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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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FORM 10-K



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

For the fiscal year ending September 30, 2001

OR

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

For the transition period from ____________ to ____________ .

Commission File Number 0-26825

N2H2, INC.

(Exact name of Registrant as specified in its charter)


|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Washington                                                     |  | 91-1686754                          
|(State or other jurisdiction of
incorporation or organization) |  | (I.R.S. Employer
Identification No.)

900 Fourth Avenue,
Suite 3600, Seattle, WA 98164
(Address of principal executive offices, including zip code)

Registrants Telephone Number, Including Area Code:
(206) 336-1501

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, Without Par Value

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. [X]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [   ]

As of December 4, 2001, the registrant had outstanding 22,066,114 shares
of common stock, no par value, and the aggregate market value of those shares
(based upon the closing price as reported by NASDAQ) held by non-affiliates was
approximately $8,826,446

Documents incorporated by reference:



|(1) |  | Portions of the registrants definitive 2002 Proxy Statement to be filed
with the Commission are incorporated by reference into Part III hereof.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------





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TABLE OF CONTENTS



|                                  |                                                                                               |                                                                      |  |  |  |  |  | 
|--------------------------------- | --------------------------------------------------------------------------------------------- | -------------------------------------------------------------------- |  |  |  |  |  | 
|PART I                           
|                                  | Item 1. General.                                                                             
|                                  | Item 2. Properties.                                                                          
|                                  | Item 3. Legal Proceedings.                                                                   
|                                  | Item 4. Submission of Matters to a Vote of Security Holders.                                 
|PART II                          
|                                  | Item 5. Market for Registrants Common Stock and Related Stockholder Matters.                
|                                  | Item 6. Selected Financial Data.                                                             
|                                  | Item 7. Managements Discussion and Analysis of Financial Condition and Result of Operations.
|                                  | Item 7A. Quantitative and Qualitative Disclosures About Market Risk.                         
|                                  | Item 8. Financial Statements and Supplementary Data.                                         
|REPORT OF INDEPENDENT ACCOUNTANTS
|                                  |                                                                                               | CONSOLIDATED BALANCE SHEETS                                         
|                                  |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS                               
|                                  |                                                                                               | CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY (DEFICIT)
|                                  |                                                                                               | CONSOLIDATED STATEMENTS OF CASH FLOWS                               
|                                  |                                                                                               | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                          
|PART III                         
|                                  | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
|                                  | Item 10. Directors and Executive Officers of the Registrant.                                 
|                                  | Item 11. Executive Compensation.                                                             
|                                  | Item 12. Security Ownership of Certain Beneficial Owners and Management.                     
|                                  | Item 13. Certain Relationships and Related Transactions.                                     
|PART IV                          
|                                  | Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.                    
|SIGNATURES                       
|EXHIBIT INDEX                    
|EXHIBIT 3.2                      
|EXHIBIT 10.26                    
|EXHIBIT 10.27                    
|EXHIBIT 10.28                    
|EXHIBIT 10.29                    
|EXHIBIT 23.1                     



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PART I




Item 1.General.

The following discussion in this annual report on Form 10-K contains
forward-looking statements regarding N2H2, Inc. and its subsidiaries (together,
N2H2), its business, prospects and results of operations that involve risks
and uncertainties. N2H2s actual results could differ materially from the
results that may be anticipated by such forward-looking statements and
discussed elsewhere herein. Factors that could cause or contribute to such
differences include, but are not limited to, those discussed herein as well as
those discussed under the captions risk factors and managements discussion
and analysis of financial condition and results of operations as well as those
discussed elsewhere throughout this annual report on Form 10-K.

Forward-looking statements typically are identified by the use of such
terms as may, will, expect, believe, anticipate, estimate, plan,
and similar words, although some forward-looking statements are expressed
differently. These forward-looking statements are qualified by the risks and
challenges posed by general economic conditions, increasing competition, hiring
and retaining experienced employees, achieving our growth objectives, and other
risks and uncertainties, including the uncertain economic and political
environment arising from the terrorist acts of September 11th and subsequent
terrorist activities.

Readers are cautioned not to place undue reliance on these forward-looking
statements, which speak only as of the date of this report. N2H2 undertakes no
obligation to revise any forward-looking statements in order to reflect on
events or circumstances that may subsequently arise. Readers are urged to
carefully review and consider the various disclosures made by N2H2 in this
report and in N2H2s other reports filed with the Securities and Exchange
Commission that attempt to advise interested parties of the risks and factors
that may affect N2H2s business, prospects and results of operations.

N2H2 is a leading provider of content filtering for the Internet. N2H2
creates hardware and software solutions that allow Internet users to filter 41
content categories thereby increasing productivity, reducing bandwidth
consumption, and limiting potential legal liability.

We market our products through our direct sales force, resellers and
service providers. This multiple-channel approach allows customers to select
the channel that addresses their specific needs and provides us with broad
coverage of worldwide markets.

Our strategy is to provide Internet management and content filtering
solutions to the education, enterprise, and consumer markets. N2H2 has three
product lines: a software plug-in filtering solution, a client-server hybrid
targeted at internet service providers (ISPs) and affinity groups, and a
legacy product in place, our proxy server-based filtering solution.

N2H2 was incorporated in Washington in June 13, 1995 and is headquartered
in Seattle. The mailing address for our headquarters is 900 Fourth Avenue,
Suite 3600, Seattle, Washington 98164, and our telephone number at that
location is 206-336-1501. We can also be reached at our website,
http://www.n2h2.com.

Filtering Solutions and Technology

N2H2 Internet Filtering  Our Software Plug-in Filtering Solution

The N2H2 software plug-in filtering solution harnesses N2H2s newest
filter engine technology to deliver fast Internet filtering at the server
level. Unlike N2H2s traditional proxy server model, this new solution is
customer-administered and not directly managed by N2H2, allowing network
administrators to implement and tune the solution to meet their specific
performance needs.

Our software plug-in solution targets the enterprise market, which is
comprised of corporate and government customers. N2H2 has developed
applications that reside on a customers server, behind or on the network
firewall. This service solution is designed to be downloadable from the
Internet and installed by the customer. N2H2s database of Internet content,
typically updated daily, is provided to the product via a secure pull method
that is designed to allow the customer the ability to download the database
without opening their firewall to external intrusion.

This solution has a user interface that allows the customer to tailor the
filtering profiles for their organization by selecting categories to block
from N2H2s extensive Internet category list. It also allows the customer to
generate log files of Internet usage by user name and group, rather than merely
log files of Internet usage by IP address, that can be stored on the server or
transferred to a separate server for secure and/or long-term storage. This
solution also has a standard reporting suite that provides system
administrators and managers with the ability to view Internet usage patterns of
their organization.

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The N2H2 Software plug-in Internet Filtering solution is available on
Microsoft Internet Security and Acceleration (ISA) Server 2000, Microsoft Proxy
II, Volera Excelerator (formerly Novell ICS), and Check Point Firewall-1, and
may be available on other enterprise grade hardware and operating systems
platforms in the event that N2H2 determines there is adequate demand in the
marketplace.

N2H2 Internet Filtering Manager  Our Client-based Filtering Solution

The N2H2 Internet Filtering Managers primary target audiences are ISPs
or affinity groups that serve home users and small businesses. This solution is
a PC-based layered service provider operation that communicates with our
filtering engine to determine if a site is blocked or allowed. If a site is
blocked, the browser is directed to a block page. The filtering engine resides
outside the users PC, for example, on the server at the users ISP. This
location allows for daily updates from the N2H2 database of Internet content
via push methods, which keeps the local database secure, current and
accurate.

The user interface design of this product can be easily modified via
separate resource files  facilitating co-branding and affording interested
customers the ability to extend their brands via this product.

To pass enhancements to customers, our software automatically performs a
daily check with an update server to see if a newer version is available. This
check occurs when the browser is launched and the filtering is on. If a more
current version of the client software is available, the user has the option to
download or postpone the download of the updates.

I2100, G2100, and I1100 Servers  Our Proxy-based Filtering Solution

Our on-site proxy servers are shipped to customers ready to install into
their networks. N2H2 proxy servers are a combination of readily available
computer hardware, including a high capacity hard drive and a high-speed
network connection, purchased from outside suppliers. We configure these
servers with software developed by us that enables the filtering functions. We
also monitor and maintain all the software and hardware components necessary to
meet our proxy-based filtering customers filtering needs remotely from our
Seattle network facility. Our proxy-based filtering solution has two main
components:



| |  |  | a proxy server infrastructure, and                  
| | - |  | ----------------------------------------------------
|
| |  |  | our advanced Internet content categorization system.

Proxy server infrastructure.Rather than installing a filter on every
workstation, as is necessary with client-based products, our proxy-based
filtering solution uses a proxy server that is usually installed on the
customers network. With this structure, every networked workstation uses our
filtering solution to access the Internet.

Proxy server-based systems are generally secure and difficult to bypass
because the proxy server is installed directly in the network, thus making it
virtually impossible for users to access the Internet without passing through
this server. From a customers point of view, a proxy-based system is
relatively easy and economical to operate because we manage it from a central
site. The parameters our clients use to control the filtering of their Internet
content are stored by the proxy server located on their networks and are based
on information received from our central database of categorized Web sites.
This information is updated and sent to our customers proxy servers daily. In
addition, we also send system upgrades and enhancements to our customers proxy
servers via the Internet. In most cases, we provide on-site proxy server
configuration to our clients; however, for smaller networks, we offer a
redirect service that enables multiple customers to share one regionally
located proxy server.

