capital Resources                                              |  | 34      
|         |  | Research and Development                                                     |  | 38      
|         |  | Trend Information                                                            |  | 38      
|Item 6.  |  | Directors, Senior Management and Employees                                   |  | 38      
|         |  | Directors and Senior Management                                              |  | 38      
|         |  | Compensation                                                                 |  | 40      
|         |  | Board Practices                                                              |  | 41      
|         |  | External Directors; Independent Directors                                    |  | 41      
|         |  | Employees                                                                    |  | 43      
|         |  | Share Ownership                                                              |  | 44      
|Item 7.  |  | Major Shareholders and Related Party Transactions                            |  | 46      
|         |  | Major Shareholders                                                           |  | 46      
|         |  | Related Party Transactions                                                   |  | 47      
|         |  | Interests of Experts and Counsel                                             |  | 49      
|Item 8.  |  | Financial Information                                                        |  | 50      
|         |  | Consolidated Statements and Other Financial Information                      |  | 50      
|         |  | Significant Changes                                                          |  | 50      
|Item 9.  |  | The Offer and Listing                                                        |  | 51      
|         |  | Market Price Information                                                     |  | 51      
|         |  | Markets on Which our Ordinary Shares Trade                                   |  | 51      
|Item 10. |  | Additional Information                                                       |  | 52      
|         |  | Share Capital                                                                |  | 52      
|         |  | Memorandum and Articles of Association                                       |  | 52      
|         |  | Material Contracts                                                           |  | 54      
|         |  | Exchange Controls                                                            |  | 54      
|         |  | Taxation                                                                     |  | 54      
|Item 11. |  | Quantitative and Qualitative Disclosures about Market Risk                   |  | 64      
|Item 12. |  | Description of Securities other than Equity Securities                       |  | 64      
|PART II  |  |                                                                              |  | 65      
|Item 13. |  | Defaults, Dividend Arrearages and Delinquencies                              |  | 65      
|Item 14. |  | Material Modifications to the Rights of Security Holders and Use of Proceeds |  | 65      
|Item 15. |  | Controls and Procedures                                                      |  | 65      
|Item 16. |  | [RESERVED]                                                                   |  | 65      
|PART III |  |                                                                              |  | 66      
|Item 17. |  | Financial Statements                                                         |  | 66      
|Item 18. |  | Financial Statements                                                         |  | 66      
|Item 19. |  | Exhibits                                                                     |  | 66      



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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 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.



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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



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, 2000, 2001 and 2002, and the selected consolidated balance sheet data as of December 31, 2001 and 2002, 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, 1998
and 1999 and the selected consolidated balance sheet data as of December 31, 1998, 1999 and 2000 from audited consolidated financial statements that are not included in this annual report.



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Summary Consolidated Financial Information



|                                                                                                                                                     |  | Year Ended December 31, |        
|---------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | -------
|                                                                                                                                                     |  | 1998                    |        
|Statement of Operations Data:                                                                                                                        |  |                         |        
|Revenues:                                                                                                                                            |  |                         |        
|Software licenses                                                                                                                                    |  | $                       | 1,801  
|Maintenance and services                                                                                                                             |  |                         | 11,724 
|                                                                                                                                                     |  |                         |        
|Total revenues                                                                                                                                       |  |                         | 13,525 
|Cost of revenues:                                                                                                                                    |  |                         |        
|Software licenses                                                                                                                                    |  |                         | 146    
|Maintenance and services                                                                                                                             |  |                         | 9,709  
|                                                                                                                                                     |  |                         |        
|Total cost of revenues                                                                                                                               |  |                         | 9,855  
|Gross profit                                                                                                                                         |  |                         | 3,670  
|                                                                                                                                                     |  |                         |        
|Operating expenses:                                                                                                                                  |  |                         |        
|Research and development, net                                                                                                                        |  |                         | 5,322  
|Sales and marketing                                                                                                                                  |  |                         | 8,862  
|General and administrative                                                                                                                           |  |                         | 2,602  
|Provision for doubtful accounts and write-off of bad debts                                                                                           |  |                         |       
|In-process research and development write-off                                                                                                        |  |                         |       
|Amortization of deferred stock compensation(1)                                                                                                       |  |                         | 250    
|                                                                                                                                                     |  |                         |        
|Total operating expenses                                                                                                                             |  |                         | 17,036 
|Operating loss                                                                                                                                       |  |                         | (13,366
|Financial income (expenses), net                                                                                                                     |  |                         | 234    
|Financial expenses related to amortization of beneficial conversion feature and compensation related to warrants to investors in
convertible loan(*) |  |                         |       
|                                                                                                                                                     |  |                         |        
|Net loss                                                                                                                                             |  | $                       | (13,132
|                                                                                                                                                     |  |                         |        
|Preferred shares deemed dividend                                                                                                                     |  | $                       | (61    
|                                                                                                                                                     |  |                         |        
|Net loss to shareholders of ordinary shares                                                                                                          |  | $                       | (13,193
|                                                                                                                                                     |  |                         |        
|Basic and diluted net loss per share                                                                                                                 |  | $                       | (51.60 
|Weighted average number of shares used in computing basic and diluted net loss per ordinary share                                                    |  |                         | 255,465
|(1) Amortization of deferred stock compensation relates to the following:                                                                            |  |                         |        
|Cost of revenues                                                                                                                                     |  | $                       |       
|Research and development, net                                                                                                                        |  |                         |       
|Sales and marketing                                                                                                                                  |  |                         | 120    
|General and administrative                                                                                                                           |  |                         | 130    
|                                                                                                                                                     |  |                         |        
|                                                                                                                                                     |  | $                       | 250    
|                                                                                                                                                     |  |                         |        
|Balance Sheet Data:                                                                                                                                  |  |                         |        
|Cash and cash equivalents                                                                                                                            |  | $                       | 554    
|Working capital (deficit)                                                                                                                            |  |                         | (2,342 
|Total assets                                                                                                                                         |  |                         | 8,638  
|Long-term loan, including current maturities                                                                                                         |  |                         | 62     
|Shareholders equity (deficiency)                                                                                                                    |  |                         | (1,452 

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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 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



Risk Relating to Our Business



Our business is impacted by the slowdown in the
worldwide economy.



Our business is dependent on
current and anticipated market demand for software products, which 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, the
war in Iraq led by coalition forces. Many of our customers and prospective customers are experiencing economic downturns currently, including those in the utility, energy and telecommunications market. The uncertainty regarding the growth rate of
the worldwide economies has caused companies to reduce purchasing and capital investment. Furthermore, this uncertainty has resulted in longer purchasing cycles with our customers and in customers requests for longer payment terms as evidenced
by our DSO (Days of Sales Outstanding) performance. 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 excess product capacity, 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 these global economic conditions remain the same or worsen, we may experience a material adverse impact on our business, operating results and financial condition.



Existing and any additional measures taken by us to address the
downturn in the global economy may have an adverse effect on our business.



We have taken and may continue to take, if necessary, cost reduction measures to address the downturn in the global economy and the particular slowdown in the markets we serve, particularly the telecommunications
market. These measures are intended to reduce our expenses in the face of decreased revenues due to decreased customer orders. Our implementation of these measures and any additional measures taken in the future, if necessary, may be unsuccessful in
addressing the downturn in the global economy and the slowdown in the markets we serve, particularly the telecommunications market. Current and additional cost reduction actions, if necessary, may result in further cash and non-cash charges, which
would have a material adverse effect on our results of operations and financial condition. In addition, each of these measures and any additional measures taken in the future, if necessary, may have long-term negative effects on our business and may
make it more difficult to achieve our current or future business objectives.



We have a history of losses and our recent financial results have been lower than expected.



We incurred net losses of approximately $13.1 million in 1998, $20.4 million in 1999, $26.8 million in 2000, $14.6 million in 2001, and $11.4 million in
2002. As of December 31, 2002, we had an accumulated deficit of approximately $100.8 million. As a result, we will need to generate significant revenues to achieve and maintain profitability. Our revenues in 2002 were $8.7 million compared with
$20.0 million in 2001, a decline of $11.3 million or 57%. This revenue decline was due primarily to customers and prospective customers, especially in the utilities and telecommunications areas, experiencing issues related to current adverse
economic conditions that are causing them to defer their technology purchasing. Such continued adverse economic



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conditions could cause our revenues to continue to decrease and make it more difficult for us to reach profitability.



We have a limited operating history in our current principal market,
which will make it difficult or impossible for you to predict our future results of operations.



We began operations in March 1988 as a general software services company. In 1995, we changed our strategic focus to the development of service delivery
chain management applications based on client-server technology, Service Suite. We did not introduce ViryaNet Service Hub, based on Internet and wireless technologies, until the fourth quarter of 1999. Each of these changes has required us to adjust
our business processes and make a number of significant personnel additions and changes. Historically, prior to 2000 most of our revenues were generated from our services activities. Substantially all of our revenues in 1999 and 2000 were generated
from our service delivery chain management applications, including Service Suite. In 2001 and 2002, and the foreseeable future the substantial majority of our revenues were generated and are expected to generate, respectively, from transactions
which will include the ViryaNet Service Hub product and mobile workforce management solutions. Our prospects must be considered in light of the risks and difficulties frequently encountered by companies dependent upon operating revenues from a new
product line in an emerging and rapidly evolving market. Because of our limited experience in our principal market and with our principal product, we cannot provide assurance that our strategy for operating in that market or selling that product
will be successful. Our historical results of operations should not serve as indications of future performance.



We may experience significant fluctuations in our quarterly results, which makes 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:



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



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



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



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



| |  |  | changes in the proportion of service and license revenues;
| | - |  | ----------------------------------------------------------



| |  |  | Price and product competition;
| | - |  | ------------------------------



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



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



| |  |  | adverse economic conditions and currency fluctuations, and especially the conditions associated with the September 11, 2001 terrorist attacks in the U.S., as well as the current and
after effect from the war in Iraq led by coalition forces; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | consolidation of our customers.
| | - |  | -------------------------------



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. 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. 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.



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Historically, our revenues have been concentrated in a few large orders and a small number of
customers and 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. In 1998, 1999 and 2000, we derived 55%, 55% and 9% of our revenues, respectively, from two
customers, Sun Microsystems and GE, who are shareholders or warrant holders. In 1999, 71% of our revenues were derived from four customers, including Sun Microsystems and GE, and no customer accounted for more than 33% of our revenues. In 2000, two
customers each accounted for approximately 11% or more of our revenues), and represented an aggregate of 23% of our total revenues. In 2001, three customers each accounted for approximately 7% or more of our revenues, and represented an aggregate of
28% of our total revenues. In 2002, three customers each accounted for approximately 10% or more of our revenues, and represented an aggregate of 38% of our total revenues. We do not expect that these customers 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 loss of key customers or the occurrence of significant reductions in sales from a key customer would cause our revenues to decrease and make it more difficult for us to reach profitability.



Our sales cycle is variable and sometimes long and involves significant
resources on our part, but may never result in actual sales.



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 is 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. 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. A number of companies decide which products to buy
through a request for proposal process. In those situations, we 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.



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



Our success depends on market acceptance of our ViryaNet Service Hub internet-based products and related applications. We have licensed applications to
only a small number of customers. If our products do not achieve or maintain market acceptance or if our competitors release new products that achieve quicker market acceptance, have more advanced features, offer better performance or are more price
competitive, license revenues for our products may not grow and may even decline.



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 solutions is still developing and evolving. This makes it difficult to predict
demand and market acceptance for our products. We cannot guarantee that the market for our internet-based products will grow or that our products will become widely accepted. If the market for our internet-based products does not develop as quickly
as we expect or if our internet-based products are not accepted by customers, our future revenues and profitability will be adversely affected. Changes in technologies, industry standards, the regulatory environment, 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. A significant increase in the number of customers, or a significant increase in our
development of new product offerings, or both, could require us to expend significant amounts of money, time and other resources to meet the demand. This could strain our personnel and financial resources.



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



Our margins on service
revenues have declined from 22% in 2000 to 14% in 2001. This decrease was primarily caused by the decline in the volume of our service revenues. In 2002, our services margins increased to 16% as a result of an increase in the billable utilization of
our services personnel and further cost reductions. To continue to improve our margins, we are working on increasing the volume of our service revenues and improving the billable utilization of our services personnel while decreasing our cost of
service revenues. Although our services margins increased slightly during 2002 compared to 2001, there is no assurance that the services margins will not further decrease in the future. Failure to improve our margins on service revenues could cause
our services business to be less profitable or unprofitable.



If we fail to expand our relationships with third parties, 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 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. A number of our competitors have significantly
more established relationships with these third parties and, as a result, these third parties may be more likely to recommend competitors products and services rather than our own. Even if we are successful in developing relationships with
third-party implementation and consulting providers, we will be subject to significant risk as we cannot control the level and quality of service provided by third-party implementation and consulting partners.



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 critical to our customers operations. As a result, our customers and potential customers have a greater
sensitivity to product defects than do customers of software products generally.



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;
| | - |  | ----------------------------------------------------------------



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



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



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



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



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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.



Decisions by customers to develop their own service management
solutions or greater market acceptance of our competitors products could result in reduced revenues or gross margins.



The market for third-party mobile workforce management is relatively immature, but has begun to develop and competition is intense. This market and the
market for service management solutions is fragmented and stratified. We compete for the business of global or nationwide organizations that seek to support complex and sophisticated products across a variety of industries.



Our competitors may 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. As 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.



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.



We integrate various third-party
software products as components 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.



We may be unable to expand our sales, marketing, research & development and support organizations which may hinder our ability to grow and meet customer demands.



During both 2001 and 2002, we substantially reduced our headcount in sales,
marketing, research & development and professional services in order to reduce costs. We believe we currently have sufficient resources available to meet and support our current obligations, but, we may need to substantially expand our direct
and indirect sales and marketing operations 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. Qualified individuals are in demand throughout the software industry and there is significant competition for qualified personnel. Competition for qualified people may lead to increased labor and personnel costs. If we do not succeed in
retaining our personnel or in attracting new employees, our business could suffer significantly. If we 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 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



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that is not subject to patent or similar protection. We filed a provisional patent application covering some of our technologies for creating and supporting
service communities on the Internet. On November 30, 2000, we filed the patent application detailing the claims regarding some of our technologies for creating and supporting service communities on the Internet. As of the date hereof, we have not
heard from the U.S. patent office whether our application has been approved or rejected. 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.



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. We have provided our software directly to customers and resellers. 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 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, the Middle East, and the Far East. We received 25% of our total revenues in 2000, 37% of our total revenues in 2001 and 42% of our total revenues in 2002 from sales to customers located outside of
the United States. The expansion of our existing operations and entry into additional international markets will require significant management attention and financial resources. We have limited experience in developing localized versions of our
products and marketing and distributing our products outside of the United States. We are subject to a number of risks customary for international operations, including:



| |  |  | 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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| |  |  | difficulties and costs of staffing and managing foreign operations;
| | - |  | -------------------------------------------------------------------



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



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



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



We will most likely require additional financing and may not be able to raise additional financing on favorable terms or at all.



We will most likely require additional funding for our business
operations. However, we cannot assure you that additional financing will be available on terms favorable to us, or at all. 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 or may be reduced, and these newly-issued securities, if
issued, may have rights, preferences or privileges senior to those of existing shareholders. For further details about our cash position see the Cash paragraph under Liquidity and Capital Resources in Item 5.



We will need sufficient funds to re-pay the loan from Bank Hapoalim.



During January 2003, we replaced the $6.0 million
line of credit with Bank Hapoalim with a loan in the amount of $3.45 million. Under the terms of such loan, we are required to pay back the loan amount in full by July 21, 2003. Under the terms of the loan, the loan amount will incur interest at an
annual rate of 4.375%. During July 2003, Bank Hapoalim agreed to restructure a portion of the loan by converting $2.4 million of the $3.45 million short-term loan into a long-term loan and deferring payment of $0.5 million under the short-term loan
until August 15, 2003. The $2.4 million long-term loan is payable quarterly over a two year period beginning on January 1, 2004, with interest payable quarterly at a rate to be determined beginning on October 21, 2003. The debt restructure is
subject to several conditions, including the following conditions: (i) the Company shall be cash flow positive on a quarterly basis, (ii) the Company shall deposit $800,000 into its account with Bank Hapoalim, (iii) the Company shall raise no less
than $1 million of new capital by January 1, 2004, and, (iv) the Company will grant Bank Hapoalim a warrant to purchase 40,000 Ordinary Shares of the Company at an exercise price of $1.00 per Ordinary Share and will reprice a prior warrant to
purchase 60,000 Ordinary Shares of the Company to an exercise price of $1.00 (the warrants were granted and repriced on July 2, 2003, see Liquidity and Capital Resource section of Item 5). However, we may need additional funding to re-pay the
balance of the short-term loan by its due dates, or to meet our obligations for quarterly payments of the long-term loan by its due dates, and there is no assurance that we will meet the above conditions, or that Bank Hapoalim will grant us an
extension to these payment dates in the future.



We may
not be able to achieve compliance with the listing rules of The Nasdaq SmallCap Market.



Our Ordinary Shares were previously listed on The Nasdaq National Market and in light of our inability to comply with all maintenance standards of The
Nasdaq National Market we have requested to be listed for trading on The Nasdaq SmallCap Market, and our Ordinary Shares have begun trading on The Nasdaq SmallCap Market starting as of December 31, 2002. The Nasdaq SmallCap Market has several
maintenance standards for continued listing, including the requirements (i) that the Company shall maintain (a) a shareholders equity of at least $2,500,000, or (b) market value of $35,000,000, or (c) net income from operations of $500,000 in
the last year or two of the last three fiscal years, (ii) that the Company shall have at least 500,000 shares held by persons or entities other than officers, directors and beneficial owners of more than 10% of the Companys Ordinary Shares
(the Public Float), (iii) that the Company shall have an aggregate market value of Public Float of at least $1,000,000, (iv) that the Company shall have at least two market makers, (v) that the Company shall have at least



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300 shareholders who hold at least 100 Ordinary Shares, and (vi) that the Company shall be in compliance with all corporate governance under rules 4350 and
4351 (the foregoing requirements are collectively referred to as the Maintenance Standards). We believe we are not currently in compliance with some of the requirements under the Maintenance Standards for continued listing. If we fail to
maintain compliance with one or more requirements of the Maintenance Standards, our Ordinary Shares would be subject to delisting from The Nasdaq SmallCap Market, but may qualify for inclusion on the Over-the-Counter Bulletin Board (OTCBB). 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 and could have an adverse effect on the market price and the efficiency of 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.



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;
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | public announcements concerning us or our competitors, or the Internet industry;
| | - |  | --------------------------------------------------------------------------------



| |  |  | 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 loss of any of our key personnel; 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.



As of May 1, 2003, we had 2,681,733 ordinary shares outstanding, warrants to purchase 182,389 ordinary shares outstanding and in addition we have reserved
up to 940,000 ordinary shares for issuance under our option plans, out of which 40,047 options were already exercised as of May 1, 2003. If a large number of our ordinary shares are sold, the price of our ordinary shares would likely decrease.



We may continue to issue warrants and options and the issuance
of these securities could be dilutive to our shareholders. These warrants will be valued using the Black-Scholes method when they are issued, and we may reflect appropriate charges in our financial statements at that time.



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 May 1, 2003, our executive officers and directors serving as of such date, and entities affiliated with them, in the aggregate, beneficially owned
approximately 25.1% of our outstanding ordinary shares. These



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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.



We may acquire or make investments in 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 be able to make the acquisitions or investments on commercially acceptable terms or 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 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. On February 25, 2002 we completed the acquisition of all of the outstanding shares of iMedeon, Inc., a provider of mobile workforce management solutions to the utilities sector. However, there is no
assurance that we will not have difficulties assimilating iMedeons personnel, operations, customers, technology or products and service offerings into our own.