N2H2s operating infrastructure has been designed and implemented to
provide high system availability and to support remote management and
maintenance of thousands of servers handling millions of user requests per day.
Our filtering systems are individually designed and configured to support
unique and disparate customer network and performance requirements. This
scalability enables us to provide effective solutions to a wide range of
customers, from small organizations with less than 100 Internet users, all the
way up to statewide-managed networks.

N2H2 proxy servers are built by ISO9002 certified hardware vendors
utilizing industry standard hardware components easily obtained from commercial
sources. N2H2 proprietary filtering software can be deployed on a broad range
of platforms, including Microsoft, Sun, IBM, Linux, and Novell. Our standard
I2100 and I1100 filtering proxy servers run on the Linux operating system and
use custom-developed filtering proxy server software.

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During fiscal 2001, we introduced our new software-based filtering
solutions and we plan to eventually phase out the proxy server product line.
We will no longer promote the proxy server-based product to new customers.
N2H2 plans to continue support of our existing customers proxy-based filtering
installations, however, an effort will be made to migrate existing proxy-using
customers to one of our new software-based filtering solutions.

Advanced Internet Content Categorization System.The selectable filtering
criteria available to our clients are based on our listing of Internet content
categories. In our Web site categorization process, we employ a multi-step
procedure using automated search technology backed by human review to place
Internet content into 41 content categories. Automated search is used to scan
the Internet on a continuous basis to quickly identify Web sites that
potentially fit into these categories. We employ a wide variety of techniques
for this part of our automated categorization process including artificial
intelligence, keyword search, and site associations and linkages. Once a Web
site has been identified as fitting into one or more of our categories, it is
stored in a database and prioritized for human review. For details on
categories, see
http://www.n2h2.com/solutions/filtering_info/filter_categories.php

Our customers have the flexibility to select which of the categories they
wish to enable. Categorized sites are stored in a proprietary database located
at our headquarters. The contents of this database are continuously updated
using both human and automated review and reflect the introduction of new sites
on the Internet and changes to sites we previously categorized.

We maintain a log of Internet data retrieval requests and the workstations
that originated the request. This process does not provide us with information
about the identity of the individual originating the request. We will provide
third parties with log file information only if appropriate legal procedures
are followed.

Research and Development

N2H2s continued evolution of its software filtering solutions continues
to be driven in sync with the expansion of our strategic relationships and
enterprise market growth. We are leveraging our market leadership position in
the education marketplace, using our experience of filtering large-scale
networks within sensitive environments. We are currently developing our third
release for the Microsoft ISA Server 2000, an enterprise firewall and Web cache
server designed to help organizations protect, accelerate, and control their
network access. We are also currently developing additional products to run on
other major hardware platforms for release in 2002.

Fee Structure

We generate our revenues primarily from filtering subscriptions,
installation fees and maintenance fees charged for our filtering and Internet
management services, and historically, from advertising. Beginning in November
2000, N2H2 made a strategic move away from the Bess Partner Program, our
advertising-based revenue model in education. During 2001, we completed our
transition to a fee-only subscription basis. We will no longer have any
revenue from advertising.

Customers

N2H2 provides filtering services to a customer base that includes the
following:

Enterprise Market.Enterprise customers include corporations and
government agencies. These customers represent an increasing component of our
customer base. Enterprise customers generally are large organizations with 500
or more employees with complex networking needs, usually spanning multiple
locations and types of computer systems. As enterprise managers become
increasingly aware of liability issues related to employee Internet usage,
employee productivity issues, and bandwidth conservation, we believe the
enterprise market will present us with significant opportunities.
Small/medium-sized businesses have less than 500 employees and a need for
networks of their own, as well as connection to the Internet and to business
partners. Since small/medium-sized businesses generally have limited expertise,
we target services that are affordable and easy to install and use to these
customers.

ISP/Affinity Market.ISP/Affinity Group customers provide Internet
services to businesses and consumers. They include regional, national, and
international long distance telecommunications carriers, as well as Internet,
cable, and wireless service providers. Some of the ISPs may also serve as
resellers of our services to small businesses, schools and homes. We also
provide our core technology for filtering to affinity groups, who purchase our
filtering services for their own members.

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Education Market.Our school customers range from single schools to
statewide systems. N2H2 has one of the largest market share in the K-12 school
market, providing filtering to over 15 million students in 25,000 schools, from
small districts to large, statewide networks.

International.N2H2s strategic partnerships market to corporations,
consumers, and schools internationally. We provide filtering services to
customers in many countries including Canada, Australia, the United Kingdom,
Japan, Germany, Switzerland, Korea, Chile, and Mexico. We believe the demand in
the international market will continue to present us with significant
opportunities.

Sales and Marketing

Organization

N2H2 has achieved substantial market share within the education market
where we use primarily a direct sales force. We are continuing to establish
relationships with value-added resellers who sell into the enterprise sector as
we expand our reach into the enterprise and international markets. We have
senior sales representatives dedicated to developing sales in the enterprise
and international markets directly and indirectly through our partnerships with
major technology and marketing companies, as well as developing relationships
with key ISPs and affinity ISP groups.

Our worldwide direct sales and marketing organization has sales offices in
the United Kingdom and Australia. Currently, we have resellers in the
international arena and provide filtering services to interactive TV providers,
ISPs, and schools located in the United Kingdom, Australia, Switzerland, and
Latin America. N2H2 continues working with its partner, Nissho Electronics in
Japan, to extend and support infrastructure and technical implementation and
build Nisshos expertise in the filtering market.

Historically, our customer base has been predominately in the education
market, however, we intend to increase our customer base in the enterprise
market. In each of the past five fiscal years, no single customer has accounted
for 10 percent or more of our net sales.

Marketing

Promotional emphasis has shifted from the education to the enterprise
market. As new products are developed, we expect to launch and promote them
using a variety of tactics, including:



| |  |  | Direct Marketing.Traditional direct mail and e-mail messages will be
targeted at qualified sales prospects.                                                                                                                                                                                               
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Online Marketing.Our Web site, www.n2h2.com, is used to provide
sales prospects with relevant product information and downloadable demo
versions of filtering products. By maximizing the self-service sales
potential of the web, we intend to lower our overall cost of sales.                          
|
| |  |  | Public Relations.We retain the services of public relations firms
with the objective of securing favorable product reviews and general
commentary.                                                                                                                                                        
|
| |  |  | Trade Shows.Carefully selected industry events have proven effective
in building awareness and in generating sales leads. We are frequently
able to optimize our investment in event participation by attending
shows in conjunction with our partnering organizations, such as
Microsoft and Check Point.
|
| |  |  | Advertising.Limited print and online advertising are used to target
market niches and to complement the overall marketing strategy.                                                                                                                                                                       

Strategic Alliances

We pursue strategic alliances with industry leaders in areas where
collaboration can produce industry advancement and acceleration of new markets.
Our objectives and goals for strategic alliances can include one or more of the
following: technology exchange, product development, joint sales and marketing,
and new-market creation. This year we expanded or entered into alliances with
Microsoft, Dell, Check Point, and Cisco, among others.

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Customer Service and Support

Our network operations center, or NOC, provides post-installation support
to customers in the following areas: monitoring, repair and trouble tracking,
N2H2-owned equipment maintenance and/or replacement, data collection and
analysis, service changes, and general technical support and customer service.
In addition to these services, we provide contracted network design and
configuration consulting services at our then-current rates. The NOC is staffed
Monday through Friday 5am  5pm PST by skilled representatives available and
trained in network diagnostics, server diagnostics, general system engineering,
N2H2 software and hardware, TCP/IP, and remote circuit management.

Competition

We face five major competitors in the server-based Internet filtering
industry, along with a number of smaller competitors. Our major competitors and
their respective products are Surf Control  SuperScout, CyberPatrol, Websense,
Elron Software  Internet Manager, Symantec  I-Gear, and Secure Computing -
SmartFilter. We have one of the largest market shares in the education market,
but we have a smaller market share than each of these competitors in the
enterprise market. We have focused on establishing market share in the
education market before entering the enterprise market, and we are only now
moving to implement what we believe is the necessary business model for success
in the enterprise market: selling software subscription service on multiple
widely accepted platforms.

Intellectual Property

Intellectual property is critical to our success, and we rely upon
trademark, copyright and trade secret laws in the United States and other
jurisdictions to protect our proprietary technology and brands. N2H2, BESS and
SEARCHOPOLIS are U.S. registered service marks. We have also applied in the
U.S. to register the N2H2 and BESS logos, and DELIVERING THE WEB YOU WANT, and
have filed foreign applications for many of these marks. These applications may
not be granted. In addition, any of our marks may be challenged by others or
invalidated through administrative process or litigation. None of our
technology is patented. We rely on United States trade secret and copyright law
to protect our proprietary search technology. We own and operate the servers
that provide our proxy-based filtering services. We protect our proprietary
rights through the use of intellectual property agreements with employees and
consultants, which cover confidentiality, nondisclosure, and assignment of
invention matters. Some of our former employees and consultants who may have
had access to our proprietary information have not entered into these
intellectual property agreements, although we believe that all intellectual
property that is material to our business is covered by signed agreements. If
we are incorrect in this assessment, our business could be seriously harmed.

Trademark, copyright, and trade secret protection may not be available to
us in every country in which our services are available. The laws of some
foreign countries may not be as protective of intellectual property rights as
United States laws, and mechanisms for enforcement of intellectual property
rights may be inadequate. Despite our efforts to protect our proprietary
rights, unauthorized parties may attempt to obtain, copy, and use our
proprietary technology.

Regulatory and Legislative Issues

As use of the Internet has become more prevalent and various negative
issues associated with the Internet have received increasing amounts of
publicity, there has been a correspondingly greater amount of governmental
attention directed to the Internet in the United States Congress and elsewhere.
While various pieces of legislation regulating different aspects of the
Internet and Internet-related activity have been proposed, to date there has
been no legislation enacted which places any direct and substantial regulatory
burden on N2H2. Nonetheless, we anticipate further attempts to regulate
Internet-related activity, some of which may impose substantial burdens on our
ability to do business.

There has been a public-policy debate regarding Internet filtering in
schools and libraries within the U.S. Congress. This debate has resulted in the
Childrens Internet Protection Act, a bill passed and signed into law mandating
Internet filtering in schools and libraries receiving certain federal funds,
among other requirements. It should be noted, however, that a suit has been
filed in the United States District Court by the American Library Association
et. al. and by Multnomah County Public Library seeking to overturn the
Childrens Internet Protection Act. If the suit is successful, some of our
current customers may decide to not provide filtering in their organizations,
which in turn, could lead them to not renew contracts with N2H2 and thereby
harming an important source of revenue.

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We have never been party to a lawsuit regarding users acquiring
inappropriate content through our system. Management believes this is unlikely
in the future, partly because of the protections provided under Section 509 of
the Telecommunications Act of 1996 for organizations that provide filtering
tools or employ them. Our customer contracts do not provide for a guaranteed
level of filtering performance, and we do not intend to offer guarantees in the
future.

The U.S. Copyright Office issued a final rule interpreting the provisions
of the Digital Millennium Copyright Act, or DMCA, that prohibits the
circumvention of technological copyright protection mechanisms. The final rule
took effect on October 28, 2000, and created an exemption to the DMCA
anti-circumvention provisions for compilations consisting of lists of Web sites
blocked by filtering software applications. The consequence of the final rule
is that lists of Web sites blocked by filtering software do not receive extra
protection under the DMCA, and technological measures used to prevent access to
such lists may be circumvented without violating the new anti-circumvention
provisions Copyright Act.

N2H2 considers its lists of blocked Web sites to be proprietary, valuable
information. However, N2H2 does not believe that the final rule will affect the
value of its lists of blocked Web sites. N2H2 regards its lists as trade
secrets and protects their confidentiality primarily through physical security
controls and contractual non-disclosure provisions. The final rule simply
exempts lists of blocked Web sites from the new copyright law protections
available under the DMCA, so that the level of copyright law protection
available for such lists is the same as it was before the DMCA was enacted in
1998.

Employees

As of September 30, 2001, we employed 110 full time equivalent staff
worldwide. As necessary, we supplement our regular employees with temporary
and contract personnel. N2H2 has no collective bargaining agreements and
employee relations are good.

Risk Factors

You should carefully consider the following risk factors and all other
information contained in this Form 10-K before making an investment decision
regarding our common stock. Investing in our common stock involves a high
degree of risk. The risks described below are not the only ones that we may
face. Additional risks that are not yet identified or that we currently think
are immaterial may materially adversely affect our business and financial
condition in the future. Any of the following risks could seriously harm our
business, financial condition, and operating results and could result in a
complete loss of your investment.

Our Stock May Be Delisted from NASDAQ.

At the time of this filing, our stock price has closed below $1.00 for
more than 90 consecutive business days. A minimum bid price of $1.00 is
required for continued listing on the Nasdaq National Market System. After the
events of September 11, 2001, the Nasdaq placed a moratorium on the $1.00
listing requirement, and N2H2s delisting hearing was dropped. The moratorium
lasts until January 1, 2002. At that time, Nasdaq will begin again the process
of enforcement of its listing requirements. If at any time after January 1,
2002 N2H2s common stock bid price falls below $1.00 per share for a period of
thirty consecutive business days, Nasdaq has the right to delist the stock if
within ninety days thereafter the bid price for the stock is not at least $1.00
per share for a minimum of ten consecutive business days. In the event our
stock price does not rise above $1.00 for the required ten consecutive business
days, we would have the right to request a hearing to appeal a determination
that our stock should be delisted. There is no guarantee that we would prevail
in such a hearing.

In addition, as of September 30, 2001, N2H2 has $3.2 million in net
tangible assets, which is less than the Nasdaq requirement of $4 million. If
N2H2 fails to raise its net tangible assets to the required $4 million, Nasdaq
has the right to delist the stock or require N2H2 to move its stock to the
Nasdaq SmallCap Market System which has a net tangible asset requirement of $2
million. Both the Nasdaq National Market System and the Nasdaq SmallCap Market
System, have a $1.00 minimum bid price requirement and they have the same
appeal process.

If our stock were delisted, the delisting would most likely have a
material adverse affect on the price of our common stock, would adversely
affect the liquidity of the shares held by our shareholders, and would severely
restrict any ability we may have to raise additional capital.

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We Have a History of Losses and Our Future Operating Results Are Uncertain.

We have incurred net losses in each quarter since we incorporated in 1995.
We incurred net losses of $881,000 for 1997, $2.6 million for 1998, $7.7
million for 1999, $39.3 million for 2000, and $35.5 million for 2001. We
anticipate that we will incur a net loss in fiscal 2002. Operating expenses
will continue to consume a significant amount of our cash resources, although
at a reduced level (see Liquidity and Capital Resources within Managements
Discussion and Analysis). Operating expenses in 2002 and beyond will include:



| |  |  | sales and marketing costs,                  
| | - |  | --------------------------------------------
|
| |  |  | research and development costs,             
|
| |  |  | general and administrative costs; and       
|
| |  |  | our customer support and service operations.

We will need to significantly increase our revenues to achieve and
maintain profitability. Although our revenues have grown in recent quarters, we
may not be able to continue this growth or achieve or maintain profitability.
We may also fail to accurately estimate and assess increased operating expense
requirements as we grow. If we fail to achieve and maintain profitability, our
future capital raising efforts and planned growth of our business would be
seriously harmed.

We May Need Additional Capital And May Be Unable To Raise It On Acceptable
Terms.

We may experience additional material decrease in liquidity due to
increased operating expenses, unforeseen capital requirements or other events
and uncertainties. After that, we may need to raise additional funds, and
additional financing may not be available on favorable terms, if at all.
Further, if we issue additional equity securities, shareholders may experience
significant dilution, and the new equity securities may have rights,
preferences or privileges senior to those of existing holders of our common
stock. If we cannot raise funds on acceptable terms, we may not be able to
develop or enhance our services, take advantage of future opportunities or
respond to competitive pressures or unanticipated requirements. This may
seriously harm our business and results of operations.

We have Discontinued Free Filtering for Schools, and Our Future Replacement of
Lost Advertising Revenue Is Uncertain.

During 2001, we terminated the advertising-based filtering structure
previously offered to schools. Furthermore, education customers were parties
along with us to contracts which may not allow unilateral termination by either
party. As a result, any unilateral termination by us of these contracts may
give rise to liabilities associated with breach of contract claims. As of
November 30, 2001, no breach of contract claims has been made against us.

Our Quarterly Financial Results Fluctuate and May Be Affected by Seasonal
Variations.

Our quarterly operating results have fluctuated significantly in the past
and will continue to fluctuate in the future. Operating results vary depending
on a number of factors, many of which are outside our control, including:



| |  |  | it is difficult to project the rate of market acceptance of new
product introductions,                                                                                                     
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | quarterly cash flows from subscription payments are difficult to
forecast because the sales cycle, from initial evaluation to delivery of
services, varies substantially between customers,
|
| |  |  | our educational customers typically budget and purchase goods and
services on a fiscal school year basis beginning in August of each year.                                                 

Due to the combination of these and other factors, quarter to quarter
comparisons of operating results are not necessarily meaningful or indicative
of future performance. Further, it is possible that in some future quarter or
quarters our operating results will not meet or exceed the expectations of
public market analysts or investors. If that happens, or if adverse conditions
prevail or are perceived to prevail, either for our business or the market
generally, the market price of our common stock could be seriously harmed.

8



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Our Success Depends on Continued Market Acceptance and Operation of Our
Internet Filtering Services.

If we are unable to continue to solve our customers Internet content
filtering problems, we will experience diminished revenues and the growth of
our business will be impaired. We currently receive, and expect to continue to
receive, a substantial portion of our revenues from our Internet filtering
services or products. Our future financial performance will depend, in part,
upon the successful development, introduction, and customer acceptance of new
and enhanced versions of our Internet filtering services or products. We cannot
assure you that we will be successful in upgrading and continuing to sell our
Internet filtering services and products or that any new products or services
that we may develop or acquire will achieve market acceptance. Any failure to
upgrade our services or products or to maintain our market acceptance could
seriously harm our business, financial condition, and results of operations.

We May Fail to Filter All Potentially Objectionable Content.