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 rapidly
evolving. Our future success will depend on the acceptance by customers of the Internet and business-to-business Internet solutions as an integral part of their business model. Demand for and market acceptance of recently introduced services are
each subject to a high level of uncertainty. If use of the Internet does not continue to develop, or develops more slowly than expected, we may not be able to execute our business plan successfully.



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.
| | - |  | -------------------------------------------------



We cannot assure you that the Internet infrastructure will be able to support expected growth or that the performance and reliability of the Internet will
not decline as a result of this growth. Many Internet sites have experienced a variety of interruptions in their service as a result of outages and other delays occurring throughout the internet network infrastructure. If these outages or delays
frequently occur in the future, Internet usage could grow more slowly than anticipated or even decline.



Our business is dependent on the projected growth and adoption of wireless and mobile technologies to improve field service automation.



The wireless data and mobile application market is
very new and fragmented. There are few applications that have received widespread acceptance. Our future success relies on the adoption of mobile field service



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applications across all targeted vertical markets. Significant deployments of mobile applications have been limited to the utilities industry.



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 limited adoption of mobile applications has to do
with several aspects that are dependent on market maturity:



| |  |  | The high 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.
| | - |  | -----------------------------------------------



| |  |  | 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.
| | - |  | -----------------------------------------------------------------------------



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



The use of wireless Internet applications adds another dimension of concern and risk to the list above. There are numerous solutions in the marketplace
for mobile applications. These are usually form-based environments for developing mobile applications. They are based on the use of fat-clients that are developed and deployed on the mobile device and that have a server component with which the
mobile device communicates.



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.



If acceptance and growth of the Internet as a medium for
business-to-business commerce does not continue, our business strategy may not be successful because there may not be a continuing market demand for our services.



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.



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 executive officers and directors 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



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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. Also, the recent war in Iraq led by coalition forces and the consequences of such war may negatively impact our business.



Generally, all male adult citizens and permanent residents of Israel under the age of 54 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 officers and employees are currently obligated to perform annual
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 new Israeli shekel 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 personnel expenses, are in new Israeli shekels, or NIS. As a result, we 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 dollar against the NIS was similar to the rate of inflation. 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 available to us from government
programs may be discontinued or reduced at any time, which would likely increase our taxes.



We have received grants in the past and receive tax benefits under Israeli government programs. To maintain our eligibility for these programs and
benefits, we must continue to meet specified conditions, including making specified investments in fixed assets from our equity. Some of these programs restrict our ability to manufacture particular products or transfer particular technology outside
of Israel. If we fail to comply with these conditions in the future, the benefits received could be canceled and we could be required to refund any payments previously received under these programs or pay increased taxes. The government of Israel
has reduced the benefits available under these programs recently and these programs and tax benefits may be discontinued or reduced in the future.



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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. The terms of these grants prohibit us from
manufacturing products or transferring technologies developed using these grants outside of Israel without special approvals. Even if we receive approval to manufacture these products outside of Israel, we may be required to pay increased royalties,
up to 300% of the grant amount plus interest, depending on the manufacturing volume that is performed outside of Israel. The technology developed with these grants may not be transferred to third parties, including in the context of an acquisition
of our company, without the prior approval of a governmental committee under the Research and Development Law, and may not be transferred to non-residents of Israel. These restrictions may impair our ability to outsource manufacturing or engage in
similar arrangements for those products or technologies. In addition, if we fail to comply with any of the conditions imposed by the Office of the Chief Scientist, we may be required to refund any grants previously received, together with interest
and penalties.



In 2002, the Research and Development Law was
amended to, among other things, enable companies applying for grants from the Office of the Chief Scientist to seek prior approval for conducting manufacturing activities outside of Israel without being subject to increased royalties. However, this
amendment will not apply to any of our existing grants. In addition, the amendment provides that one of the factors to be taken into consideration by the Office of the Chief Scientist in deciding whether to approve a grant application is the
percentage of the manufacturing of the relevant product that will be conducted outside of Israel. Accordingly, should we seek additional grants from the Office of the Chief Scientist in connection with which we also seek prior approval for
manufacturing products outside of Israel, we may not receive such grant or may receive a grant in an amount that is less than the amount we sought.



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



We cannot assure you that we will not be treated as a
passive foreign investment company in 2002 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 you 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;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



See also the discussion in the Taxation section in Item 10.



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 Israeli Companies Ordinance (New Version), 1983, as a private limited company, 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 (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 15 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 Initial Public Offering (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 became a dual listed company.



On February 25, 2002, we acquired the outstanding shares of iMedeon, Inc., 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 SmallCap
Market began on December 31, 2002.



Business Overview



ViryaNet is a
leading provider of integrated mobile and Web-based software applications for workforce management and complementary applications for spare parts logistics, contract management, and depot repair



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operations. Our mission is to provide companies with solutions that improve the quality and efficiency of their complex service business processes.



ViryaNet targets companies in the utility, telecommunications,
high technology manufacturing, building services, grocery/retail, and general service industries that have large mobile workforces, extensive service agreements, complex products, strong commitments to customer satisfaction, and a need to improve
their service operations.



Our award-winning ViryaNet Service
Hub product supports a wide range of work order needs: from short-duration tasks to more complex, multi-day, multi-resource projects. ViryaNet Service Hub provides a solution that supports the range of work types and the entire lifecycle of a work
order, including, high-volume and project-based 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
have issued at least one major version release of ViryaNet Service Hub annually since the products inception in 1999.



ViryaNets major product release in 2002 was ViryaNet Service Hub version 7.0. Version 7.0 combined the best features and technology components of
iMedeons iM:Work with ViryaNet Service Hub. ViryaNet Service Hub 7.0 is the first workforce management solution to address both simple service tasks as well as complex, non-linear maintenance and construction activities, which can span months
and include hundreds of tasks that must be managed and tracked within the context of an entire project. ViryaNet Service Hub 7.0 introduced significant functional enhancements, including a wider range of mobile and wireless capabilities, enhanced
scheduling, and dramatically improved workflow technologies.



During the second quarter of 2003, we released the ViryaNet Service Hub version 8.0. Version 8.0 boasts a new web-based service logistics management system entitled eStock. eStock is a supply chain management product that automates the
functions of allocation, picking, shipping, receiving, stock views, stock movements, and adjustments. ViryaNet Service Hub 8.0 also includes many enhancements to ViryaNets Mobile Workforce Management application, including a new map-based
dispatching utility. ViryaNet Service Hub 8.0 users can graphically see both the location of the task and the location of the field engineer, and, with the use of drag and drop, can assign a task to the engineer.



Our revenues are derived mainly from the licensing of our software and from
maintenance and services that we provide. 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, |  
|------------------------ |  | ----------------------- | -
|                         |  | 2000                    |  
|Revenues:                |  |                         |  
|Software licenses        |  | 62.8                    |  
|Maintenance and services |  | 37.2                    |  
|                         |  |                         |  
|Total revenues           |  | 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                    |  | 2000                    |  
|United States              |  | 75                      |  
|Europe and the Middle East |  | 6                       |  
|Far East                   |  | 19                      |  
|                           |  |                         |  
|Total                      |  | 100                     | %



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Over the past year, we have seen an increased percentage of our revenue derived from our growing
partnership network. We continue to 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 identified by them. 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, advertising and business
management consulting. As of May 1, 2003, we employed 15 sales, marketing and business development personnel. The majority of our sales personnel operate through our United States subsidiary, and the rest operate through our Japan subsidiary. During
the past year, we have restructured our sales and support strategy in Europe and the Middle East from a combined direct and indirect channel strategy to exclusively indirect channels, utilizing partners actively invested in the mobile workforce
sector which are 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 and Israel.



We also intend to explore and establish indirect sales
channels through relationships with additional resellers who offer complementary products and application service providers. Such resellers will be primarily used to sell special versions of our product configured for targeted markets and in
combination with their complementary products.

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. To date, ViryaNet has partnered
with three companies that have hosting capability: Aspective, BT Global Services, and Mobile Field Engineer.



ViryaNet Service Hub and Applications



Our award-winning flagship product, the ViryaNet Service Hub, was introduced in 1999 as an Internet-architected service business platform that allows organizations to:



| |  |  | Deploy our industry-packaged applications, taking advantage of the flexibility, ease of use, and pervasive adoption of the Internet.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Unite their service communities, including field engineers, customers, partners, vendors and suppliers, using the power and flexibility of the Internet to share information and
conduct service business.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Integrate systems and applications across their service operation using a common portal.
| | - |  | ----------------------------------------------------------------------------------------



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 API (application protocol interface) 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



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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



As depicted in the diagram below, ViryaNet Service Hub Internet
platform components consist of:



| |  |  | Service Portal
| | - |  | --------------



| |  |  | mService Gateway
| | - |  | ----------------



| |  |  | Service Intelligence and Data Mart
| | - |  | ----------------------------------



| |  |  | Service Workflow Engine/Editor
| | - |  | ------------------------------



| |  |  | Integration Server
| | - |  | ------------------



Each of these components is described in detail in the following sections.



LOGO



High-Level Overview of ViryaNet
Service Hub



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 the Mobile users with access to the data and applications they require, allowing them to stay productive, regardless of location. ViryaNet mService Gateway enable mobile users to work in both on-line and off-line mode.



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.



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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 Service Hub Internet platform components consist of:



| |  |  | ViryaNet Mobile Workforce Management
| | - |  | ------------------------------------



| |  |  | ViryaNet Service Scheduler
| | - |  | --------------------------



| |  |  | ViryaNet eContract
| | - |  | ------------------



| |  |  | ViryaNet eStock
| | - |  | ---------------



| |  |  | ViryaNet eRepair
| | - |  | ----------------



ViryaNet Mobile Workforce Management



ViryaNet Mobile Workforce Management, an integral component of ViryaNet Service Hub, provides end-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 intelligently 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.



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 Hubincorporates two mobile options:



| |  |  | Fat client application, SH Field
| | - |  | --------------------------------



| |  |  | Web-based thin client with on-line and off-line capability, Mobile FE
| | - |  | ---------------------------------------------------------------------



Both applications have the same functional capabilities.



SH Field



SH Field supports Win 32 OS and offers peer-to-peer messaging, provides emergency notifications, and supports all forms of field-activity reporting.



Mobile FE



Mobile FE combines the efficiency and robustness of fat clients with the
simplicity and flexibility attributed to thin clientswithout the limitation of having to be connected to process work. Fat client benefits, such as optimal compression and full functional off-line operations, are combined with the thin client
benefits of rapid application deployment and no administrationall fully functional even when the device is not within wireless coverage.



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ViryaNet Service Scheduler



ViryaNet Service Scheduler is a powerful schedule and route optimization product to maximize customer satisfaction while
minimizing cost. The product 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 Service Supply Chain



ViryaNet Service Supply Chain provides a closed-loop
inventory and logistics system.



eContract



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



eRepair



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. Service Hub for 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 packages its applications for specific industries. We have captured best business practices and embedded 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, has allowed us to package ViryaNet Service Hub and applications into industry
bundles, including:



| |  |  | ViryaNet Service Hub for Utilities;
| | - |  | -----------------------------------



| |  |  | ViryaNet Service Hub for Telecommunications;
| | - |  | --------------------------------------------



| |  |  | ViryaNet Service Hub for Building Services;
| | - |  | -------------------------------------------



| |  |  | ViryaNet Service Hub for High Technology; and
| | - |  | ---------------------------------------------



| |  |  | ViryaNet Service Hub for Grocery / Retail.
| | - |  | ------------------------------------------



ViryaNets Customers



Over 600 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:



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, is utilizing 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 ILEC 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,



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reacting responsively to increased volumes, assimilating 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.



Ionexthis
integrated communications provider (ICP) serving customers in mid-America states, uses ViryaNet Service Hub to automate and optimize the activities of its field workforce and streamline work-order management. Ionex keeps track of, manages, and
improves the effectiveness of field engineers and third-party contractors, captures logistics and labor activity, and monitors, reports, and measures field activity.



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 will 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 will optimize LoJacks 300
field technicians and 100 support staff who manage the functions of appointment booking, dispatch, and scheduling. ViryaNet Service Hub is also intended to integrate with LoJacks primary in-house order entry system.



Publix Super Marketsthe largest employee-owned supermarket chain
and one of the 10 largest volume supermarket chains in the United States, chose 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 will enable 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.



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



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collecting valuable information to effectively achieve its current business goals and influence future manufacturing directions.



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.



Verizonthis large provider of
broadband services uses ViryaNet Service Hub to automate their order processing requirements and as a customer-facing portal to conduct a wide range of transactions, reducing the number of disputed invoices and order errors.



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. Aspective has its own ViryaNet practice and has licensed ViryaNet software to European telecommunication providers T-Mobile and Orange.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | BT Ignitea European information and communications technology company that positions ViryaNet Service Hub and mobile workforce management in hosted environments.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | GE Network Solutionsa business unit of GE Power Systems and leading global supplier of strategic network solutions to the utilities industry. GE is a major investor in
ViryaNet, 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.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Mobile Field Engineera value added reseller of ViryaNet Service Hub to the broad field service market in hosted environments. Mobile Field Engineer may enable ViryaNet
to broaden its presence into previously untapped markets.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Omron Alphateca systems integrator and distributor of ViryaNet Service Hub in the Far East region.
| | - |  | ---------------------------------------------------------------------------------------------------



Organizational Structure



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



|Name of Subsidiary   |  | Country of Incorporation
|-------------------- |  | ------------------------
|ViryaNet, Inc.       |  | United States of America
|iMedeon, Inc.        |  | United States of America
|ViryaNet Europe Ltd. |  | United Kingdom          
|ViryaNet Japan       |  | Japan                   



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Property, Plants and Equipment



We do not own any real property. Our engineering and research and development facilities are located in Jerusalem, Israel, where we occupy approximately 7,600 square feet with total annual rent of approximately $144,000. This agreement
expires on October 30, 2003 but we have the option to extend the agreement for one year at the same terms by notifying the landlord no later than June 30, 2003.



ViryaNet, Inc., our subsidiary located in Massachusetts leases approximately 14,000 square feet of office space in Southborough, Massachusetts, that is
utilized primarily for administrative, marketing, sales, service and technical support purposes. The premises are leased under a lease agreement that will expire in April 2005 with a total annual rent of approximately $331,000. A portion of these
premises are sublet for a current annual fee of approximately $54,000. ViryaNet, Inc. also leases approximately 3,600 square feet of office space in San Jose, California with a total annual rent of approximately $128,000 under a lease agreement that
will expire in September 2004.



iMedeon, Inc., the subsidiary
of ViryaNet, Inc. located in Alpharetta, Georgia, leases approximately 7,000 square feet of office space used primarily for sales, services and technical support purposes. The premises are leased under a lease agreement which will expire in May 2004
with a current total annual rent of approximately $375,549 (out of which approximately $135,539 will be accrued under a note and will be waived by the landlord subject to our full compliance with the terms of the lease agreement).



Our Europe subsidiary, located in the United Kingdom, leased approximately
2,700 square feet in Hemel Hempsted, under a lease agreement which expires in December 2003 with a total annual rent of approximately $71,000. With the restructuring of our operations in Europe, we terminated the lease and our financial obligations
for this space in January 2003.



Our subsidiary in Japan leases
approximately 2,100 square feet under a lease agreement which will expire on June 30, 2004, with a total annual rent of approximately $89,000.



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.



Overview



We are a leading
provider of integrated mobile and Web-based software applications for workforce management, and 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, 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 Web and at the least cost.



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We were founded in 1988. Through 1995, we generated revenue primarily from the sale of customized systems
for customer service and product support and related services, and invested relatively few resources in developing software products. In the first quarter of 1995, we began to deliver our standardized service delivery chain management software,
Service Suite. During 1997 and 1998, we intensified our research and development activities and, in the fourth quarter of 1999, we commercially released our Internet-based product for service communities, ViryaNet Service Hub. Concurrently with the
release, we began to build our direct sales force and expand our marketing activities.



On February 25, 2002, we acquired the outstanding shares of iMedeon, Inc., a provider of mobile workforce management solutions to the utilities and energy sectors. 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. 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 have issued at least one major version release of the ViryaNet Service Hub
annually since its inception in 1999. ViryaNets major product release in 2002 was ViryaNet Service Hub version 7.0. Version 7.0 combined the best features and technology components of iMedeons iM:Work with ViryaNet Service Hub. ViryaNet
Service Hub 7.0 was the first workforce management solution that addressed both simple service tasks as well as complex, non-linear maintenance and construction activities, which can span months and include hundreds of tasks that must be managed and
tracked within the context of an entire project. ViryaNet Service Hub 7.0 introduced significant functional enhancements including a wider range of mobile and wireless capabilities, enhanced scheduling, and dramatically improved workflow
technologies.



In conjunction with our entry into the utilities
and energy sectors of the mobile workforce management market, we established a reseller agreement with GE Network Solutions, a business unit of GE Power Systems, and an affiliate of GE Capital Equity Holdings, which is a shareholder of ViryaNet.
Under the terms of the agreement, GE Network Solutions will act as a value added reseller (VAR) of the ViryaNet solution set, and will market, sell, implement, and support the ViryaNet solutions in the utilities, oil & gas, and
telecommunications markets worldwide. The terms of the agreement included an initial purchase by GE Network Solutions of ViryaNet software licenses.



During the fourth quarter of 2002, we restructured our sales and support strategy in Europe and Middle East from a combined direct and indirect channel
strategy to exclusively indirect channels. This resulted in the termination of twelve ViryaNet personnel and contractors employed directly by our subsidiary in the United Kingdom. In Europe and Middle East we now rely solely on partners actively
invested 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.



Where We Derive Our Revenues



We derive revenues from licenses of our software products and from related services, which include implementation, consulting, customization and
integration, post-contract customer support and training. Our products are typically licensed to customers for a perpetual term. Before the first quarter of 2000, all of our license revenues were derived from licenses of Service Suite products. In
the first quarter of 2000, we also started to recognize revenues relating to licenses and implementation of ViryaNet Service Hub. We bill customers according to contract terms.



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How We Recognize Revenue



We recognize license and services revenues on contracts involving significant customization, integration and installation by us in accordance with
Statement of Position 81-1 Accounting for Performance of ConstructionType and Certain ProductionType Contracts (SOP 81-1), 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 and in accordance with the Input Method. We classify revenue from these arrangements as license and service revenues based on the estimated fair
value of each element. Provision for estimated contract losses are recognized in the period in which the loss becomes probable and can be reasonably estimated. License revenues on contracts that do not involve significant customization, integration
and installation by us are recognized, under Statement of Position (SOP) No. 97-2, as amended, when persuasive evidence of an arrangement exists, the fee is fixed and determinable, collection is probable and delivery has occurred. Where
software arrangements involve multiple elements, revenue is allocated to each element based on vendor-specific objective evidence of the relative fair values of each element in the arrangement. Our vendor-specific objective evidence used to allocate
the sales price to professional services and maintenance, is based on the price charged when these elements are sold separately. License revenues are recorded based on the residual method according to SOP 98-9, Modification of SOP 97-2, Software
Revenue Recognition, for certain transactions. Under the residual method, revenue is recognized for the delivered elements when (1) there is vendor-specific objective evidence of the fair values of all the undelivered elements, (2) vendor-specific
objective evidence 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.



Service revenues from
professional services and training are recognized as these services are performed. Service revenues from post-contract maintenance services are recognized pro-rata over the contractual support term, generally one year. Amounts collected from
customers in excess of revenues recognized are recorded as deferred revenue.



How We Sell Our Products



We sell our products
through our direct sales force, and expand our sales efforts through relationships with system integrators, resellers and vendors of complementary products. Our revenues are derived from customers in the United States, Europe, the Middle East and
the Far East. We price our products based on the market conditions in each jurisdiction where we operate.



A significant portion of our revenues has been derived from a small number of relatively large companies. For the years, 1999 and 2000 respectively, we
derived 55% and 9% of our revenues from two customers, Sun Microsystems and GE, who are shareholders or warrant holders. In 1999, 71% of our revenues were derived from four customers, including Sun Microsystems and GE, and no single customer
accounted for more than 33% of our revenues. In 2000, two customers each accounted for approximately 11% of our revenue and represented an aggregate of 23% of our total revenues. In 2001, three customers each accounted for approximately 7% or more
of our revenues, and represented an aggregate of 28% of our total revenues. In 2002, three customers each accounted for approximately 10% or more of our revenues, and represented an aggregate of 38% of our total revenues. We do not expect that these
customers 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 expect this portion
to decrease as a percentage of our total revenues.



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. Assets and liabilities have been
translated at period-end exchange rates. Results of operations have been translated at average exchange rates. As the exchange gains and losses arising from these translations are immaterial, they are recorded as financial expenses.



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Stock-Based Compensation



Through December 31, 2002, we have recorded unearned stock compensation related to stock option grants to our employees and directors totaling $1.9
million, all of which was amortized or cancelled. This amount represents the difference between the exercise price and the estimated fair value of our ordinary shares on the date these stock options were granted. This amount is included as a
component of shareholders equity and is being amortized by charges to operations over the vesting period of the options, consistent with the method described in Accounting Principles Board Opinion No. 25. We recorded amortization of unearned
stock compensation of $1,072,000, $(64,000) and $36,000 in 2000, 2001 and 2002, respectively. The amortization of stock compensation is classified as a separate component of operating expenses in our consolidated statement of operations.



Initial Public Offering and Private Placements



In February and March 2000, some of our shareholders loaned us an aggregate
of $5.0 million. These convertible loans were converted into the convertible debentures issued in April 2000 as described below. These shareholders were also issued warrants to purchase up to an aggregate of 12,500 ordinary shares at an exercise
price of $45.60 per share. The warrants, which may be exercised until the earlier of five years from the date of issuance, a merger of ViryaNet, or the sale of all or substantially all of our shares or assets, were valued at $505,000. In April 2000,
we issued convertible debentures to three additional investors in an aggregate amount of $11.0 million. All of the convertible debentures bore annual interest at the London interbank offered rate (Libor) plus 2%. On the date of our
initial public offering, all of the convertible debentures, including unpaid interest, were automatically converted into 334,389 ordinary shares reflecting a conversion price of $48.00 per share, a discount of 40% of the price per share of the
initial public offering. In September 2000, we recorded a one-time financing expense of approximately $16.6 million.



In September 2000, we completed our initial public offering. In this offering, we raised gross proceeds of $32 million, issuing 400,000 ordinary shares at
a price of $80 per share.



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 U.S. 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.



We recognize license
and services revenues on contracts involving significant customization, integration and installation by us in accordance with Statement of Position 81-1 Accounting for Performance of ConstructionType and Certain ProductionType
Contracts (SOP 81-1), 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 and in accordance with the
Input Method. We classify revenue from these arrangements as license and service revenues based on the estimated fair value of each element. Provision for estimated contract losses are recognized in the period in which the loss becomes
probable and can be



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reasonably estimated. License revenues on contracts that do not involve significant customization, integration and installation by us are recognized, under
Statement of Position (SOP) No. 97-2, as amended, when persuasive evidence of an arrangement exists, the fee is fixed and determinable, collection is probable and delivery has occurred. Where software arrangements involve multiple
elements, revenue is allocated to each element based on vendor-specific objective evidence of the relative fair values of each element in the arrangement. Our vendor-specific objective evidence used to allocate the sales price to professional
services and maintenance, is based on the price charged when these elements are sold separately. License revenues are recorded based on the residual method according to SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, for certain
transactions. Under the residual method, revenue is recognized for the delivered elements when (1) there is vendor-specific objective evidence of the fair values of all the undelivered elements, (2) vendor-specific objective evidence 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.



Service revenues from professional services and
training are recognized as these services are performed. Service revenues from post-contract maintenance services are recognized pro-rata over the contractual support term, generally one year. Amounts collected from customers in excess of revenues
recognized are recorded as deferred revenue.



Impairment of
long-lived assets.    We and our subsidiaries long-lived assets and certain identifiable intangibles 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 or group of assets may not be recoverable. Recoverability of an asset or group
of assets to be held and used is measured by a comparison of the carrying amount of an asset or group of assets to the future undiscounted cash flows expected to be generated by the assets. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. We have performed impairment tests on our long-lived assets and as of December 31, 2002, and no impairment losses
have been identified as of such time.



Goodwill.    Under Statement of Financial Accounting Standard No.142, Goodwill and Other Intangible Assets (SFAS No. 142) goodwill acquired in a business combination which 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 performed impairment tests and determined that our goodwill of $2.8 million is not subject to an impairment
charge as of year end 2002.



Allowance for Doubtful
Accounts.    We evaluate the collectability of our accounts receivable based on a combination of factors. 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 based on our historical experience.



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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, |  
|------------------------------------------------------------------------------------ |  | ----------------------- | -
|                                                                                     |  | 2000                    |  
|Revenues:                                                                            |  |                         |  
|Software license                                                                     |  | 62.8                    | %
|Maintenance and services                                                             |  | 37.2                    |  
|                                                                                     |  |                         |  
|Total revenues:                                                                      |  | 100.0                   |  
|Cost of revenues:                                                                    |  |                         |  
|Software licenses                                                                    |  | 3.5                     |  
|Maintenance and services                                                             |  | 28.9                    |  
|                                                                                     |  |                         |  
|Total costs of revenues                                                              |  | 32.4                    |  
|Gross profit                                                                         |  | 67.6                    |  
|                                                                                     |  |                         |  
|Operating expenses:                                                                  |  |                         |  
|Research and development, net                                                        |  | 26.7                    |  
|Sales and marketing                                                                  |  | 60.4                    |  
|General and administrative                                                           |  | 14.2                    |  
|Provision for doubtful accounts and write-offs of bad debt                           |  | 0.0                     |  
|                                                                                     |  |                         |  
|In-process research and development write-off                                        |  | 0.0                     |  
|Amortization of deferred stock Compensation                                          |  | 4.1                     |  
|Total operating expenses                                                             |  | 105.4                   |  
|Operating loss                                                                       |  | (37.8                   | )
|Financial income (expenses), net                                                     |  | 0.09                    |  
|Financial expenses related to beneficial conversion feature of convertible debenture |  | (61.1                   | )
|Net loss                                                                             |  | (98.8                   | )
|Net loss to shareholders of ordinary shares                                          |  | (98.8                   | )
|                                                                                     |  |                         |  



Geographic Distribution



While our products are sold in specified countries, the
implementation of these products may be performed for global customers on a worldwide basis. 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             |  | 2000                    |  
|United States              |  | 75                      |  
|Europe and the Middle East |  | 6                       |  
|Far East                   |  | 19                      |  
|                           |  |                         |  
|Total                      |  | 100                     | %



Comparison of Fiscal Years Ended
December 31, 2001 and 2002



Revenues



Total revenues declined by 57% from $20.0 million in
2001 to $8.7 million in 2002.



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Software Licenses



Software license revenues are derived from the licensing of our software as well as third-party software. Third-party
software consists of software that is either embedded in our software or enhances the functionality of our software. We resell third-party software to our customers at margins that are lower than margins that we earn on our software. Software
license revenues decreased 72% from $12.5 million in 2001 to $3.5 million in 2002. This decrease was primarily attributable to the fact that many of our customers and prospects experienced issues related to the general economic downturn within the
United States and global markets, which intensified after the September 11th, 2001 terror attacks and continued through 2002.



Maintenance and Services



Maintenance and services revenues consist of consulting, implementation, customization and integration, post-contract customer maintenance, and training.
Our maintenance and services revenues declined by 31% from $7.5 million in 2001 to $5.2 million in 2002. This decline was primarily due to the lower number of sales of software licenses resulting from the economic downturn.



Cost of Revenues



Total cost of revenues decreased by 47% from $8.9 million in 2001 to $4.7
million in 2002.



Software Licenses



Cost of software license revenues consists primarily of payments to third
parties for our reselling of their software. The cost of software licenses decreased by 85% from $2.4 million in 2001 to $0.4 million in 2002. Cost of software licenses as a percentage of revenues from software licenses declined from 19% in 2001 to
10% in 2002. The decrease was primarily due to a decrease in third-party software license content as a result of adding internally developed capability in the areas of mobility and scheduling.



Maintenance and Services



Cost of maintenance and services revenues consists primarily of salaries and
facility costs. Maintenance and service costs decreased 32% from $6.5 million in 2001 to $4.4 million in 2002. This decrease resulted primarily from a reduction in headcount and related administrative costs. Maintenance and services costs as a
percentage of maintenance and services revenues declined from 86% in 2001 to 84% in 2002. The decrease in maintenance and services costs as a percentage of maintenance and services revenues resulted primarily from the improved utilization of
services personnel and lower administrative costs.



Operating Expenses



Research and
Development



Research and development includes costs
relating to the development of our products. These costs consist primarily of employee salaries and benefits, facilities costs, and the cost of consulting resources that supplement our internal development team. 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. Research and
development expenses decreased 49% from $6.6 million in 2001 to $3.4 million in 2002. This decrease was attributable to the reduction of research and development personnel and lower administrative costs. We expect that we will continue to devote
substantial resources to research and development. The research and development expenses in 2002 are net of $461,000 of governmental funds that were received.



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Sales and Marketing



Sales and marketing expenses consist of salaries, commissions, office expenses, travel and entertainment, advertising,
promotional expenses, and facility costs. Sales and marketing expenses decreased 53% from $14.2 million in 2001 to $6.6 million in 2002. The 53% decrease of $7.6 million was attributable to a decline in personnel costs of $4.6 million and a
reduction in marketing programs of $3.0 million.



General
and Administrative



General and administrative expenses
consist of salaries for administrative, executive and finance personnel, information system costs, fees for professional services and allocated facilities costs. These costs decreased 41% from $3.9 million in 2001 to $2.3 million in 2002.



Provision for Doubtful Accounts



In 2001 and 2002, provision for doubtful accounts expenses were $1.3 million
and $2.3 million, respectively. The expense in 2002 for $2.3 million includes a provision for approximately $1.7 million related to customers based in Europe that were affected by an economic downturn and the Company believes are not collectible,
and $0.6 million for a balance due from an insurance company that the Company has determined to be uncollectible.



Write-off In-Process Research and Development



In connection with the acquisition, the Company recorded a one time expense of $480,000 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.



Amortization of Stock-Based Compensation



Amortization of stock-based compensation includes the amortization of unearned employee stock-based compensation and expenses for stock granted to
consultants in exchange for services. Stock-based compensation expense is amortized over the vesting schedule of the option, typically four years, using the straight line approach. With the grant of some stock options, we recorded aggregate unearned
stock-based compensation expense of $2.2 million through December 31, 2002. Stock-based compensation included in operating expenses provided $64,000 of income in 2001, and $36,000 of expenses in 2002.



Financial Income and Financial Expenses



Net financial expenses were $189,000 in 2002 compared to net financial
income of $190,000 in 2001. In 2001 and 2002, financial expenses were $328,000 and $346,000 respectively, and financial income decreased from $518,000 to $157,000 due to a reduction in cash and cash equivalents during the year. The interest expense
resulted from the use of factoring and bank lines of credit and the interest income resulted from interest earned on our cash and cash equivalents balances.



Comparison of Fiscal Years Ended December 31, 2000 and 2001



Revenues



Total revenues decreased 26% from $27.1 million in 2000 to $20.0 million in 2001.



Software Licenses



Software license revenues are derived from the licensing of our software as well as third-party software. Third-party software consists of software that
is either embedded in our software or enhances the functionality of our software. We resell third-party software to our customers at margins that are lower than margins that we earn on our software. Software license revenues decreased 27% from $17.0
million in 2000 to $12.5 million in 2001. This decrease was primarily attributable to the fact that many of our customers and prospects experienced issues related to the general economic downturn within the United States and global markets, which
intensified after the September 11th, 2001 terror attacks.



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Maintenance and Services



Maintenance and services revenues consist of consulting, implementation, customization and integration, post-contract
customer maintenance, and training. Our maintenance and services revenues declined by 26% from $10.0 million in 2000 to $7.5 million in 2001. This decline was primarily due to the lower sales of software licenses resulting from the economic
downturn.



Cost of Revenues



Total cost of revenues increased slightly by 1% from $8.8 million in 2000 to
$8.9 million in 2001.



Software Licenses



Cost of software license revenues consists primarily
of payments to third parties for our reselling of their software. The cost of software licenses increased 158% from $0.9 million in 2000 to $2.4 million in 2001. Cost of software licenses as a percentage of revenues from software licenses increased
from 6% in 2000 to 19% in 2001. This increase was primarily due to an increase in third-party software license content.



Maintenance and Services



Cost of maintenance and services revenues consists primarily of salaries and facility costs. Maintenance and service costs decreased 18% from $7.9 million
in 2000 to $6.5 million in 2001. This decrease resulted primarily from a reduction in headcount and related administrative costs. Maintenance and services costs as a percentage of maintenance and services revenues increased from 78% in 2000 to 86%
in 2001. The increase in maintenance and services costs as a percentage of maintenance and services revenues resulted primarily from the reduction in the volume of maintenance and services revenues.



Operating Expenses



Research and Development



Research and development includes costs relating to the development of our
products. These costs consist primarily of employee salaries and benefits, facilities costs, and the cost of consulting resources that supplement our internal development team. 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. Research and development expenses decreased 9% from $7.2
million in 2000 to $6.6 million in 2001. This decrease was attributable to the reduction of research and development personnel throughout the year.



Sales and Marketing



Sales and marketing expenses consist of salaries, commissions, office expenses, travel and entertainment, advertising, promotional expenses, and facility
costs. Sales and marketing expenses decreased 14% from $16.4 million in 2000 to $14.2 million in 2001. This decrease of $2.2 million was attributable to a decline in personnel costs of $0.4 million and a reduction in marketing programs of $1.8
million.



General and Administrative



General and administrative expenses consist of salaries for administrative,
executive and finance personnel, information system costs, fees for professional services, and allocated facilities costs. These costs in 2001 were $3.9 million, which are approximately the same as the costs incurred in 2000.



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Provision for Doubtful Accounts



In 2000 and 2001, provision for doubtful accounts expenses were $9,000 and $1,265,000, respectively.



Amortization of Stock-Based Compensation



Amortization of stock-based compensation includes the amortization of
unearned employee stock-based compensation and expenses for stock granted to consultants in exchange for services. Stock-based compensation expense is amortized over the vesting schedule of the option, typically four years, using the straight line
approach. With the grant of some stock options, we recorded aggregate unearned stock-based compensation expense of $2.2 million through December 31, 2001. Stock-based compensation included in operating expenses totaled $1.1 million of expense in
2000 and $64,000 of income in 2001.



Financial Income and
Financial Expenses



Net financial income was $190,000 in
2001 compared to net financial income of $26,000 in 2000. In 2000 and 2001, financial expenses were $589,000 and $328,000 respectively and financial income was $615,000 and $518,000, respectively. The interest expense resulted from the use of bank
lines of credit and the interest income resulted from interest earned on our cash and cash equivalents balances.



Liquidity and Capital Resources



How We Have Financed Our Business



We
have financed our operations primarily through placements of our ordinary and preferred shares and convertible debentures. Through December 31, 2002, gross proceeds from private placements of ordinary and preferred shares and convertible debentures
totaled $56.3 million. In September 2000, we completed our initial public offering in which we raised gross proceeds of $32 million. At the initial public offering, all the preferred shares and convertible debentures were converted into ordinary
shares. To a lesser extent, we have financed our operations through short-term bank facilities and other financing arrangements (see Line of Credit with Bank Hapoalim and Loan Arrangement with Bank Hapoalim, below). In March 1999 and January 2000,
we issued warrants to purchase an aggregate of 28,696 ordinary shares to a subsidiary of Bank Hapoalim, at exercise prices ranging from $46.00 to $57.50 per share. The warrants contained a cashless exercise feature and were exercised by the bank at
the time of the initial public offering. In February 2002 we issued additional warrants to purchase an aggregate of 60,000 ordinary shares to a subsidiary of Bank Hapoalim, at an exercise price of $5.00 per share. On July 2, 2003, we repriced the
warrants to purchase 60,000 Ordinary Shares issued in February 2002 to an exercise price of $1.00 per Ordinary Share and issued an additional warrant to purchase 40,000 Ordinary Shares of the Company to a subsidiary of Bank Hapoalim, at an exercise
price of $1.00 per share. During the first four months of 2000, we raised an aggregate of $16.0 million by way of convertible debentures, bearing interest at the rate of Libor plus 2%, payable on a quarterly basis starting in April 2001. On the date
of our initial public offering, all of the convertible debentures, including unpaid interest, were automatically converted into 334,389 ordinary shares reflecting a conversion price of $48.00 per share, a discount of 40% of the price per share of
the initial public offering.



Cash



As of May 1, 2003, we had cash and cash equivalents of $1.4 million. During
July 2003, we converted $2.4 million of the $3.45 million short-term loan with Bank Hapoalim to long-term debt payable quarterly over a two year period beginning on January 1, 2004, with interest payable quarterly at a rate to be determined
beginning on October 21, 2003. See the paragraph headed We will most likely require additional financing and may not be able to raise additional financing on favorable terms or not at all in the Risk Factors set forth in Item 3 above.



Net cash used in operating activities was $15.8 million in
2000, $17.0 million in 2001, and $5.7 million in 2002.



Net
cash used in investing activities was $2.2 million in 2000 and $1.0 million in 2001. Net cash from investing activities was $1.8 million in 2002. Investing activities in 2000 and 2001 consisted primarily of purchases of computers and software and in
2002 of cash provided from the iMedeon acquisition.



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Net cash provided by financing activities was $38.2 million in 2000 and $4.9 million in 2001. Net cash
used in financing activities was $1.6 million in 2002. In 2000, the net cash provided by financing activities consisted primarily of the net proceeds from the issuance of preferred and ordinary shares as well as long term convertible debentures. In
2001, the net cash provided by financing activities consisted of a net increase in short-term bank line of credit. In 2002, net cash used in financing activities resulted from a net decrease in short-term bank line of credit.



Line of Credit with Bank Hapoalim



In April 2001, Bank Hapoalim agreed to extend the line of credit that
allowed us to borrow up to $6.0 million until March 31, 2002. In February 2002, Bank Hapoalim agreed to extend the line of credit until January 31, 2003 and added two covenants that the Company was required to maintain: (a) that the Companys
shareholders equity will not be less than 30% of the total balance sheet and (b) that the Companys annual earnings before interest and taxes will be positive and the quarterly losses before interest and taxes will not exceed $1,000,000.
These covenants were measured according to the generally accepted accounting principals in Israel. In connection with the extensions of the credit line, in April 2001 and February 2002 we issued to a subsidiary of Bank Hapoalim warrants to purchase
an aggregate of 60,000 Ordinary Shares, at an exercise price of $5.00 per share. The fair value of such warrants is approximately $87,000 which was accounted for as a cost of the line of credit and was expensed as financial expenses



Borrowings under the line of credit with Bank Hapoalim before January 2003
were in United States dollars and bear interest annually at the rate of Libor plus 3.0%. All borrowings under the line of credit with Bank Hapoalim were secured by a floating charge on our assets.