We may not succeed in sufficiently filtering Internet content to meet our
customers expectations. We rely upon a combination of automated filtering
technology and human review to categorize Web site content through our
filtering services and products. The total number of Web sites and partial Web
sites is growing rapidly. A partial Web site is a graphic image, text or other
visual appearing as a part of a full Webscreen display. We rely upon our staff
of reviewers to place Internet content into our 41 content categories. We
cannot assure our customers that our filtering technologies will successfully
block all potentially objectionable Internet content. Our categorized database
also may not contain substantially all of the material available on the
Internet fitting into any one of our content categories. In addition, our
customers may not agree with our categorization determinations. Our failure to
effectively categorize and filter Internet content according to our customers
expectations could generate negative publicity which would impair the growth of
our business and our efforts to increase brand awareness.

Our Ability to Manage Growth Is Unproven.

Potential growth is likely to place a significant strain on our
managerial, operational, financial, and other resources. Our future success
will depend, in part, upon the ability of our senior management to manage
growth effectively.

We May Fail to Compete Successfully With Other Providers of Internet Filtering
Services.

The market for our services and products is intensely competitive and
rapidly changing. Many of our competitors are larger and have substantially
greater resources than us. Our primary competition comes from Pure Artificial
Intelligence (AI), Universal Resource Locator, and packet filtering software
applications. Although we believe our products provide a better quality
filtering service, some of our competitors products are significantly less
expensive than our filtering services. In addition, our competitors products
and services may achieve greater market acceptance than ours.

Although we believe the Internet provides opportunities for more than one
provider of content filtering products similar to ours, one or more of our
competitors may eventually dominate the sector.

Increased competition could result in price reductions, reduced
profitability, or loss of market share, any of which would seriously harm our
business, financial condition, and results of operations.

We Will Need to Establish and Maintain Reseller Networks to Sell into the
Corporate and Government Market.

During 2001, N2H2 significantly reduced its direct sales staff as it began
to develop its reseller channel for selling products and services into the
enterprise markets. In order to establish market share in the enterprise
markets and increase revenue significantly in 2002, N2H2 will need to
substantially increase the number of resellers that can sell its services and
products. If N2H2 fails to sufficiently build this channel, our business,
financial condition, and results of operations will be seriously harmed through
decreased growth opportunities.

Even if we are able to recruit the number of resellers we require, these
firms may fail to effectively promote our services or products, in which case
our business, financial condition, and results of operations would be seriously
harmed through decreased growth opportunities.

9



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We Will Need to Establish and Maintain Strategic Relationships.

We pursue strategic alliances with other industry leaders in areas where
collaboration can produce industry advancement and acceleration of new markets.
The objectives and goals for a strategic alliance can include one or more of
the following: technology exchange, product development, joint sales and
marketing, and new market creation. This year, we expanded or entered into
alliances with Microsoft, Dell, Check Point and Cisco, among others. We depend
on strategic relationships to offer services and products to a larger customer
base than can be reached through our direct sales efforts. We cannot assure
you that we will be able to maintain and expand our strategic relationships or
enter into new strategic relationships or that these new relationships will be
on commercially reasonable terms.

If we are unable to maintain and expand our existing strategic
relationships or enter into new strategic relationships, we will need to use
substantially more resources to develop, distribute, sell, and market our
services and products than planned. We would also lose the customer
introductions and co-marketing benefits that we anticipate from such strategic
relationships. Our success will depend both on the success of the other parties
to these relationships and on their ability to market our services and products
successfully. Most of these companies have multiple strategic relationships,
and we cannot assure you that they will regard their relationships with us as
significant for their own businesses. If any of these firms fail to effectively
promote our services or products, our business, financial condition, and
results of operations would be seriously harmed through decreased growth
opportunities.

Our Success Depends on Our Ability to Attract and Retain Qualified and
Experienced Employees.

We face a significant risk from a loss of any member of our senior
management team or any key employee, particularly if they join or form a
competitor. These risks relate mainly to:



| |  |  | the loss of such individuals skills and talent,                                                       
| | - |  | -------------------------------------------------------------------------------------------------------
|
| |  |  | the resulting loss of existing or potential customers, or                                              
|
| |  |  | the unauthorized disclosure or use of our technical knowledge, practices, procedures or customer lists.

Loss of a key employee could seriously harm our business, financial
condition, and results of operations. We cannot assure you that in such an
event we would be able to recruit personnel to replace our senior management in
a timely manner and on acceptable terms.

We expect there will continue to be competition for experienced
engineering, sales, and consulting personnel, particularly in the Internet
market. Many of the companies we compete against for experienced personnel have
greater resources than us. We cannot assure you that we will be successful in
attracting and retaining qualified personnel. As a result, our growth could be
limited due to our lack of capacity to provide our services. We could also
experience deterioration in service levels or decreased customer satisfaction.
Either of these occurrences could seriously harm our business, financial
condition, and results of operations through increased costs of doing business
and decreased demand for our services.

Expanding Our International Operations Exposes us to a Number of Risks.

We currently have very limited international operations. As a key
component of our business strategy, we intend to continue to try and increase
our international sales. For that purpose we hired a European operations
director in June 1999, created N2H2 Limited (a wholly owned subsidiary formed
under the laws of the United Kingdom) in August 1999, and acquired N2H2 Pty
Limited (formerly Iseek Pty Limited, a company formed under the laws of
Australia) in February 2000. Our ability to expand our international operations
is subject to a number of risks, including:



| |  |  | our ability to customize services for local markets and foreign languages,                                               
| | - |  | -------------------------------------------------------------------------------------------------------------------------
|
| |  |  | laws and business practices favoring local competitors,                                                                  
|
| |  |  | our dependence on local staff and vendors,                                                                               
|
| |  |  | compliance with multiple, conflicting and changing governmental laws and regulations, including tax laws and regulations,

10



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| |  |  | longer sales cycles,                                                    
| | - |  | ------------------------------------------------------------------------
|
| |  |  | possible delays or greater difficulty in accounts receivable collection,
|
| |  |  | import and export restrictions and tariffs, and                         
|
| |  |  | uncertainties regarding transactions in foreign currencies.             

If we are unable to successfully manage the risks associated with our
international operations, our international sales growth will be limited and
our results of operations will be seriously harmed. Currently, we do not engage
in or intend to engage in hedging.

Our Services May Have Limited Interoperability and May Not Keep Pace With Rapid
Technological Changes.

We may fail to develop filtering services compatible with future operating
systems, and we may not keep pace with technological advances. Our Internet
services are designed to operate with a variety of hardware and software used
by our customers. Our school customers may use older operating systems,
however, requiring us to maintain multiple service platforms at increased cost
to us. In addition, we must continuously modify and enhance our services to
keep pace with changes in hardware, software, communication, browser and
database technology. Uncertainties about the timing and nature of vendors new
product announcements or their introduction or modification of operating
systems would require increased research and development expenses. The failure
of our services to operate effectively across existing and future versions of
hardware and software used by customers would limit or reduce the market for
our services, result in customer dissatisfaction and seriously harm our
business, financial condition and results of operations.

We Have Limited Protection of Our Intellectual Property and Proprietary
Technology.

We may fail to adequately protect our intellectual property and
proprietary technology. Intellectual property is critical to our success, and
we rely upon trademark, copyright and trade secret laws in the United States
and other jurisdictions to protect our proprietary technology and brands. N2H2,
BESS and SEARCHOPOLIS are U.S. registered service marks. We have also applied
in the U.S. to register the N2H2 and Bess logos, and DELIVERING THE WEB YOU
WANT, and have filed foreign applications for many of these marks. These
trademark applications may not be granted. In addition, any of our trademarks
may be challenged by others or invalidated through administrative process or
litigation. None of our technology is patented. Our proprietary search
technology is protected by United States trade secret and copyright laws. We
own and operate the servers that provide our filtering services. We protect our
proprietary rights through the use of intellectual property agreements with
employees and consultants covering confidentiality, nondisclosure, and
assignment of invention matters. Some of our former employees and consultants
who may have had access to our proprietary information have not entered into
these intellectual property agreements, although we believe that all
intellectual property that is material to our business is covered by signed
agreements. If we are wrong in this assessment, former employees could use our
proprietary technology without our having an effective remedy, and our business
would be seriously harmed.

We Are Subject to Risks of Infringement.

Trademark, copyright and trade secret protection may not be available to
us in every country in which our services are available. The laws of some
foreign countries may not be as protective of intellectual property rights as
United States laws, and mechanisms for enforcement of intellectual property
rights may be inadequate. Despite our efforts to protect our proprietary
rights, unauthorized parties may obtain, copy and use our proprietary
technology. We expect that it will become more difficult to monitor use of our
services as we increase our international presence. We cannot assure you that
our means of protecting our proprietary technology and brands will be adequate
or that our competitors will not independently develop similar technology.

Many of Our Products Are Dependent on Third-Party Software or Hardware.

Many of our products are dependent on third-party software or hardware
providers, including our products that run on Microsoft ISA, Microsoft Proxy
II, Volera Excelerator (formerly Novell ICS), and Check Point. If any of these
companies (i) cancel their product, (ii) change the design of their product
such that it becomes incompatible with our products, or (iii) delay the launch
of their product, it may have a negative impact on our business, financial
condition and results of operations.

We May Become Involved in Intellectual
Property Disputes and cannot Predict the Likelihood or Impact of an Unfavorable
Outcome.