The line of credit was terminated as of January 21, 2003, and was replaced by
the loan arrangement described below.



Loan Arrangement
with Bank Hapoalim



On January 21, 2003, the line of
credit with Bank Hapoalim referred to above, was terminated and the $3.45 million outstanding under such credit line as of such date was converted to a loan which is subject to re-payment in full by July 21, 2003. The loan bears interest at an
annual rate of 4.375% and is secured by a floating charge on our assets. During July 2003, Bank Hapoalim agreed to restructure a portion of the loan by converting $2.4 million of the $3.45 million short-term loan into a long-term loan and deferring
payment of $0.5 million under the short-term loan until August 15, 2003. The $2.4 million long-term loan is payable quarterly over a two year period beginning on January 1, 2004, with interest payable quarterly at a rate to be determined beginning
on October 21, 2003. The debt restructure is subject to several conditions, including the following conditions: (i) the Company shall be cash flow positive on a quarterly basis, (ii) the Company shall deposit $800,000 into its account with Bank
Hapoalim, (iii) the Company shall raise no less than $1 million of new capital by January 1, 2004, and, (iv) the Company will grant Bank Hapoalim a warrant to purchase 40,000 Ordinary Shares of the Company at an exercise price of $1.00 per Ordinary
Share and will reprice a prior warrant to purchase 60,000 Ordinary Shares of the Company to an exercise price of $1.00.



Sale of Receivables



We have previously engaged in the sale of trade receivables to Bank Hapoalim. As part of such transactions we have provided the bank with an unlimited
guarantee securing the obligations of applicable customers under the trade receivables sold by us. A total of $1.7 million of receivables was sold to Bank Hapoalim during the year ended December 31, 2002. There was no sale of receivables during the
year ended December 31, 2001.



Operating Leases



Payments under non-cancelable operating lease
agreements for facilities expire on various dates through 2006. As of the date hereof, our annual aggregate lease obligations range from approximately $779,000 in 2003 to approximately $97,000 in 2005.



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Future Cash Needs



We expect that operating expenses and capital expenditures will continue to be a material use of our cash resources. We may
utilize cash resources to fund acquisitions or investments in other businesses, technologies, or product lines or repay the credit line. Although we have taken substantial restructuring and headcount reduction actions to date and increased our
emphasis on reseller channels as evidenced by agreements with GE, Hitachi and Aspective, our working capital may not be sufficient and we will most likely require additional funding for our day to day operations (see the paragraph headed We
will most likely require additional financing and may not be able to raise additional financing on favorable terms or not at all in the Risk Factors set forth in Item 3 above).



In addition, our working capital may not be sufficient to meet our obligations with Bank Hapoalim (see the paragraph headed
We will need sufficient funds to re-pay the loan from Bank Hapoalim in the Risk Factors set forth in Item 3 above).



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 Office of the Chief Scientist of the Ministry of Industry and Trade of the Government of Israel. Under these grants, royalties are payable to the Israeli government, generally at the rate of 3% during the first three
years, 4% over the following three years, and 5% in the seventh year and future years, on the revenues derived from products developed by us according to those programs. The maximum aggregate royalties will not exceed 100%, of the dollar-linked
value of the total grant received and 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. During 1996, we paid all royalties due to the Office of the Chief Scientist
amounting to a total of $676,000. Therefore, we are under no further obligation to pay royalties to the Office of the Chief Scientist on the sale of products funded by the Office of the Chief Scientist prior to the royalty re-payment. The Government
of Israel does not own proprietary rights in the technology developed using its funding and there is no restriction on the export of the products manufactured using the technology. Some restrictions on the technology do apply, however, including the
obligation to manufacture the product based on the technology in Israel and to obtain the Office of the Chief Scientists consent for the transfer of the technology to a third party. These restrictions continue to apply to us although we have
paid the full amount of royalties payable under these grants. If the Office of the Chief Scientist consents to the manufacture of the products outside Israel, the regulations allow the office of the chief scientist to require the payment of
increased royalties, ranging from 120% to 300% of the amount of the office of the chief scientist grant, depending on the percentage of foreign manufacture. If the Office of the Chief Scientist consents to the manufacture of our products outside
Israel, we cannot assure you that we will not be required to pay the Office of the Chief Scientist additional royalties.



In 2001 and 2002, we received initial approval for a grant from the Office of the Chief Scientist in the amount of up to approximately $373,000, out of
which $297,000 has been received through May 1, 2003. We have not yet determined whether we can satisfy the terms and conditions of the proposed grants. It is possible that we will receive only a portion of the proposed grants. The Company has not
paid or accrued royalties relating to the repayment of such grants for the years ended December 31, 2002, and it has an outstanding contingent liability to pay royalties in the amount of approximately $297,000.



In 1998 and 2002, we received grants from the United States-Israel Binational
Industrial Research and Development Foundation 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. The cumulative
amount of grants received was $514,000 as of May 1, 2003. We believe that the Supported Project has failed and that consequently we will not be required to pay the United States-Israel Binational Industrial Research and Development Foundation any
royalties from the sale of any of our products.



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Effects of Currency Fluctuations



Revenues generated and costs incurred outside of the United States are
generally denominated in non-dollar currencies. For the years 2000, 2001 and 2002 respectively, 25%, 24% and 16% of our revenues 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 2000, we had a net loss of
$48,000 due to currency fluctuations and in 2001 and 2002, we had net income of $118,000 and $66,000, 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 or 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, 2000, 2001 and 2002, while the rate of inflation was low, there was a devaluation of the dollar against the NIS. 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 tax
rate will reflect a mix of the United States, Japan, and the United Kingdom statutory tax rates on our United States, Japan, and United Kingdom income and the Israeli tax rate discussed below. Israeli companies are generally subject to income tax at
the rate of 36%. The majority of our income, however, is derived from our three investment programs with approved enterprise status under the Law for the Encouragement of Capital Investments and is eligible for some tax benefits.



Under our first investment program, we will enjoy a reduced tax rate of 10%
to 25% during a period of seven years in which this investment program produces taxable income depending on foreign investment. Under our other two 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, 2002, we had net operating loss carryforwards for tax
reporting purposes of approximately $42.2 million in the United States, $17.5 million in Israel, $14.3 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, 2002, we have not used these net operating losses.



Adaptation to New Euro Currency



In January 1999, a new currency called the euro was introduced in the
following members of the European Monetary Union: Austria, Belgium, Finland, France, Germany, Greece, Italy, Luxembourg, the Netherlands,



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Portugal, the Republic of Ireland and Spain. On January 1st, 2002, these countries adopted the euro as a valid currency. By the end of February, 2002, these
countries completed the replacement of legacy currencies with the euro. Computer systems and software products will need to be designed or modified to accept the euro currency and, during the transitional phase, may need to accept both the euro and
local currencies. Conversion to the euro requires restructuring of databases and internal accounting systems and the conversion of historical data. We believe that all products offered by us are adapted to the euro. Since the introduction of the
euro we have not experienced any difficulties or complaints from the adaptation of our products to the euro. However, we did not contact our customers or suppliers to determine their preparedness for the adoption of the euro.



We have not incurred any material expenses from the adaptation of our
products to the euro and we do not expect to incur any expenses from future adaptation to the euro. However, we cannot assure you that our products or software provided to our customers by other vendors, or developed internally by our customers,
will ensure an errorless transition to the euro. Even if our products and services satisfy these requirements, the products and services provided to our customers by other software vendors or developed internally by our customers may not be euro
compliant and may disrupt our customers ability to use our products.



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 2000, 2001 and 2002 were $7.2 million, $6.6 million and $3.4 million, respectively (see the paragraph
headed We may be unable to expand our sales, marketing, research & 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



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.



Item 6.Directors, Senior Management and Employees



Directors and Senior Management



|Name                 |  | Age |  | Position                                                                   
|-------------------- |  | --- |  | ---------------------------------------------------------------------------
|Samuel I. HaCohen    |  | 45  |  | Executive Chairman of the Board of Directors                               
|Winfried A. Burke    |  | 55  |  | President, Chief Executive Officer and Director                            
|Albert A. Gabrielli  |  | 44  |  | Executive Vice President, Professional Services and Chief Financial Officer
|Masayo Hobo          |  | 42  |  | General Manager, Japan                                                     
|Vladimir Morgenstern |  | 45  |  | Director                                                                   
|Hillel Milo          |  | 51  |  | Director                                                                   
|Peter Gyenes         |  | 57  |  | Director                                                                   
|Yeoshua Agassi       |  | 54  |  | Director                                                                   



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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.



Winfried A. Burke joined ViryaNet in October 1999 as ViryaNets senior vice president of worldwide marketing. From October 2000 until February 2001, Mr. Burke served as ViryaNets president and chief
operating officer. Since February 2001, Mr. Burke has served as president and chief executive officer. Prior to joining ViryaNet, Mr. Burke was vice president of sales and marketing for ViewSoft and was instrumental in its acquisition by Citrix. He
also served as general manager of North American operations and vice president of business development and channel sales at Gentia Software; as a merger and acquisition consultant for several years; and as vice president of sales and marketing for
Oberon Software. Mr. Burke previously held various management positions in product management, marketing and sales at Prime Computer, Apollo and Wang. He began his career as a software engineer at the MIT Instrumentation Laboratory/Draper
Laboratory, where he worked on the Apollo and Space Shuttle projects, followed by software engineering assignments at the MIT Lincoln Laboratory and Data General. Mr. Burke was trained in computer science at the Massachusetts Institute of
Technology, and is a part-time PSIA certified ski instructor.



Albert A. Gabrielli has served as our chief financial officer since April 2001 and assumed responsibility for worldwide professional services in November 2002. 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 networks 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.



Masayo Hobo served as a general manager of ViryaNet Japan since she
joined ViryaNet in November 1998. Prior to joining ViryaNet, Ms. Hobo held several senior level positions at SAP Japan and SAP AG, including manager of the Advanced Solution Center and senior consultant. Before her employment with SAP, Ms. Hobo held
several positions at IBM Japan and IBM USA, including systems engineer and consultant. Ms. Hobo earned a Bachelor of Law degree from Kansai University in Japan and a Master of Science degree in Industrial Administration from Carnegie Mellon
University in Pittsburgh, PA.



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 the Chief Technology Officer for Fitracks, Inc., a company based in Israel specializing in high-tech
solutions for footwear and footcare industries. Mr. Morgenstern also 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.



39



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##### Table of Contents

Hillel Milo has served as one of our directors since June 2000. Mr. Milo is currently a partner
and investment manager with Alice Ventures. Prior to Alice Ventures, Mr. Milo co-founded and managed Walden Israel Venture Capital Fund, Clal Venture Capital and Infinity Venture Capital Fund. Mr. Milo has also served on the board of directors of
Breezecom, a manufacturer of wireless access products, and Radvision, a developer of internet and network based communications products. Mr. Milo has a Bachelor of Science degree in mechanical engineering and a Master of Arts degree in management
science from the University of Alabama.



Peter Gyenes
has served as one of our directors since September 2002. Mr. Gyenes currently serves as the chairman and chief executive officer of Ascential Software Corporation (NASDAQ: ASCL), a leading provider of enterprise data integration solutions to the
Global 2000. 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, Concerto Software (NASDAQ: CRTO) 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.



Yeoshua Agassi has served as a director of ViryaNet since July 2001. Since 2001, Mr. Agassi has served concurrently as Chief Executive Officer and President of Scitex Corporation and as vice president of Clal
Industries and Investments Ltd. (CII), one of Israels largest investment and holding companies. CII, located in Tel Aviv, Israel, is invested primarily in the industrial and technology sectors and holds a major equity position in
ViryaNet. During 2000, Mr. Agassi served as the general manager of Leumicard Ltd., one of Israels leading credit card providers and servicers located in Bene Brak, Israel. From 1993 until 1998, Mr. Agassi served as the general manager of
Israeli Direct Insurance Company (IDI), a direct insurer located in Tel Aviv, which he co-founded in 1993. Before founding IDI, Mr. Agassi was employed from 1987 until 1992 at The Magen Insurance Company, a direct insurer located in Tel
Aviv, most recently as the vice president of Operations. Mr. Agassi has earned a Bachelor of Arts degree in Economics from Tel Aviv University and has an MBA in Marketing from Bar Ilan University.



Compensation



We have entered
into employment agreements with Messrs. HaCohen, Burke, Gabrielli, and with Ms. Hobo. These employment agreements contain various provisions, including provisions relating to assignment of intellectual property rights to us, non-competition and
confidentiality. Under the agreements with Messrs. HaCohen, Burke and Gabrielli, they are entitled to 6 months of severance, including benefits, in the event we terminate their respective employment without cause, under the circumstances provided in
each of their employment agreements. Under the agreements with Ms. Hobo, she is entitled to 3 months of severance, including benefits, in the event we terminate her employment without cause. We have also entered into executive incentive bonus or
commission plans with all of these executives.



The aggregate
remuneration we paid for the year ended December 31, 2002 to our directors and executive officers as a group was $1,819,722 in salaries, fees, commissions and bonuses. Included in this amount is remuneration to four of our former executive officers.
This amount includes $22,548 set aside or accrued to provide for pension, retirement or similar benefits provided to our directors and executive officers.



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Our directors who are not executive officers do not receive cash compensation for their service on the
board of directors or any board committee. All directors are reimbursed for their expenses for each board meeting attended, and with respect to our external directors, such reimbursement is made in accordance with the applicable provisions of
Companies Law. For additional information, please see the discussion under the heading External Directors. During fiscal 2002, options to purchase 313,750 ordinary shares were granted to our directors and executive officers. Included in
this amount are options to purchase 106,200 ordinary shares granted to five of our former directors and executive officers, of which 80,533 were canceled after the termination of their employment with us. The weighted average exercise price of these
outstanding options was $1.88 per share, with vesting over two to three years. All options were issued pursuant to the 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                                                     |  | Commencementof Office |  | Termination/RenewalDate of Office
|--------------------------- |  | -------------------------------------------------------------------------- |  | --------------------- |  | ---------------------------------
|Samuel I. HaCohen           |  | ExecutiveChairman of the Board of Directors                                |  | March 1998            |  | 2003 Annual Meeting              
|Winfried A. Burke           |  | President                                                                  |  | October 2000          |  | Not applicable                   
|                            |  | Chief Executive Officer                                                    |  | February 2001         |  | Not applicable                   
|                            |  | Director                                                                   |  | June 2001             |  | 2003 Annual Meeting              
|Vladimir Morgenstern(3)     |  | Director                                                                   |  | July 1999             |  | 2003 Annual Meeting              
|Albert A. Gabrielli         |  | Executive Vice President, Professional Services andChief Financial Officer |  | April 2001            |  | Not applicable                   
|Masayo Hobo                 |  | General Manager, Japan                                                     |  | November 1998         |  | Not Applicable                   
|Hillel Milo(1),(2),(3),(4)  |  | Director                                                                   |  | June 2000             |  | 2004 Annual Meeting              
|Peter Gyenes(1),(2),(3),(4) |  | Director                                                                   |  | September 2002        |  | 2005 Annual Meeting              
|Yeoshua Agassi(2),(4)       |  | Director                                                                   |  | July 2001             |  | 2003 Annual Meeting              

---

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

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

|(3) |  | Member of Compensation Committee
|--- |  | --------------------------------

|(4) |  | Independent Directors
|--- |  | ---------------------



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, which became effective on February 1, 2000 and supersedes most of the provisions of the Israeli Companies Ordinance, New Version, 5743-1983. Under the



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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
two external directors. Messrs. Milo and Gyenes 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.
| | - |  | ----------------------------



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
| | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (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 both external directors.



Independent Directors



The ordinary shares offered in our initial public offering are listed for quotation on the Nasdaq SmallCap Market and the
Tel-Aviv Stock Exchange 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. Milo, Gyenes and Agassi serve as independent directors and meet the independence
standard of the Nasdaq rules.



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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. Milo, Gyenes and Agassi 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.



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 May 1, 2003, we
had 28 employees in Israel, 39 in the United States, and 8 in Japan. Of our 75 employees, 17 were engaged in research and development, 15 in sales, marketing and business development, 32



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in professional services and technical support and 11 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 May 1,
2003, the aggregate number of our ordinary shares beneficially owned by our directors and executive officers was 729,471 including options and warrants to purchase up to 221,608 ordinary shares which are exercisable or will become exercisable within
60 days of May 1, 2003. This number includes ordinary shares held by the Clal Group since an affiliate of the Clal Group serves on our board of directors and, accordingly, such designee may be deemed to be the beneficial owner of the ordinary shares
held by the Clal Group. Such designee disclaims beneficial ownership of such shares. See Major Shareholders and Related Party Transactions in Item 7 below.



As of May 1, 2003, options to purchase up to 250,350 ordinary shares granted to our directors and executive officers were
outstanding under our option plans. The weighted average exercise price of these options was $2.64 per share. From these options, options to purchase 210,770 ordinary shares granted to our directors and executive officers are exercisable or will
become exercisable within 60 days of May 1, 2003.



As of May 1,
2003, there were approximately 652 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.



The 1996 Stock Option and Incentive Plan



In 1996, we adopted the 1996 Stock Option and Incentive Plan and reserved 140,000 ordinary shares for issuance to employees.
As of May 1, 2003, options to purchase 53,660 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 55,609 ordinary shares that were
available for grants of additional options were transferred



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to the 1999 Stock Option and Incentive Plan. The exercise price 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. As of May 1, 2003, 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 to employees. As of May 1, 2003, 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 price 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 to employees and transferred an additional 229,444 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. As of May 1, 2003, options to purchase 452,136 ordinary shares were outstanding under the 1999 Stock Option and Incentive Plan, options
to purchase 375 ordinary shares were exercised into ordinary shares and 386,933 additional ordinary shares were available for grants of additional options. The exercise price of the options granted under the 1999 Stock Option and Incentive Plan
range from $1.64 to $120.00.



In June 2001, the Companys
shareholders approved the reservation of options to purchase an additional 300,000 ordinary shares to employees, for an aggregate of 600,000 ordinary shares to be granted under the 1999 Stock Option and Incentive Plan.



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
committee. The vesting schedule of the options is also determined by the committee but generally the options vest over a four year period. Each option granted under the option plans is exercisable 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 September 2001, ViryaNet adopted a voluntary stock option
exchange program, under which our employees had the opportunity to cancel outstanding stock options. Pursuant to the terms of this stock option exchange program, we agreed to grant new options to each eligible employee who participated in the offer
on the date of the first meeting of our board of directors held at least six months and one day following the date on



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which we accepted the options for exchange. The number of ordinary shares subject to these new options equals the number of ordinary shares subject to the
options tendered by such employee and canceled in the stock option exchange program, multiplied by a factor of 1.1 (one and one-tenth). Based on the employees that elected to participate in this stock option exchange program, 107,210 options were
canceled.



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.



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 May 1, 2003 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 May 1, 2003. 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 2,681,733
ordinary shares outstanding as of May 1, 2003.



Ordinary
Shares Beneficially Owned



|Name and Address                                                                                        |  | Number  |  | Percent of Class |  
|------------------------------------------------------------------------------------------------------- |  | ------- |  | ---------------- | -
|The Clal Group(1) Kiriat Atidim Ramat Hachayal P.O. Box 61581, Tel Aviv 58177, Israel                   |  | 438,774 |  | 16.3             | %
|                                                                                                        |  |        
|GE Capital Equity Holdings, Inc.(2) 120 Long Ridge Road Stamford, CT 06927, United States               |  | 279,760 |  | 10.2             | %
|                                                                                                        |  |        
|Advanced Technology Ventures IV L.P.(3) 485 Ramona Street, Suite 200 Palo Alto, CA 94301, United
States |  | 201,550 |  | 7.5              | %
|                                                                                                        |  |        
|SVM Star Ventures Management GmbH No. 3(4) Possartsrassa 9 D-81679 Munich, Germany                      |  | 179,441 |  | 6.7              | %
|                                                                                                        |  |        
|All directors and executive officers as a group (8 persons)(5)                                          |  | 729,471 |  | 25.1             | %



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---

|(1) |  | Includes:
|--- |  | ---------

| |  |  | 75,382 ordinary shares and warrants to purchase 1,584 ordinary shares exercisable within 60 days of May 1, 2003, held by Clal Venture capital;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 78,500 ordinary shares and warrants to purchase 1,584 ordinary shares exercisable within 60 days of May 1, 2002, held by Clalit;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------

| |  |  | 130,801 ordinary shares and warrants to purchase 3,660 ordinary shares exercisable within 60 days of May 1, 2002, held by Industries and Investments; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 139,851 ordinary shares and warrants to purchase 3,660 ordinary shares exercisable within 60 days of May 1, 2002, held by Clal Electronics;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | Options to purchase 3,750 ordinary shares exercisable within 60 days of May 1, 2003 held by Yeoshua Agassi, vice president of Clal Industries and Investments.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | Includes warrants to purchase 75,990 ordinary shares exercisable within 60 days of May 1, 2003, held by GE Capital Equity Holdings, Inc. (GE Holdings) and warrants to
purchase 5,000 ordinary shares exercisable within 60 days of May 1, 2003, held by General Electric Medical Systems, a division of General Electric Corporation.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) |  | Includes warrants to purchase 4,798 ordinary shares exercisable within 60 days of May 1, 2003 held by Advanced Technology Ventures IV L.P.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------

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

| |  |  | 41,357 ordinary shares held by STAR Management of Investments (1993) Limited Partnership;
| | - |  | -----------------------------------------------------------------------------------------

| |  |  | 33,315 ordinary shares held by SVE STAR Ventures Enterprises No. III, a German civil law partnership (with limitation of liability);
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 2,786 ordinary shares held by SVE STAR Ventures Enterprises No. IIIA, a German civil law partnership (with limitation of liability);
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 14,659 ordinary shares held by SVM STAR Ventures Managementgesellschaft GmbH Nr. 3 & Co. Beteiligungs KG;
| | - |  | ---------------------------------------------------------------------------------------------------------

| |  |  | 65,077 ordinary shares held by SVE STAR Ventures Enterprises No. V, a German civil law partnership (with limitation of liability); and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------

| |  |  | 22,247 ordinary shares held by SVM STAR Ventures Management GmbH No. 3. SVM STAR Ventures Management GmbH No. 3 has the sole power to vote or direct the vote of the ordinary shares
held by the STAR entities And is therefore considered the beneficial owner of the shares beneficially held by SVE STAR Ventures Enterprises No. III, SVE STAR Ventures Enterprises No. IIIA, SVM STAR Ventures Management gesellschaft GmbH No. 3 &
Co. Beteiligungs KG, and SVE STAR Ventures Enterprises No. V. SVM STAR Venture Capital Management Ltd. has the Sole power to vote or direct the vote of the ordinary shares held by STAR Management of Investments (1993) Limited Partnership and is
therefore considered the beneficial owner of the shares beneficially held by STAR Management of Investments (1993) Limited Partnership.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) |  | Also includes options granted to such directors and executive officers of the Company, which are exercisable within 60 days of May 1, 2003. This number includes ordinary shares held
by the Clal Group since an affiliate of the Clal Group serves on our board of directors and, accordingly, such designee may be deemed to be the beneficial owner of the ordinary shares held by the Clal Group. Such designee disclaims beneficial
ownership of such shares.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Our major 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 Inc. 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.



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VAR Agreement with GE



On January 17, 2003, we established a reseller agreement with GE Network Solutions, a business unit of GE Power Systems, and
an affiliate of GE Capital Equity Holdings, which is a shareholder of ViryaNet. Under the terms of the agreement, GE Network Solutions will act as a value added reseller (VAR) of the ViryaNet solution set, and will market, sell, implement, and
support the ViryaNet solutions in the utilities, oil & gas, and telecommunications markets worldwide. The terms of the agreement included an initial purchase by GE Network Solutions of ViryaNet software licenses.



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 May 1, 2003, the outstanding loan amount was $136,000.
Following the filing of the previous 20F of the Company for the year ended on December 31, 2001, we became aware that in accordance with the signed loan agreement with Mr. HaCohen, repayment of the loan was not due on June 30, 2002 (as set forth in
the previous filings of the Company) but 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.



Although in the previous 20F of the Company for the year ended on December 31, 2001 we stated that we intend to request
shareholders approval for the modification of the repayment terms of the loan, in light of the above no changes to the terms of the loan were or will be presented to the Company shareholders for their approval and repayment of the loan
shall be subject to the terns of the signed loan agreement, as described above.



On May 28, 2001, we have 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.



Warrants



From January 1, 2002 through December 31, 2002, we have issued to GE Capital
Equity Investments, Inc. warrants to purchase an aggregate 67,223 ordinary shares of the company, as consideration for marketing services provided to us.



Office Holder Insurance



Our Articles of Association provide that, subject to the provisions of the Companies Law, we may enter into a contract for the insurance of the liability
of any of our office holders for acts which he or she performed in his or her capacity as an office holder in relation to:





| |  |  | a breach of his/her duty of care to us or to another person;
| | - |  | ------------------------------------------------------------



| |  |  | a breach of his/her duty of loyalty to us, provided that the office holder acted in good faith and had reasonable cause to assume that his/her act would not prejudice our interests;
or
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | a financial liability imposed upon him/her in favor of another person.
| | - |  | ----------------------------------------------------------------------



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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.



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.
| | - |  | ----------------------------------------------------------



Limitations on Insurance and Indemnification



The Companies Law provides that a company may not indemnify an office holder nor enter into an insurance contract, which would provide coverage for any
monetary liability incurred as a result of:



| |  |  | a breach by the office holder of his/her duty of loyalty unless the office holder acted in good faith and had a reasonable basis to believe that the act would not prejudice the
company;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | a breach by the office holder of his/her duty of care if the breach was done intentionally or recklessly;
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | any act or omission done with the intent to derive an illegal personal benefit; or
| | - |  | ----------------------------------------------------------------------------------



| |  |  | any fine levied against the office holder.
| | - |  | ------------------------------------------



Under the Companies Law, indemnification of, and procurement of insurance coverage for, our office holders must be approved by our audit committee, our
board of directors and, in specified circumstances, by our shareholders.



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. We have obtained directors and officers liability insurance for the benefit of our office holders.



Interests of Experts and Counsel



Not applicable.



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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 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
May 31, 2003, the high and low reported sales prices for our ordinary shares were as follows:



|Period                      |  | High  |  | Low  
|--------------------------- |  | ----- |  | -----
|Year ending                 |  |       |  |      
|December 31, 2002           |  | 6.90  |  | 0.746
|December 31, 2001           |  | 41.25 |  | 3.80 
|December 31, 2000           |  | 93.75 |  | 25.63
|Quarters ending             |  |       |  |      
|                            |  |      
|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              |  |       |  |      
|                            |  |      
|2001 Fourth Quarter, ending |  | 7.70  |  | 3.80 
|December 31, 2001           |  |       |  |      
|                            |  |      
|Third Quarter, ending       |  | 10.70 |  | 6.20 
|September 30, 2001          |  |       |  |      
|Second Quarter, ending      |  | 13.13 |  | 7.50 
|June 30, 2001               |  |       |  |      
|                            |  |      
|First Quarter, ending       |  | 41.25 |  | 10.00
|March 31, 2001              |  |       |  |      
|                            |  |      
|Most Recent 6 months        |  | High  |  | Low  
|May 2003                    |  | 0.90  |  | 0.46 
|                            |  |      
|April 2003                  |  | 0.52  |  | 0.40 
|                            |  |      
|March 2003                  |  | 0.81  |  | 0.42 
|                            |  |      
|February 2003               |  | 0.92  |  | 0.80 
|                            |  |      
|January 2003                |  | 0.889 |  | 0.72 
|                            |  |      
|December 2002               |  | 0.99  |  | 0.746



Markets on Which Our Ordinary Shares Trade



Our ordinary shares have been listed on The Nasdaq National Market since 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 the Tel Aviv Stock Exchange as well.



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



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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 SmallCap Market began on December 31, 2002.



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.



There is no age limit as to the ability of individuals to serve as members of our board of directors.



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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



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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.



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 and the Lines of Credit section under Item 4 Information on our Company 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;
| | - |  | ---------------------------------------------------------------------------------------------------------



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| |  |  | 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 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;
| | - |  | --------------------------------------------------------------



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| |  |  | 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 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



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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
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 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 in 2003 or future years
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
| | - |  | --------------------------------------------------------------------------------------------------------



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| |  |  | 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 in 2003 or future years 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 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.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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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



Although we do not believe that we were a PFIC in 2002, there can be no assurance that the IRS will agree with that
conclusion or that we will not become a PFIC in 2003 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.



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



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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



The general corporate tax rate in Israel is 36% although the tax rate on capital gains was lowered to 25% on January 1, 2003. However, the effective tax
rate payable by a company which 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.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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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.



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.



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 three 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. We have elected to participate in a government grant approved enterprise program and have received grants from the investment center. Income derived from the government grant approved enterprise
program is subject to a reduced tax rate of 10% to 25% (depending on the percentage of foreign investment in us) for a period of seven years starting on the first year in which we generate taxable income from the approved enterprise. We have elected
to participate in two additional alternative benefit programs. Income derived from our 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.



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



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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 Israeli government has discussed reducing the benefits available to companies under the capital investments law. The termination or substantial
reduction of any of the benefits available under the capital investments law could materially impact the cost of future investments by us.



Each application to the investment center is reviewed separately, and a decision about whether or not to approve the application is based on the then
prevailing criteria in the capital investments law, on the specific objectives of the applicant company in the application and on financial criteria of the applicant company. We cannot assure you that any application will be approved. 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. We believe that our approved enterprise programs operate in compliance with all of
these conditions and criteria.



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 chief scientist 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



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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 the Tel Aviv Stock Exchange 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.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------



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%.



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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.



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PART II



Item 13.Defaults, Dividend Arrearages And Delinquencies



None.



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



Use of Proceeds



On September 19, 2000, we commenced an initial public offering 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 initial public
offering 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 initial
public offering.



The aggregate offering price of the initial
public offering 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). From September 19, 2000, through December 31, 2002, the aggregate
amount of expenses incurred by us in connection with the issuance and distribution of ordinary shares offered and sold in the initial public offering 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 initial public offering, after deducting underwriting discounts and commissions and other expenses, were approximately $25,624,000



From September 19, 2000, through December 31, 2002, the amount of net
offering proceeds used for purchase of equipment and software was approximately $2,339,000, and approximately $23,285,000 for working capital purposes.



Item 15.Controls and Procedures



(a)  Evaluation of disclosure controls and procedures. To their best knowledge and belief and based on their evaluation of the Companys
disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934) as of a date within 90 days of the filing date of this Annual Report on Form 20-F, the Companys chief executive officer
and chief financial officer have concluded that the Companys disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms and are operating in an effective manner.



(b)  Changes in internal controls. There were no significant changes in the Companys internal controls or in other factors that could
significantly affect these controls subsequent to the date of their most recent evaluation.



Item 16.[RESERVED]



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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, 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.        



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|ExhibitIndex |     |  |     |  | Description of Document                                                                                                                                                                                                      |  |                                                                                                                                
|------------ | --- |  | --- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------
|             |     |  | 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.        
|             |     |  |    
|             |     |  | 11) |  | Letter from Bank Hapoalim B.M. to ViryaNet dated July 14, 2003.                                                                                                                                                              |  | Translation.                                                                                                                   
|             |     |  |    
|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.        
|             |     |  |    
|             |     |  | 5)  |  | Consent of Kost, Forer & Gabbay, a member of Ernst and Young International                                                                                                                                                   |  | Filed as Exhibit 4(a) of the Companys 20-F for the year ending December 31, 2002.                                             
|             |     |  |    
|             |     |  | 6)  |  | Value Added Reseller Agreement by and between the Company and GE Networks Solutions, dated January 17, 2003.                                                                                                                 |  |                                                                                                                                
|             |     |  |    
|             |     |  | 7)  |  | First Amendment to the Lease Agreement by and between the Company and Three and 400 Northwinds Center L.P., dated June 10, 2003.                                                                                             |  |                                                                                                                                
|             |     |  |    
|             |     |  | 8)  |  | Promissory Notes by and between the Company and Three and 400 Northwinds Center L.P., dated June 10, 2003.                                                                                                                   |  |                                                                                                                                
|             |     |  |    
|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 Winfried A. Burke and Albert A. Gabrielli pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                         |  |                                                                                                                                



67



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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 15thday of July, 2003.



VIRYANET LTD.By:

/s/    WINFRIED A. BURKEWinfried A. Burke President and Chief Executive Officer




68



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##### Table of Contents

CERTIFICATIONS



I, Winfried A. Burke, certify that:



|1. |  | I have reviewed this annual report on Form 20-F of ViryaNet Limited;
|-- |  | --------------------------------------------------------------------



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



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



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



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



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



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



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



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



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



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



Date: July 15, 2003



|/s/    WINFRIED A. BURKE                                   
|-----------------------------------------------------------
|                                                           
|Winfried A. Burke, Chief Executive Officer ViryaNet Limited



69



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I, Albert A. Gabrielli, certify that:



|1. |  | I have reviewed this annual report on Form 20-F of ViryaNet Limited;
|-- |  | --------------------------------------------------------------------



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



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



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



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



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



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



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



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



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



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



Date: July 15, 2003



|                                                             
|-------------------------------------------------------------
|/s/    ALBERT A. GABRIELLI                                   
|                                                             
|Albert A. Gabrielli, Chief Financial Officer ViryaNet Limited



70



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VIRYANET LTD. AND ITS SUBSIDIARIES



CONSOLIDATED FINANCIAL STATEMENTS



AS OF DECEMBER 31, 2002

IN U.S. DOLLARS



INDEX



|                                                           |  | Page   
|---------------------------------------------------------- |  | -------
|Report of Independent Auditors                             |  | F-2    
|Consolidated Balance Sheets                                |  | F-3-4  
|Consolidated Statements of Operations                      |  | F-5    
|Statements of Changes in Shareholders Equity (Deficiency) |  | F-6-7  
|Consolidated Statements of Cash Flows                      |  | F-8-10 
|Notes to Consolidated Financial Statements                 |  | F-11-32



F-1



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[LOGO]



REPORT OF INDEPENDENT AUDITORS



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, 2001 and 2002, 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, 2002. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our
audits.



We conducted our audits in accordance with auditing
standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the 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, 2001 and
2002, and the consolidated results of their operations and cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States.



KOST FORER &
GABBAY

A Member of Ernst & Young Global



Tel-Aviv, Israel

July 15, 2003



F-2



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##### Table of Contents

VIRYANET LTD. AND ITS SUBSIDIARIES



CONSOLIDATED BALANCE SHEETS

U.S. dollars in thousands



|                                                                                                                |  | December 31,
|--------------------------------------------------------------------------------------------------------------- |  | ------------
|                                                                                                                |  | 2001        
|ASSETS                                                                                                          |  |             
|CURRENT ASSETS:                                                                                                 |  |             
|Cash and cash equivalents                                                                                       |  | $           
|Restricted cash (Note 3)                                                                                        |  |             
|Trade receivables (net of allowance for doubtful accounts of $1,302 and $1,905 for 2001 and 2002, respectively) |  |             
|Unbilled receivables                                                                                            |  |             
|Other accounts receivable and prepaid expenses (Note 4)                                                         |  |             
|                                                                                                                |  |             
|Total current assets                                                                                            |  |             
|                                                                                                                |  |             
|SEVERANCE PAY FUND                                                                                              |  |             
|                                                                                                                |  |             
|PROPERTY AND EQUIPMENT, NET (Note 5)                                                                            |  |             
|                                                                                                                |  |             
|INTANGIBLE ASSETS, NET:                                                                                         |  |             
|Technology (net of accumulated amortization of $50 as of December 31, 2002) (Notes 1d, 6)                       |  |             
|Goodwill (Notes 1d)                                                                                             |  |             
|                                                                                                                |  |             
|                                                                                                                |  |             
|                                                                                                                |  |             
|Total assets                                                                                                    |  | $           
|                                                                                                                |  |             





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



F-3



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VIRYANET LTD. AND ITS SUBSIDIARIES



CONSOLIDATED BALANCE SHEETS

U.S. dollars in thousands

(except share data)



|                                                                                                                                                                                                          |  | December 31, |        
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | -------
|                                                                                                                                                                                                          |  | 2001         |        
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                                                                      |  |              |        
|                                                                                                                                                                                                          |  |             
|CURRENT LIABILITIES:                                                                                                                                                                                      |  |              |        
|Short-term bank credit (Note 7)                                                                                                                                                                           |  | $            | 5,557  
|Trade payables                                                                                                                                                                                            |  |              | 1,938  
|Deferred revenues                                                                                                                                                                                         |  |              | 1,349  
|Other accounts payable and accrued expenses (Note 8)                                                                                                                                                      |  |              | 3,290  
|                                                                                                                                                                                                          |  |              |        
|Total current liabilities                                                                                                                                                                                 |  |              | 12,134 
|                                                                                                                                                                                                          |  |              |        
|                                                                                                                                                                                                          |  |             
|LONG-TERM LIABILITIES:                                                                                                                                                                                    |  |              |        
|Accrued severance pay                                                                                                                                                                                     |  |              | 1,316  
|Long-term bank loan                                                                                                                                                                                       |  |              |       
|                                                                                                                                                                                                          |  |              |        
|Total long-term liabilities                                                                                                                                                                               |  |              | 1,316  
|                                                                                                                                                                                                          |  |              |        
|                                                                                                                                                                                                          |  |             
|COMMITMENTS AND CONTINGENT LIABILITIES (Note 9)                                                                                                                                                           |  |              |        
|SHAREHOLDERS EQUITY                                                                                                                                                                                      |  |              |        
|Share capital (Note 11):                                                                                                                                                                                  |  |              |        
|Ordinary Shares of NIS 1.0 par valueAuthorized: 3,500,000 shares as of December 31, 2001 and 2002; Issued and
outstanding: 2,171,678 and 2,681,733 shares as of December 31, 2001 and 2002, respectively |  |              | 611    
|Additional paid-in capital                                                                                                                                                                                |  |              | 97,962 
|Deferred stock compensation                                                                                                                                                                               |  |              | (43    
|Accumulated other comprehensive loss                                                                                                                                                                      |  |              | (436   
|Accumulated deficit                                                                                                                                                                                       |  |              | (89,435
|                                                                                                                                                                                                          |  |              |        
|Total shareholders equity                                                                                                                                                                                |  |              | 8,659  
|                                                                                                                                                                                                          |  |              |        
|                                                                                                                                                                                                          |  | $            | 22,109 
|                                                                                                                                                                                                          |  |              |        