We expect that as competition in the market for Internet filtering
increases and as the number of patents continues to increase, the potential for
intellectual property claims against us may also increase. Prolonged litigation
against us concerning alleged infringement

11



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##### Table of Contents



would likely result in significant expense to us and divert the efforts of
our management and development personnel, even if we are successful in that
litigation. In the event of an adverse result, we could be required to do one
or more of the following:



| |  |  | pay substantial damages, including treble damages,                                                          
| | - |  | ------------------------------------------------------------------------------------------------------------
|
| |  |  | permanently cease use of any infringing technology,                                                         
|
| |  |  | obtain a license for the technology or expend significant resources to develop noninfringing technology, and
|
| |  |  | attempt to redesign our filtering services to avoid the infringement or to develop noninfringing technology.

Any limitation on our ability to market our services or products or any
incurrence of substantial costs and delays associated with redesigning our
services or products would seriously harm our business, financial condition,
and results of operations.

Our Services Create Risks of Potential Negative Publicity and Legal Liability.

Because customers rely on our services for providing a content safe
Internet environment, any significant defects or errors in our services or
products may result in negative publicity or legal claims. This negative
publicity or any such legal claims could seriously harm our business, financial
condition and results of operations. In addition, our ability to maintain a log
of Internet data retrieval requests and the workstations from which they
originated may result in negative publicity or claims based on potential
privacy violations. Although our agreements with customers typically contain
provisions designed to limit our exposure to potential legal liability, these
limitation of liability provisions may not be completely effective. We have not
experienced any liability claims to date, but we cannot assure you that we will
not face this type of claim in the future. We maintain errors and omissions
insurance, but we cannot assure you that this insurance coverage will
adequately cover us for any claims.

Our Systems May Be Vulnerable to Security Risks or Service Disruptions That
Could Harm Our Business.

Our servers are vulnerable to physical or electronic break-ins and service
disruptions, which could lead to interruptions, delays, loss of data or the
inability to process user requests. Such events could be very expensive to
remedy and could damage our reputation, discouraging existing and potential
customers from using our services. In the past we have experienced unsuccessful
attempts at electronic break-ins but we may experience break-ins in the future.
Any such events could substantially harm our business, financial condition, and
results of operations.

In November 2001, we entered into an Internet hosting agreement with a
third party hosting provider, which will maintain some of our servers through
November 2002, with automatic one year renewals. Our operations depend on their
ability to protect our systems against damage from fire, earthquake, power
loss, flood, telecommunications failures, vandalism and other malicious acts,
and similar unexpected adverse events. Any major disruption in our services
could diminish revenues, decrease customer and user confidence in our services
and/or stunt the growth of our business.

The Domestic and International Economies are Uncertain.

The events of September 11, 2001, additional threatened terrorist acts,
and the ongoing military action have created uncertainties in the domestic and
international economies in general. These events, and potential future
terrorist acts, may result in reduced demand from our clients for our services
and products and may potentially have a material adverse effect on our
business, financial condition and operating results.

We May Not Be Able to Distribute Our Services Abroad Due to United States
Export Laws.

The encryption technology contained in our services and products is
subject to United States export controls. Such export controls limit our
ability to distribute certain encrypted services and products outside of the
United States. While we take precautions against unlawful exportation, such
exportation inadvertently may have occurred in the past or may occur from time
to time in the future, subjecting us to potential liability. Future legislation
or regulation may further limit the encryption technology that we can include
in our services and products. In addition, foreign governments have import and
domestic use laws and regulations that restrict the types of permitted
encryption software distributed in their countries. Such regulations could
alter the design, production, distribution, and use of our services and
products.

12



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The Future Role of the Internet in Education Is Uncertain.

The success of our services and products in the education market will
depend, in large part, on the continued broad use and acceptance of the
Internet as a source of information. Schools, teachers and parents may cease to
consider the Internet a viable research tool due to concerns over the potential
exposure of students to unsuitable material, even with filtering services such
as ours, or because of inadequate development of telecommunications and
networking systems. The Internet could lose its viability due to delays in the
development or adoption of new standards and protocols to handle increased
levels of Internet activity or due to increased governmental regulation.
Cutbacks in technology funding could also limit use of the Internet in schools.
If the necessary Internet infrastructure and complementary products are not
developed on a timely basis, or if school use of the Internet experiences a
significant decline, we may not be successful in growing our business and our
financial condition and results of operations would be seriously harmed.

Government Regulation and Legal Uncertainties Could Add Additional Costs to
Doing Business on the Internet.

Currently, few laws or regulations specifically govern communications or
commerce on the Internet. In the future, laws and regulations may be adopted
regarding user privacy, pricing, and the characteristics and quality of
products and services. For example, the Telecommunications Act of 1996 sought
to prohibit transmitting various types of information and content over the
Internet. Several telecommunications companies have petitioned the Federal
Communications Commission to regulate Internet service providers and online
service providers in a manner similar to long distance telephone carriers and
to impose access fees on those companies. This could increase the cost of
transmitting data over the Internet.

We May Be Sued for Information Retrieved from the Web.

We may be subject to claims relating to information available on our Web
site. These types of claims have been brought, sometimes successfully, against
online services. We could also be subject to claims based upon the content that
is accessible from our Web sites through links to other Web sites or through
content and materials that may be posted by members in chat rooms or bulletin
boards. Our general commercial liability insurance may not adequately protect
us against these types of potential claims.

Our Stock Price Will Be Volatile.

The market price of our common stock has been and is likely to continue to
be highly volatile and could be subject to wide fluctuations in response to:



| |  |  | quarterly variations in operating results,                                                      
| | - |  | ------------------------------------------------------------------------------------------------
|
| |  |  | announcements of technological innovations or new services or products by us or our competitors,
|
| |  |  | changes in financial estimates by securities analysts,                                          
|
| |  |  | our failure to meet or exceed analyst estimates, and                                            
|
| |  |  | other events or factors, many of which are beyond our control.                                  

In addition, the stock market has experienced significant price and volume
fluctuations that have particularly affected the market prices of equity
securities of many Internet companies and that often have been unrelated or
disproportionate to the operating performance of these companies. A number of
publicly traded technology companies have current market prices below their
initial public offering price. Market fluctuations such as these may seriously
harm the market price of our common stock. In the past, following periods of
volatility in the marketplace for a companys securities, securities class
action litigation often has been instituted. We would incur substantial costs
and a diversion of management attention and resources resulting from such
litigation, which would seriously harm our business, financial condition, and
results of operations.

Our Officers, Directors and Significant Shareholders Have Voting Control.

As of September 30, 2001, 43% of our outstanding common stock was
beneficially owned by our directors, executive officers and persons or groups
that we know who own more than 5% of our common stock, assuming no exercise of
outstanding warrants or stock

13



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##### Table of Contents



options. These shareholders, if acting together, are able to control
substantially all matters requiring approval by our shareholders, including the
election of all directors and approval of significant corporate transactions.

We Have Implemented Anti-Takeover Provisions.

Some provisions of our Restated Articles of Incorporation and Amended
Bylaws, as well as provisions of Washington law, make it more difficult for a
third party to acquire us, even if doing so would be beneficial to our
shareholders.

We Do Not Intend to Pay Dividends.

We have never declared or paid any cash dividends on our common stock. We
currently intend to retain any future earnings for funding growth and,
therefore, do not expect to pay any dividends in the foreseeable future.




Item 2.Properties.

Our principal place of business is located in Seattle, Washington where,
as of September 30, 2001, we lease approximately 38,724 square feet of office
space, of which 7,530 square feet has been subleased to a third party. Our
principal lease expires on August 31, 2005. Our subsidiary office in the United
Kingdom is located in a facility under lease expiring in April 30, 2003. We
believe that these facilities are adequate to meet our current needs and that
suitable additional or alternative space will be available as needed in the
future on commercially reasonable terms. See Note 9 of Notes to Consolidated
Financial Statements.




Item 3.Legal Proceedings.

At this time, there are no material pending legal proceedings.




Item 4.Submission of Matters to a Vote of Security Holders.

No matters were submitted to a vote of security holders during the fourth
quarter ended September 30, 2001.

14



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PART II




Item 5.Market for Registrants Common Stock and Related Stockholder Matters.

Our Common Stock is traded on the Nasdaq National Market under the symbol
NTWO. The following table sets forth the high and low closing prices as
reported by Nasdaq for our Common Stock since the initial public offering for
the quarters ended as follows. Such quotations represent inter-dealer prices
without retail markup, markdown or commission and may not necessarily represent
actual transactions.

|            |                                                                   |  |      |        |     |  |  |        | 
|----------- | ----------------------------------------------------------------- |  | ---- | ------ | --- |  |  | ------ | 
|            |                                                                   |  | High |        | Low
|            |                                                                   |  |      |        |    
|Fiscal 2001 |                                                                   |  |      |        |     |  |  |       
|            | Fourth Quarter of 2001  July 1, 2001 through September 30, 2001  |  |      | 0.720  |     |  |  | 0.260  | 
|            | Third Quarter of 2001  April 1, 2000 through June 30, 2001       |  |      | 1.420  |     |  |  | 0.281  | 
|            | Second Quarter of 2001  January 1, 2001 through March 31, 2001   |  |      | 1.813  |     |  |  | 0.281  | 
|            | First Quarter of 2001  October 1, 2000 through December 31, 2000 |  |      | 2.560  |     |  |  | 0.250  | 
|Fiscal 2000 |                                                                   |  |      |        |     |  |  |       
|            | Fourth Quarter of 2000  July 1, 2000 through September 30, 2000  |  |      | 5.234  |     |  |  | 1.875  | 
|            | Third Quarter of 2000  April 1, 2000 through June 30, 2000       |  |      | 13.500 |     |  |  | 3.500  | 
|            | Second Quarter of 2000  January 1, 2000 through March 31, 2000   |  |      | 25.094 |     |  |  | 11.063 | 
|            | First Quarter of 2000  October 1, 1999 through December 31, 1999 |  |      | 33.125 |     |  |  | 7.875  | 

During the fiscal year of 2001, we continued to use proceeds from the
initial public offering dated July 30, 1999. To date, offering proceeds have
been used for working capital and other general corporate purposes.