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, |        
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ----------------------- | -------
|                                                                                                                                                                         |  | 2000                    |        
|Revenues (Note 13a):                                                                                                                                                     |  |                         |        
|Software licenses                                                                                                                                                        |  | $                       | 17,027 
|Maintenance and services                                                                                                                                                 |  |                         | 10,080 
|                                                                                                                                                                         |  |                         |        
|Total revenues                                                                                                                                                           |  |                         | 27,107 
|                                                                                                                                                                         |  |                         |        
|Cost of revenues:                                                                                                                                                        |  |                         |        
|Software licenses                                                                                                                                                        |  |                         | 938    
|Maintenance and services                                                                                                                                                 |  |                         | 7,857  
|                                                                                                                                                                         |  |                         |        
|Total cost of revenues                                                                                                                                                   |  |                         | 8,795  
|                                                                                                                                                                         |  |                         |        
|Gross profit                                                                                                                                                             |  |                         | 18,312 
|                                                                                                                                                                         |  |                         |        
|Operating expenses:                                                                                                                                                      |  |                         |        
|Research and development                                                                                                                                                 |  |                         | 7,224  
|Lessroyalty bearing grants                                                                                                                                              |  |                         |       
|                                                                                                                                                                         |  |                         |        
|                                                                                                                                                                         |  |                         | 7,224  
|Selling and marketing                                                                                                                                                    |  |                         | 16,385 
|General and administrative                                                                                                                                               |  |                         | 3,848  
|Provision for doubtful accounts and write-off of bad debts (Note 2m)                                                                                                     |  |                         | 9      
|In-process research and development write-off                                                                                                                            |  |                         |       
|Amortization of deferred stock compensation (1)                                                                                                                          |  |                         | 1,104  
|                                                                                                                                                                         |  |                         |        
|Total operating expenses                                                                                                                                                 |  |                         | 28,570 
|                                                                                                                                                                         |  |                         |        
|Operating loss                                                                                                                                                           |  |                         | (10,258
|Financial income (expenses), net (Note 14)                                                                                                                               |  |                         | 26     
|Financial expenses related to amortization of beneficial conversion feature and compensation related to warrants to investors in
convertible loan (Notes 11d, 11c(1)(d)) |  |                         | (16,556
|                                                                                                                                                                         |  |                         |        
|Net loss                                                                                                                                                                 |  | $                       | (26,788
|                                                                                                                                                                         |  |                         |        
|Basic and diluted net loss per Share                                                                                                                                     |  | $                       | (33.36 
|                                                                                                                                                                         |  |                         |        
|Weighted average number of shares used in computing basic and diluted net loss per Ordinary share                                                                        |  |                         | 802,979
|                                                                                                                                                                         |  |                         |        
|                                                                                                                                                                         |  |                         |        
|(1)   Stock based compensation relates to the following:                                                                                                                 |  |                         |        
|Cost of revenues                                                                                                                                                         |  | $                       | 4      
|Selling and marketing                                                                                                                                                    |  |                         | 207    
|General and administrative                                                                                                                                               |  |                         | 893    
|                                                                                                                                                                         |  |                         |        
|Total                                                                                                                                                                    |  | $                       | 1,104  
|                                                                                                                                                                         |  |                         |        



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



F-5



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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)



|                                                                                   |  | Preferred shares |   |  | Ordinary Shares |      | Additionalpaid-incapital |        | Deferredstockcompensation |        |   | Accumulatedothercomprehensiveloss |  |   | Accumulateddeficit |  |   | Totalcomprehensiveloss |   |  | Totalshareholdersequity(deficiency) |     
|---------------------------------------------------------------------------------- |  | ---------------- | - |  | --------------- | ---- | ------------------------ | ------ | ------------------------- | ------ | - | --------------------------------- |  | - | ------------------ |  | - | ---------------------- | - |  | ------------------------------------ | ----
|                                                                                   |  | Number           |   |  | Amount          |      |                          | Number |                           | Amount |   |                                   |  |   |                    | 
|Balance as of December 31, 1999                                                    |  | 1,014,639        |   |  | $               | 294  |                          |        | 270,064                   |        | $ | 103                               |  | $ | 37,728             |  | $ | (603                   | ) |  | $                                    |    
|Conversion of Preferred shares                                                     |  | (1,014,639       | ) |  |                 | (294 | )                        |        | 1,014,639                 |        |   | 294                               |  |   |                   |  |   |                       |   |  |                                      |    
|Issuance of Ordinary Shares, net                                                   |  |                 |   |  |                 |     |                          |        | 400,000                   |        |   | 98                                |  |   | 25,526             |  |   |                       |   |  |                                      |    
|Conversion of long-term loan, net                                                  |  |                 |   |  |                 |     |                          |        | 334,389                   |        |   | 82                                |  |   | 15,969             |  |   |                       |   |  |                                      |    
|Amortization of beneficial conversion feature                                      |  |                 |   |  |                 |     |                          |        |                          |        |   |                                  |  |   | 16,051             |  |   |                       |   |  |                                      |    
|Exercise of warrants, net                                                          |  |                 |   |  |                 |     |                          |        | 134,921                   |        |   | 30                                |  |   | 555                |  |   |                       |   |  |                                      |    
|Exercise of stock options, net                                                     |  |                 |   |  |                 |     |                          |        | 12,455                    |        |   | 3                                 |  |   | 183                |  |   |                       |   |  |                                      |    
|Amortization of compensation related to warrants to investors in convertible loans |  |                 |   |  |                 |     |                          |        |                          |        |   |                                  |  |   | 505                |  |   |                       |   |  |                                      |    
|Issuance of warrants to customers                                                  |  |                 |   |  |                 |     |                          |        |                          |        |   |                                  |  |   | 333                |  |   |                       |   |  |                                      |    
|Amortization of compensation related to warrants to bank                           |  |                 |   |  |                 |     |                          |        |                          |        |   |                                  |  |   | 254                |  |   |                       |   |  |                                      |    
|Amortization of compensation related to warrants to third party                    |  |                 |   |  |                 |     |                          |        |                          |        |   |                                  |  |   | 119                |  |   |                       |   |  |                                      |    
|Deferred stock compensation                                                        |  |                 |   |  |                 |     |                          |        |                          |        |   |                                  |  |   | 1,073              |  |   | (1,073                 | ) |  |                                      |    
|Amortization of deferred stock compensation                                        |  |                 |   |  |                 |     |                          |        |                          |        |   |                                  |  |   |                   |  |   | 1,072                  |   |  |                                      |    
|Compensation related to options granted to consultants                             |  |                 |   |  |                 |     |                          |        |                          |        |   |                                  |  |   | 32                 |  |   |                       |   |  |                                      |    
|Comprehensive loss:                                                                |  |                  |   |  |                 |      |                          |        |                           |        |   |                                   |  |   |                    |  |   |                        |   |  |                                      |     
|Foreign currency translation adjustments                                           |  |                 |   |  |                 |     |                          |        |                          |        |   |                                  |  |   |                   |  |   |                       |   |  |                                      | (288
|Net loss                                                                           |  |                 |   |  |                 |     |                          |        |                          |        |   |                                  |  |   |                   |  |   |                       |   |  |                                      |    
|                                                                                   |  |                  |   |  |                 |      |                          |        |                           |        |   |                                   |  |   |                    |  |   |                        |   |  |                                      |     
|Total comprehensive loss                                                           |  |                  |   |  |                 |      |                          |        |                           |        |   |                                   |  |   |                    |  |   |                        |   |  |                                      |     
|                                                                                   |  |                  |   |  |                 |      |                          |        |                           |        |   |                                   |  |   |                    |  |   |                        |   |  |                                      |     
|Balance as of December 31, 2000                                                    |  |                 |   |  |                 |     |                          |        | 2,166,468                 |        | $ | 610                               |  | $ | 98,328             |  | $ | (604                   | ) |  | $                                    | (288
|                                                                                   |  |                  |   |  |                 |      |                          |        |                           |        |   |                                   |  |   |                    |  |   |                        |   |  |                                      |     



The accompanying notes
are an integral part of the financial statements



F-6



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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-incapital |     |  | Deferredstockcompensation |         |   | Accumulatedothercomprehensiveloss |   |      | Accumulateddeficit |  |   | Totalcomprehensiveloss |   |  | Totalshareholdersequity(deficiency) |         
|--------------------------------------------------------------------- |  | --------------- |  | ------------------------ | --- |  | ------------------------- | ------- | - | --------------------------------- | - | ---- | ------------------ |  | - | ---------------------- | - |  | ------------------------------------ | --------
|                                                                      |  | Number          |  | Amount                   |     |  |                           |         |   |                                  
|Balance as of December 31, 2000                                       |  | 2,166,468       |  | $                        | 610 |  | $                         | 98,328  |   |                                   | $ | (604 | )                  |  | $ | (288                   | ) |  | $                                    | (74,865 
|Exercise of stock options                                             |  | 5,210           |  |                          | 1   |  |                           | 55      |   |                                   |   |     |                    |  |   |                       |   |  |                                      |        
|Stock based Compensation related to warrants to a bank                |  |                |  |                          |    |  |                           | 87      |   |                                   |   |     |                    |  |   |                       |   |  |                                      |        
|Stock based Compensation related to warrants to a consultant          |  |                |  |                          |    |  |                           | 13      |   |                                   |   |     |                    |  |   |                       |   |  |                                      |        
|Stock based Compensation related to warrants to a customer            |  |                |  |                          |    |  |                           | 104     |   |                                   |   |     |                    |  |   |                       |   |  |                                      |        
|Forfeiture of stock options to employees                              |  |                |  |                          |    |  |                           | (625    | ) |                                   |   | 625  |                    |  |   |                       |   |  |                                      |        
|Reversal of amortization of deferred stock compensation               |  |                |  |                          |    |  |                           |        |   |                                   |   | (64  | )                  |  |   |                       |   |  |                                      |        
|Comprehensive loss:                                                   |  |                 |  |                          |     |  |                           |         |   |                                   |   |      |                    |  |   |                        |   |  |                                      |         
|Foreign currency translation adjustments                              |  |                |  |                          |    |  |                           |        |   |                                   |   |     |                    |  |   | (148                   | ) |  |                                      |        
|Net loss                                                              |  |                |  |                          |    |  |                           |        |   |                                   |   |     |                    |  |   |                        |   |  |                                      | (14,570 
|                                                                      |  |                 |  |                          |     |  |                           |         |   |                                   |   |      |                    |  |   |                        |   |  |                                      |         
|Total comprehensive loss                                              |  |                 |  |                          |     |  |                           |         |   |                                   |   |      |                    |  |   |                        |   |  |                                      |         
|                                                                      |  |                 |  |                          |     |  |                           |         |   |                                   |   |      |                    |  |   |                        |   |  |                                      |         
|Balance as of December 31, 2001                                       |  | 2,171,678       |  |                          | 611 |  |                           | 97,962  |   |                                   |   | (43  | )                  |  |   | (436                   | ) |  |                                      | (89,435 
|Issuance of shares in connection with the acquisition of iMedeon Inc. |  | 510,055         |  |                          | 110 |  |                           | 2,843   |   |                                   |   |     |                    |  |   |                       |   |  |                                      |        
|Amortization of deferred stock compensation                           |  |                |  |                          |    |  |                           |        |   |                                   |   | 36   |                    |  |   |                       |   |  |                                      |        
|Stock based Compensation related to warrants to arelated party        |  |                |  |                          |    |  |                           | 136     |   |                                   |   |     |                    |  |   |                       |   |  |                                      |        
|Forfeiture of stock options to employees                              |  |                |  |                          |    |  |                           | (7      | ) |                                   |   | 7    |                    |  |   |                       |   |  |                                      |        
|Comprehensive loss:                                                   |  |                 |  |                          |     |  |                           |         |   |                                   |   |      |                    |  |   |                        |   |  |                                      |         
|Foreign currency translation adjustments                              |  |                |  |                          |    |  |                           |        |   |                                   |   |     |                    |  |   | 68                     |   |  |                                      |        
|Net loss                                                              |  |                |  |                          |    |  |                           |        |   |                                   |   |     |                    |  |   |                       |   |  |                                      | (11,350 
|                                                                      |  |                 |  |                          |     |  |                           |         |   |                                   |   |      |                    |  |   |                        |   |  |                                      |         
|Total comprehensive loss                                              |  |                 |  |                          |     |  |                           |         |   |                                   |   |      |                    |  |   |                        |   |  |                                      |         
|                                                                      |  |                 |  |                          |     |  |                           |         |   |                                   |   |      |                    |  |   |                        |   |  |                                      |         
|Balance as of December 31, 2002                                       |  | 2,681,733       |  | $                        | 721 |  | $                         | 100,934 |   |                                   | $ |     |                    |  | $ | (368                   | ) |  | $                                    | (100,785
|                                                                      |  |                 |  |                          |     |  |                           |         |   |                                   |   |      |                    |  |   |                        |   |  |                                      |         



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, |        
|---------------------------------------------------------------------------------- |  | ----------------------- | -------
|                                                                                   |  | 2000                    |        
|Cash flows from operating activities:                                              |  |                         |        
|Net loss                                                                           |  | $                       | (26,788
|Adjustments to reconcile net loss to net cash used in operating activities:        |  |                         |        
|Depreciation and amortization of current technology                                |  |                         | 900    
|In-process research and development write-off                                      |  |                         |       
|Accrued severance pay, net                                                         |  |                         | 111    
|Amortization (reversal of amortization) of deferred stock compensation             |  |                         | 1,072  
|Compensation related to warrants to a bank                                         |  |                         | 254    
|Compensation related to warrants to a related party                                |  |                         | 119    
|Compensation related to warrants to a customer                                     |  |                         |       
|Compensation related to warrants to a consultant                                   |  |                         | 32     
|Amortization of beneficial conversion feature                                      |  |                         | 16,051 
|Amortization of compensation related to warrants to investors in convertible loans |  |                         | 505    
|Decrease (increase) in trade receivables and unbilled receivables                  |  |                         | (2,687 
|Decrease (increase) in other accounts receivable and prepaid expenses              |  |                         | (2,041 
|Increase (decrease) in trade payables                                              |  |                         | 1,057  
|Increase (decrease) in deferred revenues                                           |  |                         | (5,252 
|Increase (decrease) in other accounts payable and accrued expenses                 |  |                         | 875    
|Other                                                                              |  |                         |       
|                                                                                   |  |                         |        
|Net cash used in operating activities                                              |  |                         | (15,792
|                                                                                   |  |                         |        
|Cash flows from investing activities:                                              |  |                         |        
|Purchase of property and equipment                                                 |  |                         | (2,330 
|Proceeds from sale of property and equipment                                       |  |                         | 28     
|Increase (decrease) in restricted cash                                             |  |                         | 96     
|Cash provided in connection with the acquisition of iMedeon (a)                    |  |                         |       
|                                                                                   |  |                         |        
|Net cash provided by (used in) investing activities                                |  |                         | (2,206 
|                                                                                   |  |                         |        



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, |       
|-------------------------------------------------------------------------- |  | ----------------------- | ------
|                                                                           |  | 2000                    |       
|Cash flows from financing activities:                                      |  |                         |       
|Short-term bank credit, net                                                |  | $                       | (5,138
|Proceeds from issuance of share capital and exercise of stock options, net |  |                         | 42,968
|Issuance of warrants to customers                                          |  |                         | 333   
|Decrease in accrued expenses related to issuance expenses                  |  |                         |      
|Principal payment of long-term loans                                       |  |                         | (11   
|                                                                           |  |                         |       
|Net cash provided by (used in) financing activities                        |  |                         | 38,152
|                                                                           |  |                         |       
|Effect of exchange rate on cash and cash equivalents                       |  |                         | (202  
|                                                                           |  |                         |       
|Increase (decrease) in cash and cash equivalents                           |  |                         | 19,952
|Cash and cash equivalents at the beginning of the year                     |  |                         | 1,886 
|                                                                           |  |                         |       
|Cash and cash equivalents at the end of the year                           |  | $                       | 21,838
|                                                                           |  |                         |       
|Supplemental disclosure of cash flows activities:                          |  |                         |       
|Cash paid during the year for:                                             |  |                         |       
|Interest                                                                   |  | $                       | 180   
|                                                                           |  |                         |       
|Supplemental disclosure of non-cash investing and financing activities:    |  |                         |       
|Accrued expenses related to issuance expenses                              |  | $                       | (521  
|                                                                           |  |                         |       
|Conversion of loans to shares                                              |  | $                       | 16,051
|                                                                           |  |                         |       
|Refinancing of short-term loan on a long-term basis                        |  | $                       |      
|                                                                           |  |                         |       



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 endedDecember 31,2002 |        
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------- | -------
|(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: |  |                            |        
|                                                                                                                                                                                                                                      | 
|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)
|                                                                                                                                                                                                                                      |  |                            |        







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



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VIRYANET LTD. AND ITS SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands



Note 1:    GENERAL



|a. |  | ViryaNet Ltd. (the Company), an Israeli corporation, was established in 1988. The Company develops, markets and supports software products, which provide
business-to-business internet solutions and related services that enable service organizations and their field engineers, customers, partners, vendors and suppliers to collaborate in a single environment called a service community.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



ViryaNet Ltd. has four wholly-owned
subsidiaries: two in the United States (ViryaNet Inc. and iMedeon Inc. and collectively (ViryaNet US)) one in the United Kingdom (ViryaNet UK), and one in Japan (ViryaNet Japan).



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



The Companys sales are made in the United States, Europe, Japan and
Israel. In 2000, 2001 and 2002 sales to major customers constituted 23%, 12% and 38% of the total revenues, respectively. As for major customers, see Note 13b.



|b. |  | On September 19, 2000, the Company completed its Initial Public Offering (IPO). Since then, the Ordinary Shares have been listed on the Nasdaq National Market
(Nasdaq) in the U.S. In September 2002, the Company was notified by the Nasdaq that it was not in compliance with a certain Market place rule by failing to maintain a minimum market value of $5,000 for its publicly held. The Company
requested a transfer of its securities listing from the Nasdaq to the Nasdaq Smallcap Market. The transfer was approved on December 20, 2002, and since then the Companys shares are listed on the Small Cap Market.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|c. |  | On October 29, 2001, the Company listed its shares for trade also on the Tel-Aviv Stock Exchange.
|-- |  | -------------------------------------------------------------------------------------------------



|d. |  | Acquisition of iMedeon Inc.:
|-- |  | ----------------------------



In February 2002, the Company acquired all the outstanding Ordinary Shares of iMedeon, Inc. (iMedeon), a United States based company, in a
stock-for-stock transaction. iMedeon is 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 believes the acquisition will accelerate its penetration of the utilities sector, strengthen its delivery teams and result in a further strengthening of its product offerings.



The Company determined the fair value of the issued Ordinary 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 close to the acquisition date.



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



The acquisition was accounted for using 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 and per share data)



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



|Working capital, net                   |  | $ | 123  
|-------------------------------------- |  | - | -----
|Property and equipment                 |  |   | 95   
|Technology(1)                          |  |   | 180  
|In process research and development(2) |  |   | 480  
|Goodwill(3)                            |  |   | 2,772
|                                       |  |   |      
|Net assets acquired                    |  | $ | 3,650
|                                       |  |   |      

| | 
| | 

| | (1) |  | See also note 6.
| | --- |  | ----------------

| | (2) |  | In connection with the acquisition, the Company recorded 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.
| | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (3) |  | See also note 7.
| | --- |  | ----------------



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



|                                     |  | Year ended December 31,
|------------------------------------ |  | -----------------------
|                                     |  | 2001                   
|Revenues                             |  | $                      
|                                     |  |                        
|Net loss                             |  | $                      
|                                     |  |                        
|Basic and diluted net loss per share |  | $                      
|                                     |  |                        



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 2002 or 2001, nor is it necessarily indicative of future results.



|e. |  | Restructuring charges:
|-- |  | ----------------------



During the fourth quarter of 2002, the Company restructured its sales and support strategy in Europe and the Middle East, 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 expenses, $150 in selling and marketing expenses and $104 in general and administrative expenses. As of December
31, 2002, $70 of the expense remain accrued.



|                              |  | Year endedDecember 31,2002
|----------------------------- |  | --------------------------
|Employee termination benefits |  | $                         
|Facilities closures           |  |                           
|                              |  |                           
|                              |  | $                         
|                              |  |                           



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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 2:    SIGNIFICANT ACCOUNTING POLICIES



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



|a. |  | 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.



|b. |  | Financial statements in U.S. dollars:
|-- |  | -------------------------------------



All of the Companys and ViryaNet U.S. sales are made in U.S. dollars (dollars). In addition, a substantial portion of the costs of the
Company and ViryaNet U.S. are 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 dollar is their
functional and reporting currency.



Accordingly, monetary
accounts maintained in currencies other than the dollar are remeasured into dollars in accordance with Statement No. 52 of the Financial Accounting Standard Board (FASB) Foreign Currency Translation. All transactions gains
and losses from the remeasurement of monetary balance sheet items are reflected in the statements of operations as financial income or expenses as appropriate.



The functional currency of ViryaNet UK and ViryaNet Japan has been determined to be their local currency. All balance sheet accounts have been
translated using the exchange rates in effect at the balance sheet date. Statement of operations amounts have been translated using the average exchange rate for the period. The resulting translation adjustments are reported as a component of
shareholders equity in accumulated other comprehensive loss.



|c. |  | Principles of consolidation:
|-- |  | ----------------------------



The consolidated financial statements include the accounts of the Company and its subsidiaries. Intercompany balances and transactions have been
eliminated upon consolidation.



|d. |  | Cash equivalents:
|-- |  | -----------------



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



|e. |  | Restricted cash
|-- |  | ---------------



Restricted cash represents amounts deposited in the bank as security for a litigation pending against the Company by a former employee (See also Note 3).



|f. |  | 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 depreciation rates:



|                                             |  | %   
|-------------------------------------------- |  | ----
|Computers, peripheral equipment and software |  | 33  
|Office furniture and equipment               |  | 6-25
|Motor vehicles                               |  | 15  



Leasehold
improvements are depreciated over the term of the related lease periods.



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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)



|g. |  | Technology
|-- |  | ----------



In February 2002, as a result of the iMedeon Acquisition, the Company acquired technology rights (Technology) in the amount of $180.



Intangible assets acquired in a business combination for which date is on or after July 1, 2001, should be amortized over
their useful life using a method of amortization that reflects the pattern in which the economic benefits of the intangible assets are consumed or otherwise used up, in accordance with Statement of Financial Accounting Standards No. 142
Goodwill and Other Intangible Assets (SFAS No. 142). Accordingly, current technology is amortized using the straight-line method over its estimated useful life, which is three years.



|h. |  | Impairment of long-lived assets and identifiable intangibles
|-- |  | ------------------------------------------------------------



The Companys long-lived assets and certain identifiable intangibles 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. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of an asset to the future undiscounted cash flows expected to be generated by the assets. If such assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.



|i. |  | Goodwill:
|-- |  | ---------



Goodwill represents excess of the costs over the net assets of business acquired. Under SFAS No.142, Goodwill and other Intangible Assets goodwill acquired in a business combination on or after July 1,
2001, is deemed to have indefinite life and shall not be amortized.



SFAS No.142 requires goodwill to be tested for impairment at least annually 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. 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 the impairment. The Company completed its
annual impairment test during the last quarter of 2002 and found no instances of impairment of its recorded goodwill; accordingly, the second testing phase was not necessary. No subsequent indicators of impairment have been noted by the Company.



|j. |  | Income taxes:
|-- |  | -------------



The Company and its subsidiaries account for income taxes in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, Accounting
for Income Taxes. 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.



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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)



|k. |  | 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.



Revenues from software license agreements are recognized, in accordance with Statement Of Position (SOP) 97-2 Software Revenue Recognition (as amended) SOP 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 98-9, Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain
Transactions, (SOP 98-9) for all multiple element transactions entered into after January 1, 2000. SOP 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.



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.



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, customization 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. When services are considered essential, 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. To date, the
Company had determined that the services are not considered essential to the functionality of other elements of the arrangement.



Revenues from software licenses that require significant customization, integration and installation are recognized in accordance with Statement of
Position 81-1 Accounting for Performance of ConstructionType and Certain ProductionType Contracts (SOP 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, 2002 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.



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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)



According to Statement of Opinion 81-1 Accounting for Performance of ConstructionType and
Certain ProductionType Contracts (SOP 81-1), costs that are incurred for a specific anticipated contract are being deferred, subject to evaluation of their probable recoverability, and only if the costs can be directly
associated with a specific anticipated contract.



Deferred
revenue includes unearned amounts received under maintenance and support contracts, and amounts received from customers but not recognized as revenues.



The Company has entered into software license agreements with customers whereby, upon entering into these agreements, the Company granted warrants to
these customers. In such cases, the Company deducts the fair value of these warrants from the related software revenues and amortizes the fair value over the period the related revenues are recognized. The fair value of these warrants is determined
using the Black-Scholes option pricing model (see also Note 11c3).



|l. |  | Research and development costs:
|-- |  | -------------------------------



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



Based on the Companys product development process, technological feasibility is established upon completion of a working model. The Company does not
incur any material costs between the completion of the working model and the point at which the product is ready for general release. Therefore, research and development cots are charged to the statement of operation.



|m. |  | 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, restricted cash trade receivables and unbilled receivables.



The Companys cash and cash equivalents are invested in deposits in major banks in the United States, United Kingdom, Japan and Israel. Such deposits 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. 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, Japan and Israel. The Company 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.



Managements assessment for uncertainties of outstanding debts
collectability resulted in a provision for doubtful accounts expenses in a total amount of $9, $1,265 and $2,319 for 2000, 2001 and 2002, respectively. During 2002, the Company wrote off $566 of trade receivables and $1,150 with respect to a balance
due from an insurance company that the Company has determined to be uncollectible. Of these amounts, $1,166 was recorded as provision for doubtful accounts expenses in 2001 and $550 with respect to a balance due from an insurance company was
recorded as bad debt expenses in 2002.



The Company committed
to the bank for the sale, with recourse, of certain of its trade receivables. The Company provided the bank with guarantees to secure the trade receivables. As of December 31, 2002, a total amount of $1,658 was sold to the bank. The Company has
provided the bank with an unlimited guarantee securing the obligations of applicable customers under the trade receivables sold.



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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)



The Company has no off-balance sheet concentration of credit-risk such as foreign exchange contracts,
option contracts or other foreign hedging arrangements.



|n. |  | Accounting for stock-based compensation:
|-- |  | ----------------------------------------



The Company has elected to account for stock-based compensation in accordance with the provisions of Accounting Principles Board Opinion No. 25 (APB
No. 25), Accounting for Stock issued to Employees and FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation (FIN No. 44). Under APB No. 25, when the exercise price of
the Companys stock is less than the market price of the underlying stock on the date of grant, no compensation expense is recognized.



The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of FASB
Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation :



Pro-forma information under SFAS No. 123:



|                                                                                          |  | Year ended December 31, |        
|----------------------------------------------------------------------------------------- |  | ----------------------- | -------
|                                                                                          |  | 2000                    |        
|Net loss as reported                                                                      |  | $                       | (26,788
|Add: stock based compensation expenses included in reported net loss                      |  |                         | 967    
|Deductstock-based compensation expense determined under fair value method for all awards |  |                         | 3,064  
|                                                                                          |  |                         |        
|Pro forma net loss                                                                        |  | $                       | (28,885
|                                                                                          |  |                         |        
|Pro forma basic and diluted net loss per share                                            |  | $                       | (35.97 
|                                                                                          |  |                         |        



Under SFAS No. 123,
pro forma information regarding net loss and net loss per share is required, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that statement. The fair value for these options was
estimated at the date of grant using a Black-Scholes Option Valuation Model with the following weighted-average assumptions for 2000, 2001 and 2002: risk-free interest rates of 5.75%, 3% and 3%, respectively; dividend yields of 0% for each year,
volatility factors of the expected market price of the Companys Ordinary Shares of 0.84, 0.68 and 0.5, respectively and weighted average expected life of the options of 4 years for each year.



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



The Company applies SFAS No. 123 and EITF 96-18 Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services 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.



Grants and participations:



Royalty-bearing grants from the Government of Israel and from the 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 recognized in 2002 from the OCS and the BIRD-F amounted to $276 and $185,
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)



|o. |  | Severance pay:
|-- |  | --------------



The Companys liability for severance pay 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 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, 2000, 2001 and 2002, amounted to approximately $543, $1,353 and $753, respectively.



|p. |  | 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:



Cash and cash equivalents, trade receivables unbilled
receivables and other accounts receivables and trade payables and other accounts payable and short-term bank credit approximate their fair value due to the short-term maturity of such instruments.



|q. |  | Basic and diluted 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 and warrants have been excluded from the calculation of the diluted net loss per Ordinary share because the securities are anti-dilutive for all periods presented. The total weighted average number of shares
related to the outstanding stock, options and warrants excluded from the calculations of diluted net loss per share were 761,020, 839,477 and 738,200 for the years ended December 31, 2000, 2001 and 2002, respectively.



|r. |  | Impact of recently issued accounting standards:
|-- |  | -----------------------------------------------



In June 2002, the FASB issues SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses significant
issue regarding the recognition, measurement, and reporting of costs associated with exit and disposal activities, including restructuring activities. SFAS No. 146 requires that costs associated with exit or disposal activities be recognized when
they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 is effective for all exit or disposal activities initiated after December 31, 2002. The Company does not expect the adoption of SFAS No. 146 to have
a material impact on its results of operations or financial position.



In November 2002, the FASB issued FASB Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5,
57, and 107 and Rescission of FASB Interpretation No. 34 (FIN No. 45). FIN No. 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements



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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)



about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN No. 45 does not prescribe a specific approach for subsequently measuring the guarantors recognized liability over the term of the related
guarantee.



It also incorporates, without change, the guidance
in FASB Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others, which is being superseded. The disclosure provisions of FIN No. 45 are effective for financial statements of interim or annual periods that end
after December 15, 2002 and the provisions for initial recognition and measurement are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002, irrespective of a guarantors year-end. The Company does
not expect the adoption of FIN No. 45 to have a material impact on its results of operations or financial position.



In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities(FIN 46). The objective of FIN 46
is to improve financial reporting by companies involved with variable interest entities. A variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity
investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires a variable interest entity to be consolidated by a company if that company is
subject to a majority of the risk of loss from the variable interest entitys activities or entitled to receive a majority of the entitys residual returns or both. FIN 46 also requires disclosures about variable interest entities that the
company is not required to consolidate but in which it has a significant variable interest. The consolidation requirements of Interpretation 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation
requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable
interest entity was established. As of December 31, 2002, the Company has not yet determined what effect, if any, FIN 46 will have on its consolidated financial statements.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity. This Statement establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. It requires that
an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. This Statement is effective for financial instruments
entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. The Company does not
expect that the adoption of this standard will have a material effect on its financial position or results of operations.



Note 3:    RESTRICTED CASH



The Company recorded a fixed charge on a short-term bank deposit due to a pending litigation against the Company by a former employee. As a result of the
settlement of this litigation the charge was removed on March 16, 2003.



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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 4:    OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES



|                           |  | December 31,
|-------------------------- |  | ------------
|                           |  | 2001        
|Prepaid expenses           |  | $           
|Employees                  |  |             
|Government authorities     |  |             
|Due from insurance company |  |             
|Other                      |  |             
|                           |  |             
|                           |  | $           
|                           |  |             



Note
5:    PROPERTY AND EQUIPMENT



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



|                                             |  | December 31,
|-------------------------------------------- |  | ------------
|                                             |  | 2001        
|Computers, peripheral equipment and software |  | $           
|Office furniture and equipment               |  |             
|Motor vehicles                               |  |             
|Leasehold improvements                       |  |             
|                                             |  |             
|                                             |  |             
|                                             |  |             
|Accumulated depreciation                     |  |             
|                                             |  |             
|Depreciated cost                             |  | $           
|                                             |  |             



Depreciation expenses
for the years ended December 31, 2000, 2001 and 2002, were approximately $900, $1,154 and $1,256, respectively.



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



Note 6:    INTANGIBLE ASSETS



|a. |  | Original amounts:
|-- |  | -----------------



|                         |  | December 31, |  
|------------------------ |  | ------------ | -
|                         |  | 2001         |  
|Original amounts:        |  |              |  
|Current Technology       |  | $            | 
|Accumulated amortization |  |              | 
|                         |  |              |  
|Amortized cost           |  | $            | 
|                         |  |              |  



See also note 1d.



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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 7:    SHORT-TERM BANK CREDIT



In April 2001, Bank Hapoalim agreed to extend the line of credit that
allowed the Company to borrow up to $6,000 until March 31, 2002. In February 2002, Bank Hapoalim agreed to extend the line of credit until January 31, 2003 and added two covenants that the Company was required to maintain: (a) the Companys
shareholders equity will not be less than 30% of the total balance sheet and (b) the Companys annual earnings before interest and taxes will be positive and the quarterly losses before interest and taxes will not exceed $1,000. These
covenants were measured according to Generally Accepted Accounting Principles in Israel.



The weighted average interest rate on the credit line as of December 31, 2001 and 2002, was approximately 5.4% and 3.6%, respectively.



As of December 31, 2002, the Company used $3,945 of the credit line.



In connection with the credit line, the Company granted warrants to Bank
Hapoalim (see also Note 11(2)(c)).



In January 2003, the line
of credit was terminated and $3,450 outstanding under such credit line as of such date, was converted to a loan which is subjected to repayment in full by July 21, 2003. The loan bears an

interest at an annual rate of 4.375%. The Company also has an overdraft facility with Bank Hapoalim of $125.



In July 2003, the Bank has agreed to convert $2.4 million of the short-term
loan into a long-term loan for two years (see also Note 16).



Note
8:    OTHER ACCOUNTS PAYABLE AND ACCRUED EXPENSES



|                               |  | December 31,
|------------------------------ |  | ------------
|                               |  | 2001        
|Accrued expenses               |  | $           
|Employees and payroll accruals |  |             
|Others                         |  |             
|                               |  |             
|                               |  | $           
|                               |  |             



Note 9:
    COMMITMENTS AND CONTINGENT LIABILITIES



|a. |  | Royalty commitments:
|-- |  | --------------------



Under the Companys research and development agreements with the Office of the Chief Scientist (OCS) and the Binational Industrial
Research and Development Foundation (BIRD-F), reached in 2002 and pursuant to applicable laws, the Company is required to pay royalties at the rate of 3%-5% of sales of products developed with funds provided by the OCS and BIRD-F, up to
an amount equal to 100%-150% of the research and development grants (dollar-linked) received from the OCS and 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.



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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)



The Company has not paid or accrued royalties relating to the repayment of such grants for the years
ended December 31, 2002. As of December 31, 2002, the Company has an outstanding contingent liability to pay royalties in the amount of approximately $790 (out of which $276 to the OCS and $514 to the Bird-F). The Company believes that the project
supported by the BIRD-F has failed and that consequently it will not be required to pay the BIRD-F any royalties from the sale of any of its products.



|b. |  | Lease commitments:
|-- |  | ------------------



The Company and its subsidiaries rent their facilities under various operating lease agreements, which expire on various dates, the latest of which is in
2005.



Future minimum rental payments under non-cancelable
operating leases are as follows:



|     |  | U.S. dollars
|---- |  | ------------
|2003 |  | $           
|2004 |  |             
|2005 |  |             
|     |  |             
|     |  | $           
|     |  |             



Total rent expenses
for the years ended December 31, 2000, 2001 and 2002, were approximately $1,100, $982 and $845, respectively.



|c. |  | Charges and guarantees:
|-- |  | -----------------------



The Company has a floating charge on all of its assets in favor of a bank.



The Company obtained bank guarantees in the amount of $86, in order to secure an office lease agreement.



As for the guarantee securing trade receivables sold to a bank, see Note 2m.



|d. |  | Litigation:
|-- |  | -----------



In December 1999, the Companys former vice president of sales and marketing filed an action against the Company and the Companys Chief Executive Officer seeking damages in the amount of approximately
$1,364. The former employee alleges wrongful denial of his right to exercise options, loss of compensation including options to purchase shares granted to him by the Company, severance payment and other social benefits as well as damage to his
reputation. In March 2000, the Company filed a counter action against this former employee seeking damages in the amount of approximately $970. The Company alleged that the former employee has acted in bad faith, breached his fiduciary duty with the
Company and did not perform his duties as required. In August 2001, the Company and the former employee signed a settlement agreement, according to which the Company paid $60 to the former employee and both parties waived their mutual claims.



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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:    SHAREHOLDERS EQUITY



|a.    (1) |  | The Ordinary Shares confer upon the holders the right to receive notice to participate and vote in general meetings of the Company, and the right to receive dividends, if declared.
|--------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (2) |  | Upon the IPO, the Company issued 400,000 Ordinary Shares of 80.00 per share in consideration of net proceeds of $25,624 (see also Note 1b).
| | --- |  | -------------------------------------------------------------------------------------------------------------------------------------------



| | (3) |  | In April 2002, the Board of directors approved a 10 to 1 reverse split of the Companys Ordinary Shares. The reverse split became effective on May 1, 2002. Upon effecting the
reverse split, 10 Ordinary Shares of NIS 0.1 par value each have been converted to one Ordinary Share of NIS 1.0 par value.
| | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



All share and per share amounts have been retroactively adjusted to reflect this split.



| | (4) |  | In February and April 2002, the Company issued 510,055 Ordinary Shares related to the acquisition of iMedeon (see also Note 1d).
| | --- |  | --------------------------------------------------------------------------------------------------------------------------------



|b. |  | 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 addition, the Company decided to increase the number of shares reserved for issuance under the 1999 Stock Option Plan by additional
300,000 shares.