The remaining net proceeds have been invested in cash equivalents and
short-term securities. The use of proceeds from the offering does not represent
a material change in the use of proceeds described in the prospectus included
as part of the Registration Statement.

As of October 15, 2001, there were approximately 186 registered holders of
our Common Stock which number does not include the number of shareholders whose
shares are held of record by a brokerage house or clearing agency but does
include such brokerage house or clearing agency as one record holder. We
believe that we have over 5,000 shareholders.

We have never declared or paid any cash dividends on our capital stock. We
currently intend to retain any future earnings to finance the growth and
development of our business and therefore do not anticipate paying any cash
dividends in the foreseeable future.




Item 6.Selected Financial Data.

The following selected consolidated financial data should be read in
conjunction with Managements Discussion and Analysis of Financial Condition
and Results of Operations, our Consolidated Financial Statements and Notes
thereto and other financial information included elsewhere in this annual
report.

|                                                      |  |                                       |       |      |  |      |        |         |  |         |        |   |  |   |         |   |  |   |         |  
|----------------------------------------------------- |  | ------------------------------------- | ----- | ---- |  | ---- | ------ | ------- |  | ------- | ------ | - |  | - | ------- | - |  | - | ------- | -
|                                                      |  | Fiscal Year Ended September 30,      
|                                                      |  |                                      
|                                                      |  | 1997                                  |       | 1998 |  | 1999 |        | 2000(1) |  | 2001(2)
|                                                      |  |                                       |       |      |  |      |        |         |  |        
|                                                      |  | (In thousands, except per share data)
|Statement of Operations Data:                         |  |                                       |       |      |  |      |        |         |  |         |        |   |  |   |         |   |  |   |         |  
|Revenues                                              |  | $                                     | 1,118 |      |  | $    | 3,078  |         |  | $       | 6,680  |   |  | $ | 10,973  |   |  | $ | 9,121   |  
|Loss from operations                                  |  |                                       | (762  | )    |  |      | (2,310 | )       |  |         | (7,869 | ) |  |   | (41,297 | ) |  |   | (28,683 | )
|Interest income (expense), net                        |  |                                       | (119  | )    |  |      | (287   | )       |  |         | 148    |   |  |   | 2,039   |   |  |   | 500     |  
|Net loss                                              |  |                                       | (881  | )    |  |      | (2,597 | )       |  |         | (7,721 | ) |  |   | (39,258 | ) |  |   | (35,461 | )
|Basic and diluted net loss per share                  |  | $                                     | (0.10 | )    |  | $    | (0.30  | )       |  | $       | (0.57  | ) |  | $ | (1.82   | ) |  | $ | (1.63   | )
|Basic and diluted weighted average shares outstanding |  |                                       | 8,390 |      |  |      | 8,687  |         |  |         | 13,620 |   |  |   | 21,578  |   |  |   | 21,704  |  

15



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|                                                     |  |                                 |        |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   |        | 
|---------------------------------------------------- |  | ------------------------------- | ------ | ---- |  | ---- | ------ | ---- |  | ---- | ------ |  |  | - | ------ |  |  | - | ------ | 
|                                                     |  | Fiscal Year Ended September 30,
|                                                     |  |                                
|                                                     |  | 1997                            |        | 1998 |  | 1999 |        | 2000 |  | 2001
|                                                     |  |                                 |        |      |  |      |        |      |  |     
|                                                     |  | (Dollars in thousands)         
|Balance Sheet Data:                                  |  |                                 |        |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   |        | 
|Cash                                                 |  | $                               | 71     |      |  | $    | 121    |      |  | $    | 7,743  |  |  | $ | 7,993  |  |  | $ | 5,979  | 
|Working capital (deficit)                            |  |                                 | (829   | )    |  |      | (2,234 | )    |  |      | 41,447 |  |  |   | 22,445 |  |  |   | 3,940  | 
|Property and equipment, net                          |  |                                 | 453    |      |  |      | 1,271  |      |  |      | 3,990  |  |  |   | 10,192 |  |  |   | 3,136  | 
|Total assets                                         |  |                                 | 784    |      |  |      | 1,848  |      |  |      | 67,556 |  |  |   | 44,111 |  |  |   | 12,770 | 
|Long-term obligations, excluding current portion (3) |  |                                 | 826    |      |  |      | 1,942  |      |  |      | 952    |  |  |   | 3,298  |  |  |   | 29     | 
|Total shareholders equity (deficit)                 |  |                                 | (1,201 | )    |  |      | (2,904 | )    |  |      | 61,498 |  |  |   | 34,559 |  |  |   | 3,177  | 



---

|(1) |  | Loss from operations includes the impact of a $6.1 million write-down of
acquired intangible assets that reduced basic and diluted earnings per
share by $0.28 for the year and the results of operations of N2H2 Pty
Limited since its acquisition on February 23, 2000.                                                                                                              
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|   
|   
|   
|(2) |  | Loss from operations includes the impact of a $3.4 million write-down of
field servers that reduced basic and diluted earnings per share by $0.16;
a $1.4 million write-down of acquired intangible assets that reduced basic
and diluted earnings per share by $0.06; and a $0.5 million write-down of
technology licenses that reduced basic and diluted earnings per share by
$0.02.
|   
|   
|   
|   
|(3) |  | Excludes deferred revenue.                                                                                                                                                                                                                                                                                                                                                             




Item 7.Managements Discussion and Analysis of Financial Condition and Result
of Operations.

You should read this section together with the financial statements and
other financial information included in this Form 10-K. This discussion
contains forward-looking statements that involve risks and uncertainties. Our
actual results may differ materially from those indicated in these
forward-looking statements. Certain reclassifications of prior year balances
have been made for consistent presentation with the current year. These
reclassifications have not impacted previously reported net loss, shareholders
equity or cash flows.

Overview

N2H2 is an Internet access management company, providing fast and scalable
filtering solutions that conserve bandwidth, increase user productivity, and
seek to limit potential legal liability. Our internet filtering is designed to
enable organizations (enterprises, Internet Service Providers (ISPs), and
schools) to control costs through customizable filtering levels that are
designed to allow access to only the Web content most relevant to their
specific environment.

As a leading provider of Internet content filtering to schools, N2H2 is
attempting to leverage its expertise in filtering large-scale networks within
sensitive environments via additional channel presence and expansion plans for
ISPs, corporations, governments, and other organizations. We have customers in
several countries including the US, Canada, Australia, the United Kingdom,
Japan, Germany, Switzerland, Korea, Chile, and Mexico. To cover these markets,
we use a combination of our own sales force and various resellers both domestic
and international.

Since inception, we have derived most of our revenues through a
combination of subscription, installation and maintenance fees from our
Internet filtering services. Customers generally pay a one-time installation
fee and enter into a subscription contract, which is typically 12 months in
duration. Through fiscal 2000, we recognized installation revenues upon
installation of our servers. As a result of our adoption of Staff Accounting
Bulletin No. 101 (SAB 101) on October 1, 2000, installation fees have been
recognized as revenue over the expected period of the customer relationship.
Subscription revenues continue to be recognized on a monthly basis over the
life of the subscription contract.

During 1999, we began to offer alternate fee structures to our school
customers. We gave them the choice of paying our recurring subscription fees or
receiving our filtering services at reduced rates or without charge in exchange
for allowing us to sell sponsorship rights to advertisers and to make
Searchopolis the default search engine on their networks. As noted in our
Annual Report on Form 10-K for fiscal 1999, we were unable to predict the
impact of this fee structure on our revenues. The revenues resulting from
advertising

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and sponsorships were less than hoped for. As a result, we have terminated
the advertising-based fee structure previously offered to schools and converted
over 70% of those customers to a fee-paying subscription model during the
fourth quarter of fiscal 2001.

We have built four new software-based solutions for the filtering market
place. We released N2H2 Internet Filtering for Microsoft ISA Server, N2H2
Internet Filtering for Microsoft Proxy Server 2.0, Volera Excelerator (formerly
Novell ICS), and N2H2 Internet Filtering for Check Point FireWall-1 during
2001.

N2H2s Internet Filtering Manager, our client-server hybrid solution that
was released in August 2000, has been adopted by a number of small ISPs
worldwide. The product has been localized into Spanish and Portuguese to meet
the overseas interest in this product.

Our prospects are subject to the risks, expenses, and difficulties
encountered by companies in the rapidly evolving Internet market. We have
incurred significant net losses since inception and, as of September 30, 2001,
had incurred aggregate operating losses of approximately $86.8 million from
inception. These losses have been funded primarily through the issuance of
common stock. We intend to continue to seek opportunities to improve
efficiencies in our operations to better control expenses and reduce operating
losses.

Internet filtering services and customer support costs:Costs of Internet
filtering services and customer support consists of the costs of Website
review, technical installation and support, system development and networks
operations, search engine services, collocation and bandwidth.

Educational content and advertising costs:Educational content and
advertising expenses included product license fees and advertiser commissions.
Educational content and advertising costs have been eliminated for future
periods due to the conclusion of the advertising-based filtering model during
fiscal 2001.

Sales and marketing:Sales expenses consist primarily of salaries,
commissions and bonuses. Marketing expenses consist primarily of salaries,
trade shows, market research, corporate brand identification, public relations,
advertising, and travel. Sales and marketing expenses also include an
allocation of corporate facilities costs and amortization of deferred stock
compensation related to the fiscal 2000 purchase of N2H2 Pty Limited (formerly
Iseek Pty Limited), our Australian sales office. While we plan to increase
spending on product marketing efforts during future periods, we believe that
overall sales and marketing costs will decrease as a result of our reduced
staffing level, the elimination of costs related to the advertising model,
reduced amortization of deferred stock compensation, and focusing our sales and
marketing efforts more specifically on clearly targeted markets and products.

General and administrative:General and administrative expenses consist
primarily of salaries, benefits and related costs for our executive, finance,
human resources and administrative personnel, third-party professional service
fees, and an allocation of our corporate facilities costs. General and
administrative expenses are expected to decrease in future periods due to our
reduced staffing and our continued efforts to increase the efficiency of our
operations.

Research and development:Research and development expenses consist
primarily of salaries and benefits for software developers, consulting fees,
and an allocation of corporate facilities costs. Research and development
activities consist primarily of developing new products and enhancing existing
products. Future research and development expenditures may be directed towards
development of enhancements to our filtering technologies, and other future
service enhancements not presently defined. Costs related to internal research
and development are expensed as incurred.

Income Taxes:As a C corporation, we are subject to income tax at the
corporate level to the extent we have generated net income. Any operating
losses we incur will result in net operating loss carry-forwards potentially
available to offset future taxable income. A full valuation allowance has
currently been recorded against any deferred tax assets available to us for use
in future periods because realization of these assets is primarily dependent on
generating taxable net income in the future.

In view of the rapidly changing nature of our business, we believe that
period-to-period comparisons of revenues and operating results are not
necessarily meaningful. You should not rely upon this information as an
indication of future performance.

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Fiscal Year Ended September 30, 2001 Compared to Fiscal Year Ended September
30, 2000

Internet filtering and consulting service revenues:Internet filtering and
consulting service revenues accounted for 94% of our revenues for fiscal 2001.
Internet filtering and consulting service revenues remained materially
consistent at $8.6 million for both fiscal 2001 and 2000, despite the adoption
of Staff Accounting Bulletin No. 101, Revenue Recognition in Financial
Statements (SAB 101) for fiscal 2001. SAB 101 requires that up-front
installation fees be deferred and recognized over the term of the customer
relationship. In fiscal 2000 and previous years, we recognized installation
revenue upon completion of the installation. Effective October 1, 2000, in
accordance with the provisions of SAB 101, we began deferring installation
revenue over the expected life of the customer relationship periods. The
adoption of SAB 101 resulted in a one-time, non-cash charge of $3.6 million on
October 1, 2000 for the cumulative effect of the change in accounting policy.
The cumulative effect was recorded as deferred revenue and is being recognized
as revenue over the remaining customer relationship periods. The net effect of
the change on fiscal year 2001 was to increase net losses by $1.0 million
($0.05 per share), comprised of the $3.6 million cumulative effect of
accounting change ($0.16 per share), net of $2.6 million of the related
deferred revenue which was recognized as revenue during the year ($0.12 per
share). The remainder of the related deferred revenue will be recognized as
revenue as follows: $0.8 million in fiscal 2002 and $0.2 million in fiscal
2003. Fiscal 2001 revenue reflects growth in filtering subscriptions, offset
by the effect of deferring installation revenues over the expected term of the
customer relationship in accordance with SAB 101.

Advertising revenues:Advertising revenues accounted for 6% of total
revenues for fiscal 2001, compared to 22% for fiscal 2000. Advertising revenues
decreased by $1.9 million, or 79%, to $0.5 million for fiscal 2001, from $2.4
million for fiscal year 2000. The decrease resulted from the conclusion of the
advertising model in fiscal 2001. Advertising revenue has been eliminated for
future periods due to our transition back to a subscription-based filtering
model for all customers.

Internet filtering services and customer support:Costs of Internet
filtering services and customer support decreased by $1.5 million, or 23%, to
$5.2 million for fiscal 2001, from $6.7 million for fiscal 2000. This decrease
was primarily due to our reduced level of staffing and personnel related
expenses. In addition, key vendor contracts were renegotiated to obtain more
favorable terms.

Educational content and advertising costs:Educational content and
advertising expenses decreased by $0.8 million, or 53%, to $0.7 million for
fiscal 2001, from $1.5 million for fiscal 2000. This decrease was due to the
conclusion of our advertising-based filtering model and the corresponding
cancellation of all advertising related contracts.

Sales and marketing:Sales and marketing expenses decreased by $6.9
million, or 36%, to $12.1 million for fiscal 2001, from $19.0 million for
fiscal 2000. The decrease was due in part to our reduced direct sales staffing
and related expenses, as we have shifted a large portion of our sales efforts
to the indirect sales channel. We have also renegotiated various marketing
contracts and eliminated all sales and marketing expenditures related to the
advertising-based filtering program. In addition, deferred stock compensation
expense has declined due to an accelerated method of amortization.

General and administrative:General and administrative expenses decreased
by $4.0 million, or 41%, to $5.7 million for fiscal 2001, from $9.7 million for
fiscal 2000. This decrease was primarily due to significant reductions in
administrative staffing and related personnel costs, partially offset by the
severance-related costs for employees and certain terminated officers. In
addition, amortization of deferred stock compensation has declined
significantly due to the cancellation of certain stock options for employees
who are no longer employed by us. Further, we have reduced our spending on
contractors and third-party professional service providers in a continued
effort to operate within a more disciplined cost structure.

Research and development:Research and development expenses decreased by
$0.7 million, or 15%, to $4.1 million for fiscal 2001, from $4.8 million for
fiscal 2000. This decrease was primarily a result of reducing our use of
contractors and third-party service providers in the development of our
products.

Write-down of acquired intangible assets:Intangible assets related to the
fiscal 2000 acquisition of N2H2 Pty Limited (formerly Iseek Pty Limited) were
assessed for impairment at September 30, 2000 due to operating results and
forecasts from N2H2 Pty Limited being less than expected. This assessment
resulted in a write-down of intangible assets of $6.1 million for fiscal 2000.
In June of fiscal 2001, we recorded an additional $1.4 million write-down for
the remaining carrying value of acquired intangible assets, again due to
operating results and forecasts being less than expected. The impairment
charges were calculated as the excess of the fair value, as calculated by the
present value of future cash flows from N2H2 Pty Limited, over the carrying
value of the intangible assets.

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Write-down of investment:During fiscal 2001, we recorded a $3.0 million
impairment loss on a strategic investment in a privately held company. The loss
represented the our entire investment in the common stock of that company. The
impairment was recorded based on currently available financial information of
the investee company.

Write-down of technology licenses:During fiscal 2001, we recorded a $0.5
million write-down on software license agreements, which will not be used as
part of our current or future product offerings. The impairment charge
represented the total net carrying value of the intangible assets.

Write-down of field servers:During fiscal 2001, we introduced our new
software-based filtering solutions and we plan to eventually phase out the
proxy server product line. We will no longer promote the proxy server-based
product to new customers. N2H2 plans to continue support of our existing
customers proxy-based filtering installations, however, an effort will be made
to migrate existing proxy-using customers to one of our new software-based
filtering solutions. Under the guidance provided by Financial Accounting
Standard No. 121 (FAS 121), we concluded that an event has occurred which
indicated the recovery of the carrying amounts for related field servers should
be assessed. Consequently, management completed a cash flow analysis of the
field server assets, which showed that the estimated cash flows were less than
the carrying value of the field server assets. Accordingly, pursuant to FAS
121, management estimated the fair value of the field server assets to be zero
based upon third party evidence, and hence recorded an impairment charge of
$3.4 million.

Sale of Iseek Communications:On August 31, 2001, we sold the assets and
liabilities of Iseek Communications for $1.00. Iseek Communications was a
subsidiary of N2H2 Pty Limited and offered a product line consisting of
Internet hosting and collocation services in Australia. We recorded a loss on
the sale of $205,000.

Fiscal Year Ended September 30, 2000 Compared to Fiscal Year Ended September
30, 1999

Internet filtering and consulting service revenues:Internet filtering and
consulting service revenues accounted for 78% of the revenues for fiscal 2000.
Internet filtering and consulting service revenues increased $3.0 million, or
53%, to $8.6 million for fiscal 2000, from $5.6 million for fiscal 1999. The
increase reflects the growth in proxy server installations and filtering
subscriptions. The introduction of consulting services in fiscal 2000 also
contributed to the increase in revenues.

Advertising revenues:Advertising revenues accounted for 22% of total
revenues for fiscal 2000, compared to 16% for fiscal 1999. Advertising revenues
increased by $1.3 million, or 118%, to $2.4 million for fiscal 2000, from $1.1
million for fiscal year 1999. The increase resulted from the official launch of
the advertising-based filtering model in late fiscal 1999, which led to
increased sponsorship contracts and a higher volume of ads placed.