As of December 31, 2002, an aggregate of
350,077 Ordinary Shares of the Company are still 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 four years. Any options which are canceled or forfeited before expiration become available for future grants.



|2. |  | During 2000 and 2001, 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.
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|3. |  | In September 2001, the Company adopted a new voluntary stock option exchange program, under which the employees had the opportunity to cancel outstanding Stock Options. On a date
which is not less than six months and one day from the date of cancellation of such Stock Options, the Company shall grant 1.1 new option for every 1 cancelled option to those employees who are employed by the Company at such time. Each new option
will have the same vesting commencement date and vesting schedule as the option for which it has exchanged. The exercise price of the new options will be based on the fair market value of the Companys Ordinary Shares at the time of the grant
thereof. A total of 107,120 options were cancelled in connection with the option exchange program. In March 2002, as part of the option exchange program, the Company granted 95,365 options to employees.
|-- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In January 2002, certain directors and executive officers of Viryanet
tendered and irrevocably cancelled options to purchase a total of 249,500 Ordinary Shares of Viryanet previously granted to such directors and



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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)



executive officers. The exercise price of the new options will be based on the fair market value of the Companys Ordinary Shares at the time of the
grant. In September 2002, Viryanets board of directors, the executive officers and Viryanets shareholders approved the grant of replacement options to such directors, and such replacement options were granted.



|6. |  | A summary of the Companys stock option activity (except options to consultants) under the Plans is as follows:
|-- |  | ---------------------------------------------------------------------------------------------------------------



|                                  |  | Year ended December 31,
|--------------------------------- |  | -----------------------
|                                  |  | 2000                   
|                                  |  | Numberofoptions        
|Outstandingbeginning of the year |  | 465,525                
|Granted                           |  | 184,798                
|Exercised                         |  | (12,455                
|Forfeited/canceled                |  | (89,058                
|                                  |  |                        
|Outstandingend of the year       |  | 548,810                
|                                  |  |                        
|Options exercisable               |  | 208,804                
|                                  |  |                        



The options
outstanding as of December 31, 2002, have been separated into ranges of exercise price, as follows:



|Ranges of exercise price |  | Optionsoutstanding asof December 31,2002 |  | Weighted average remainingcontractual life |  | Weighted average exercise price |       | Optionsexercisable atDecember 31, 2002 |         | Weighted averageexercise price of exercisableoptions
|------------------------ |  | ---------------------------------------- |  | ------------------------------------------ |  | ------------------------------- | ----- | -------------------------------------- | ------- | ----------------------------------------------------
|                         |  |                                          |  | Years                                      |  |                                 |       |                                        |         |                                                     
|$  1.64-5.60             |  | 429,115                                  |  | 6.48                                       |  | $                               | 4.86  |                                        | 344,763 |                                                     
|6.10-10.00               |  | 63,339                                   |  | 0.76                                       |  |                                 | 7.01  |                                        | 57,998  |                                                     
|23.00-37.50              |  | 15,150                                   |  | 3.69                                       |  |                                 | 30.33 |                                        | 11,306  |                                                     
|57.50                    |  | 4,550                                    |  | 3.71                                       |  |                                 | 57.50 |                                        | 3,778   |                                                     
|80.00-120.00             |  | 8,400                                    |  | 4.53                                       |  |                                 | 99.52 |                                        | 5,184   |                                                     
|                         |  |                                          |  |                                            |  |                                 |       |                                        |         |                                                     
|$  1.64-120.00           |  | 520,554                                  |  |                                            |  | $                               | 7.85  |                                        | 423,029 |                                                     
|                         |  |                                          |  |                                            |  |                                 |       |                                        |         |                                                     



The Company has
recorded deferred compensation for options issued with an exercise price below the market price of the Ordinary shares. The deferred compensation is amortized and recorded as compensation expense ratably over the vesting period of the option.
Compensation expenses of approximately $1,072 and $36, were recognized during the years ended December 31, 2000 and 2002, respectively. Compensation income of approximately $64 was recognized during the year ended December 31, 2001.



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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)



The weighted average fair values of options granted for the years ended December 31, 2000, 2001 and
2002, were:



|                                           |  | For exercise price on the grant date that:
|------------------------------------------ |  | ------------------------------------------
|                                           |  | Equals market price                       
|                                           |  | Year ended December 31,                   
|                                           |  | 2000                                      
|Weighted average exercise prices           |  | $                                         
|                                           |  |                                           
|Weighted average fair values on grant date |  | $                                         
|                                           |  |                                           



|8. |  | Options issued to consultants:
|-- |  | ------------------------------



| | a) |  | The Companys outstanding options to consultants as of December 31, 2002, are as follows:
| | -- |  | -----------------------------------------------------------------------------------------



|Issuance date  |  | Options forOrdinary Shares |  | Exercise priceper share |  | Optionsexercisable |  | Exercisablethrough
|-------------- |  | -------------------------- |  | ----------------------- |  | ------------------ |  | ------------------
|December 1996  |  | 25,000                     |  | 10.00                   |  | 25,000             |  | (*)               
|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     
|July 2000      |  | 200                        |  | 110.00                  |  | 200                |  | July 2007         
|December 2000  |  | 1,160                      |  | 25.70                   |  | 1,160              |  | December 2007     
|May 2001       |  | 3,539                      |  | 9.60                    |  | 3,539              |  | May 2003          
|               |  |                            |  |                         |  |                    |  |                   
|Total          |  | 36,099                     |  |                         |  | 36,099             |  |                   
|               |  |                            |  |                         |  |                    |  |                   

| | 
| | 

| | (*) |  | The options are 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 and EITF 96-18. The fair value for these options was estimated using a
Black-Scholes option pricing model with the following weighted-average assumptions for 2000 and 2001: risk-free interest rates of 5.75% and 3% respectively, dividend yields of 0% for each year, volatility factors of the expected market price of the
Companys Ordinary Shares of 0.84 and 0.68, respectively, and a weighted-average expected life of the options of approximately 2 and 2 years, respectively.
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|c. |  | Warrants:
|-- |  | ---------



|1. |  | Warrants issued to investors:
|-- |  | -----------------------------



| | a) |  | As part of the investment agreement in 1996, the Company issued to certain investors warrants to purchase 137,511 Series A Preferred shares at an exercise price of $30 of which
warrants to purchase 21,667 shares were converted in December 1996 into warrants to purchase 21,667 Series B Non-Voting Preferred shares. Upon the IPO, 19,512 warrants were exercised in consideration of $585 and 117,999 warrants were exercised into
73,750 Series A Preferred shares, by way of cashless exercise.
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | As part of the investment agreement in February 1998, the Company issued to the shareholders warrants to purchase 3,180 Series C-1 Preferred shares at an exercise price equal to the
par value of the shares. Upon the IPO, 308 warrants were exercised into 308 Series C-1 Preferred shares, by way of cashless exercise.
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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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)



| | c) |  | As part of the investment agreement in June 1999, the Company issued to certain Series C-2 Preferred shares investors detachable warrants to purchase 34,783 Series C-2 Preferred
shares at an exercise price of $57.50. The warrants contain a cashless exercise feature and expire upon the earlier of June 2004 or a merger or sale of all or substantially all of the Companys assets or issued and outstanding share capital.
The cashless exercise feature allows the holder to convert the warrant into Ordinary Shares without the payment of any exercise price. The number of shares issuable upon exercise is determined by subtracting the exercise price of the warrant from
the aggregate market value of the underlying shares, and then dividing such amount by the market value of an Ordinary share. The Company recorded a deemed dividend at the amount of 303,000. This transaction was accounted for according to EITF 98-5
Accounting for Convertible Securities with Beneficial Conversion Features or Contingent Adjustable Conversion Ratios (EITF 98-5) and APB 14 Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants
(APB 14). The fair value of this warrant was determined using the Black-Scholes pricing model, assuming a risk free interest of 5.75%, a volatility factor of 0.5, dividend yields of 0% and an expected life of warrants of six months.
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | d) |  | The Company granted to the investors in the convertible loan 12,500 warrants at an exercise price equal to 95% of the conversion price per share determined in the IPO. The warrants
are exercisable upon the IPO.
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In connection
with these warrants, the Company recorded financial expenses of $ 505, which were fully amortized over the life period of the convertible debentures. This transaction was accounted for according to APB 14. The fair value of these warrants was
determined using the Black-Scholes pricing model, assuming a risk free interest rate of 5.75%, a volatility factor of 0.5, dividend yields of 0% and an expected life of six months.



|2. |  | Warrants issued to financial institutions:
|-- |  | ------------------------------------------



| | a) |  | In connection with a credit line from Bank Hapoalim, in March 1999, the Company issued a warrant to purchase Ordinary Shares of the Company having an aggregate market value at the
date of exercise of $1,250 in exchange for $1,000 in cash to a subsidiary of Bank Hapoalim. The warrant contained a cashless exercise feature. The fair value of the warrant was approximately $250, which has been accounted for as a cost of the line
of credit and was amortized ratably over a one year period. The Company recorded $198 in 1999 and $52 in 2000 as compensation expenses and included these amounts in financial expenses (see Note 14). Upon the IPO, the warrants were exercised into
9,240 Ordinary Shares, by way of cashless exercise.
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | In connection with an additional credit line received in January 2000, the Company issued to a subsidiary of Bank Hapoalim, a warrant to purchase additional 6,957 Ordinary Shares of
the Company against payment of $400. The warrants contained a cashless exercise feature and were exercised into 1,957 Ordinary Shares upon the IPO.
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The Company recorded a compensation of approximately $202, which was amortized ratably over a period of one year and
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 5.75%, a volatility factor of 0.5, dividend yield of 0% and an expected life of the warrant of
one year.



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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)



| | c) |  | 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 aggregated exercise price of $300. This warrant may be exercised during a period of two years from the date of grant.
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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 an expected life of the warrants of two years (see also Note 16).





|3. |  | Warrants issued to customers:
|-- |  | -----------------------------



In 2000, the Company issued warrants to various customers to purchase 21,485 Ordinary Shares at exercise prices ranging from $25.70 to $110 per share with
a weighted average exercise price of $85.90. These warrants have expiration dates ranging from two to three years from the execution date of each customers respective software license agreement. The estimated aggregate fair value of the
warrants, based on the fair value of each of the warrants on their respective grant date, was $449. The fair value of each of these warrants was determined using the Black-Scholes pricing model, assuming a risk free interest rate of 5.75%, a
volatility factor ranging from 0.5 to 0.84, dividend yields of 0% and an expected life of two to three years. The Company deducted the fair value of these warrants from software revenues over the period such revenue was recognized.



These transactions were accounted for according to EITF 96-18:
Accounting for equity instruments that are issued to other than employees for acquiring or in conjunction with selling goods or services.



|4. |  | Warrants to third party and to related party:
|-- |  | ---------------------------------------------



| | a) |  | During 2000, the Company granted to a third party, in respect with marketing services, a warrant to purchase 4,760 Ordinary Shares at an exercise price ranging from $25.70 to $120.
The Company accounted its warrant under the fair value method of SFAS 123 and according to EITF 96-18. At the grant date, the fair value of the warrant was determined using the Black and Scholes pricing model assuming a risk free rate of 5.75%, a
volatility factor ranging from 0.5 to 0.84, dividend yield of 0% and an expected life of two to three years. In relation to the warrants, the Company recorded $119 as sales and marketing expenses.
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) |  | In February 2002, the Company granted to a related party in respect with marketing activities, a warrant to purchase 67,222 Ordinary Shares of the Company, at an exercise price of
$5.15 per share. The Company were accounted its warrant under the fair value method of SFA 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 an expected life of 3 years. In relation to the warrants, the Company recorded $136 as sales and marketing expenses.
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|d. |  | Convertible debentures:
|-- |  | -----------------------



In February and March 2000, the Company entered into convertible loan agreements with existing shareholders in the aggregate amount of approximately
$5,000. These convertible loans were then converted into convertible debentures in April 2000, as described below.



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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)



In April 2000, the Company entered into a convertible debenture agreement (agreement)
with additional investors in the aggregate amount of approximately $11,000. The debentures were denominated in dollars and bore annual interest at the rate of LIBOR plus 2%, payable quarterly, commencing in April 2001.



Upon the IPO, the debentures were automatically converted into 334,389
Ordinary Shares. This shares amount was calculated by dividing the principal amount of $16,600 and the unpaid accrued interest of $51 by the IPO price discounted by 40%.



Upon the IPO and in relation to the conversion, the Company recorded $16,000 of financial expenses in accordance with to
EITF 98-5 Accounting for Convertible Securities with Beneficial Conversion Features or Contingent Adjustable Conversion Ratios.



In respect to warrants issued to investors in the convertible debentures, see Note 11c1d.



|e. |  | 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.



Note 11:    TAXES ON INCOME



|a. |  | 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.



According to the provisions of the law, income derived from the February 1989 program during a period of seven years from the year in which it first earns
taxable income is subject to reduced corporate tax of 10%-25%, based on the percentage of foreign ownership.



According to the provisions of the law, the Company has elected for its other two investment programs the alternative system of benefits (the
waiver of 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.



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 2003 to 2012.



As the Company currently has no taxable income, the benefits from all these
programs have not been yet utilized.



The tax-exempt income
attributable to the Approved Enterprise can be distributed to shareholders without subjecting the Company to taxes only upon the complete liquidation of the Company. If the retained tax-exempt income is 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 (currently20%). 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, maintaining the development and



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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)



production nature of its facilities, and financing of at least 30% of the investment program by equity, it may be subject to corporate tax in Israel at the
regular corporation tax rate of 36% and may be required to refund the amount of the benefits, in whole or in part, including interest.



The law also grants entitlement to claim accelerated depreciation 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 regular rates (36%).



|b. |  | Tax benefits under the Law for the Encouragement of Industry (Taxes), 1969:
|-- |  | ---------------------------------------------------------------------------



The Company is an industrial company, as defined by this law and, as such, is entitled to certain tax benefits, mainly accelerated
depreciation of machinery and equipment, as prescribed by regulations published under the Inflationary Adjustments Law, and the right to claim public issuance expenses as a deduction for tax purposes.



|c. |  | Measurement of results for tax purposes under the Income Tax Law (Inflationary Adjustments), 1985:
|-- |  | --------------------------------------------------------------------------------------------------



Results for tax purposes are measured in real terms of earnings in NIS after certain adjustments for increases in the
Israeli Consumer Price Index (CPI). As explained in Note 2b, the financial statements are measured in U.S. dollars. The difference between the annual change in the CPI and in the NIS/dollar exchange rate causes a further difference between taxable
income and the pre-tax income presented in the financial statements. In accordance with paragraph 9(f) of SFAS No. 109, the Company has not provided deferred income taxes on the difference between the functional currency and the tax bases of assets
and liabilities.





|d. |  | On July 24, 2002, Amendment 132 to the Israeli Income Tax Ordinance (the Amendment) was approved by the Israeli parliament and came into effect on January 1, 2003. The
principal objectives of the Amendment were to broaden the categories of taxable income and to reduce the tax rates imposed on employees income.
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The material consequences of the Amendment applicable to the Company include, among other things, imposing tax upon all income of Israel residents,
individuals and corporations, regardless of the territorial source of income and certain modifications in the qualified taxation tracks of employee stock options.



|e. |  | Net operating losses carryforwards:
|-- |  | -----------------------------------



The Company has accumulated losses for tax purposes as of December 31, 2002, in the amount of approximately $17,500, which may be carried forward and
offset against taxable income in the future for an indefinite period.



Through December 31, 2002, ViryaNet UK had accumulated losses for income tax purposes of approximately $14,300, which can be carried forward and offset against taxable income in the future for an indefinite period.



Through December 31, 2002, ViryaNet Japan had accumulated losses for income
tax purposes of approximately $1,550, which can be carried forward and offset against taxable income for 10 years and expire from 2008 to 2012.



As of December 31, 2002, the U.S. subsidiary had U.S. federal net operating loss carryforwards for income tax purposes in the amount of approximately
$42,200. Net operating loss carryforwards arising in taxable years beginning before August 6, 1997 can be carried forward and offset against taxable income for 15 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)



and expiring between 2010 and 2012. Net operating loss carryforwards 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 2022.



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.



|f. |  | 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,              |        
|---------------------------------------------------- |  | ------------------------- | -------
|                                                     |  | 2001                      |        
|                                                     |  | U.S. dollars in thousands |        
|US net operating loss carryforwards                  |  | $                         | 12,962 
|UK net operating loss carryforwards                  |  |                           | 3,724  
|Japan net operating loss carryforwards               |  |                           | 362    
|Other reserve and allowances                         |  |                           | 443    
|                                                     |  |                           |        
|Total deferred tax assets before valuation allowance |  |                           | 17,491 
|Valuation allowance                                  |  |                           | (17,491
|                                                     |  |                           |        
|Net deferred tax assets                              |  | $                         |       
|                                                     |  |                           |        



ViryaNet UK, ViryaNet
US and ViryaNet Japan have provided valuation allowances on deferred tax assets resulting from tax loss carryforwards and other temporary differences, since they have a history of losses therefore. Management currently believes that it is more
likely than not that the deferred tax regarding the loss carryforwards 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.



|g. |  | Pre-tax loss:
|-- |  | -------------



|         |  | Year ended December 31,
|-------- |  | -----------------------
|         |  | 2000                   
|Domestic |  | $                      
|Foreign  |  |                        
|         |  |                        
|         |  | $                      
|         |  |                        



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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 13:    SEGMENTS, CUSTOMERS AND GEOGRAPHIC INFORMATION



|a. |  | Summary information about geographical areas:
|-- |  | ---------------------------------------------



The Company manages its business on a basis of one reportable segment (see Note 1a for a brief description of the Companys business) and follows the
requirements of SFAS No. 131 Disclosures About Segments of an Enterprise and Related Information.



The Company attributes revenues from external customers, on the basis of the location of the customer.



The following presents total revenues and long-lived assets for the years
ended December 31, 2000, 2001 and 2002:



|                       |  | Year ended December 31, 2000 |        | Year ended December 31, 2001 |   | Year ended December 31, 2002
|---------------------- |  | ---------------------------- | ------ | ---------------------------- | - | ----------------------------
|                       |  | Totalrevenues                |        | Long-livedassets             |   | Totalrevenues               
|United States          |  | $                            | 20,280 |                              | $ | 1,842                       
|Europe and Middle East |  |                              | 1,739  |                              |   | 1,015                       
|Far East               |  |                              | 5,088  |                              |   | 50                          
|                       |  |                              |        |                              |   |                             
|                       |  | $                            | 27,107 |                              | $ | 2,907                       
|                       |  |                              |        |                              |   |                             



|b. |  | Major customers data (percentage of total revenues):
|-- |  | ----------------------------------------------------



|           |  | Year ended December 31,
|---------- |  | -----------------------
|           |  | 2000                   
|           |  |                        
|Customer A |  |                       
|Customer B |  | 11                     
|Customer C |  | 4                      
|Customer D |  |                       
|Customer E |  |                       
|Customer F |  | 12                     



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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 14:    SELECTED STATEMENTS OF OPERATIONS DATA



Financial income (expenses), net:



|                                                            |  | Year ended December 31,   |    
|----------------------------------------------------------- |  | ------------------------- | ---
|                                                            |  | 2000                      |    
|                                                            |  | U.S. dollars in thousands |    
|Financial expenses:                                         |  |                           |    
|Interest                                                    |  | $                         | 221
|Other expenses                                              |  |                           | 66 
|Foreign currency translation differences                    |  |                           | 48 
|Stock-based compensation related to options toBank Hapoalim |  |                           | 254
|                                                            |  |                           |    
|                                                            |  |                           | 589
|                                                            |  |                           |    
|Financial income:                                           |  |                           |    
|Interest                                                    |  |                           | 541
|Other income                                                |  |                           | 74 
|Foreign currency translation differences                    |  |                           |   
|                                                            |  |                           |    
|                                                            |  |                           | 615
|                                                            |  |                           |    
|                                                            |  | $                         | 26 
|                                                            |  |                           |    



Note 15:    RELATED PARTY TRANSACTIONS



|a. |  | In June, 1999, the board of directors issued to its chairman 17,390 Series C-2 Preferred Shares, in consideration of $100,000, 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%. Following the filing of the previous Financial Statements of the Company for the year ended on December 31, 2001, the Company became aware that in accordance with the
signed loan agreement with the chairman, repayment of the loan was not due on June 30, 2002 (as set forth in the previous filings of the Company) but 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 payment of the loan and the interest thereon in the event that (i) its chairman becomes bankrupt or files a motion for bankruptcy, or (ii) its 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 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.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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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 16:    SUBSEQUENT EVENTS



During July 2003, Bank Hapoalim agreed to restructure a portion of the loan
by converting $2.4 million of the $3.45 million short-term loan into a long-term loan and deferring payment of $0.5 million under the short-term loan until August 15, 2003. The $2.4 million long-term loan is payable quarterly over a two year period
beginning on January 1, 2004, with interest payable quarterly at a rate to be determined beginning on October 21, 2003. The debt restructure is subject to several conditions, including the following conditions: (i) the Company shall be cash flow
positive on a quarterly basis, (ii) the Company shall deposit $800,000 into its account with Bank Hapoalim, (iii) the Company shall raise no less than $1 million of new capital by January 1, 2004, and, (iv) the Company will grant Bank Hapoalim
a warrant to purchase 40,000 Ordinary Shares of the Company at an exercise price of $1.00 per Ordinary Share and will reprice a prior warrant to purchase 60,000 Ordinary Shares of the Company to an exercise price of $1.00.



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F-33