Internet filtering services and customer support:Costs of Internet
filtering services and customer support increased by $3.9 million, or 139%, to
$6.7 million for fiscal 2000 from $2.8 million for fiscal 1999. This increase
was primarily due to the hiring of additional customer operations personnel to
provide more technical support and service to our expanded customer base.

Educational content and advertising costs:Educational content and
advertising costs increased by $1.2 million, or 365%, to $1.5 million for
fiscal 2000, from $0.3 million for fiscal 1999. This increase was primarily due
to software license contracts entered into during the year and advertising
commissions. In addition, in fiscal 1999, we switched many customers from our
subscription-based filtering model to the advertising-based filtering model.
This resulted in a full year of advertising related costs in fiscal 2000
compared to a partial year in fiscal 1999.

Sales and marketing:Sales and marketing expenses increased by $15.0
million, or 377%, to $19.0 million for fiscal 2000, from $4.0 million for
fiscal 1999. This increase was primarily due to the hiring of additional sales
and marketing personnel during the year to expand our market position, both
domestically and internationally. We also increased expenditures in fiscal
2000 for general corporate brand awareness campaigns and the introduction of
new products. In addition, amortization of deferred stock compensation
increased significantly as a result of the acquisition of N2H2 Pty Limited in
February 2000. We recorded deferred stock compensation of $8.9 million related
to the employment of certain executives of N2H2 Pty Limited, which is amortized
over a three-year period.

General and administrative:General and administrative expenses increased
by $5.8 million, or 151%, to $9.7 million for fiscal 2000, from $3.8 million
for fiscal 1999. This increase was primarily due to the addition of personnel
to support the growth of our business, notably in information technology, and
the severance-related costs for certain terminated officers.

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Research and development:Research and development expenses increased by
$2.3 million, or 96%, to $4.8 million for fiscal 2000, from $2.5 million for
fiscal 1999. This increase was primarily due to an increase in the number and
cost of software developers and technical personnel supporting development of
our filtering products and services. The increase reflected our ongoing R&D
efforts in a wide variety of new products, including the client server hybrid
solution and enterprise filtering line of products. We also purchased licensed
agreements for technology in order to bring products to the market in a timely
fashion. All of our R&D costs were expensed as incurred.

Write-down of acquired intangible assets:Intangible assets related to the
acquisition of N2H2 Pty Limited were assessed for impairment at September 30,
2000 due to operating results and forecasts from N2H2 Pty Limited being less
than expected. This assessment resulted in a write-down of intangible assets of
$6.1 million. The impairment charges were calculated as the excess of the fair
value, as calculated by the present value of future cash flows from N2H2 Pty
Limited, over the carrying value of the intangible assets.

Liquidity and Capital Resources

Since inception, we have funded our operations primarily through private
sales of equity securities, the use of short-term and long-term debt, and
capital leases. As of September 30, 2001, we had cash and cash equivalents of
$6.7 million, including restricted cash of $675,000. Our operating activities
consumed $12.3 million, $24.8 million and $6.0 million for the years ended
September 30, 2001, 2000, and 1999, respectively. These operating cash outflows
resulted principally from net operating losses, as adjusted for depreciation,
amortization, write-downs, and other non-cash items.

Capital expenditures, excluding those under capital leases, totaled $1.6
million, $9.5 million and $2.2 million in fiscal 2001, 2000, and 1999,
respectively. We anticipate that our overall capital expenditures will continue
to decrease in future years, as we phase out our hardware-based filtering
products and move to software-only solutions. We believe that our current
internal infrastructure is adequate to support additional growth. We anticipate
that minimal purchases of equipment will be required to support our internal
operations, administrative infrastructure, and personnel in fiscal 2002.

Investment activities provided net cash flows of $15.8 million and $20.1
million in fiscal 2001 and 2000, respectively. These net cash inflows were the
result of maturing of investments offset by purchases of investments and
additions to property and equipment.

Financing activities for fiscal 2001 consumed $5.5 million, primarily due
to repayment of all outstanding borrowings from Comerica (formerly Imperial
Bank). In April 2001, Comerica notified us that we were in violation of
certain covenants specified in the loan agreement dated September 20, 2000. As
a result, we paid off the entire loan balance of $3.9 million in May 2001.
However, we still maintain a revolving line of credit with Comerica, which
allows for draws up to a maximum short-term borrowing of $2.5 million if
specified conditions are met. Our current commitments against the line of
credit consist of an irrevocable standby letter of credit for our leased office
space in the amount of $665,000, which expires on July 31, 2005, and a $10,000
deposit held by Comerica for the issuance of corporate credit cards. The total
of these commitments is in excess of our eligible borrowing base as of
September 30, 2001. To cover the over-advance against the line of credit, we
established a $675,000, 30-day, automatically renewing certificate of deposit,
which is pledged as collateral to Comerica. The cash restriction will remain
in effect until such time as our over-advance is cured.

Operating expenses will consume a significant amount of our cash
resources. At historical rates of cash consumption, our current cash and
investment balance is insufficient to sustain our operations beyond six months
from the end of the year. However, we have taken several cost-cutting measures
throughout fiscal 2001 that have significantly reduced our level of spending.
Specifically, we reduced world-wide headcount by almost 60% since the beginning
of the fiscal year, we renegotiated or eliminated numerous contracts with a
range of vendors, and subsequent to year-end we have sublet a portion of our
office space which will result in savings of $196,000 annually. We are in the
process of subleasing our entire headquarter premise with the intent to move to
substantially less expensive office space. Further, we are phasing out our
expensive hardware-based filtering model and moving to a more profitable
software-based solution. With these changes, assuming our more profitable
software filtering solutions are accepted by customers, we believe that our
cash on hand, together with cash from operations, will be sufficient to meet
our anticipated cash needs for at least the next 12 months. If cash generated
from operations is insufficient to satisfy our longer-term liquidity
requirements, we may seek to sell additional equity or debt securities or to
re-obtain a credit facility. The incurring of indebtedness would result in
increased fixed obligations and could result in covenants that would restrict
our operations. We have not made arrangements to obtain additional financing
and we cannot assure you that financing will be available in amounts or on
terms acceptable to us, if at all. If we are unable to raise additional funds
on acceptable terms when needed, our business, financial position and results
of operations would be seriously harmed. See Risk Factors  We May Need Additional Capital And May Be
Unable To Raise It On Acceptable Terms for a description of risks associated
with a decrease in liquidity.

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Recently Issued Accounting Standards

In July 2001, the
FASB issued Financial Accounting Standard 141  Business
Combinations (FAS 141). FAS 141, effective for all business combinations
initiated after July 1, 2001, requires that all business combinations be
accounted for using the purchase method of accounting. Further, FAS 141
requires certain intangible assets to be recognized as assets apart from
goodwill if they meet certain criteria. FAS 141 also requires expanded
disclosures regarding the primary reason for consummation of the combination
and the allocation of the purchase price to the assets acquired and liabilities
assumed by major balance sheet caption. We do not expect FAS 141 to have a
material effect on our results of operations or financial position.

In July 2001, the Financial Accounting Standards Board (FASB) issued
Financial Accounting Standard 142  Goodwill and Intangible Assets (FAS 142).
FAS 142, effective for fiscal years beginning after December 15, 2001, defines
accounting requirements for the treatment of goodwill. Under FAS 142, goodwill
is considered to have an indefinite life and is therefore subject to impairment
accounting rather than amortization. We do not expect FAS 142 to have a
material effect on our results of operations or financial position.

In July 2001, the
FASB issued Financial Accounting Standard 143 
Accounting for Asset Retirement Obligations (FAS 143). FAS 143, effective for
fiscal years beginning after June 15, 2002, addresses financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs. It applies to legal
obligations associated with the retirement of long-lived assets that result
from acquisition, construction, development, and (or) the normal operation of a
long-lived asset, except for certain obligations of lessees. We do not expect
FAS 143 to have a material effect on our results of operations or financial
position.

In August 2001, the
FASB issued Financial Accounting Standard 144 
Accounting for the Impairment or Disposal of Long-Lived Assets (FAS 144). FAS
144, effective for fiscal years beginning after December 15, 2001, addresses
financial accounting and reporting requirements for the impairment or disposal
of long-lived assets. We do not expect FAS 144 to have a material effect on
our results of operations or financial position.




Item 7A.Quantitative and Qualitative Disclosures About Market Risk.

We are exposed to market risk related to changes in foreign currency
exchange rates and interest rates relating to debt and investment instruments.
We have assets and liabilities denominated in certain foreign currencies
related to our international subsidiaries. We have not hedged our translation
risk on these assets and liabilities as we have the ability to hold them for an
indefinite period. We do not expect that a sudden or significant change in
foreign exchange rates would have a material impact on results of operations,
financial position, or cash flows. We believe the reported amounts of cash
equivalents and capital lease obligations at September 30, 2001 are reasonable
approximations of their fair values. As a result, we believe that the market
risk arising from our holdings of financial instruments is minimal.




Item 8.Financial Statements and Supplementary Data.

|                                                                                                                                  |  |      |    | 
|--------------------------------------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|                                                                                                                                  |  | Page
|                                                                                                                                  |  |     
|Report of Independent Accountants                                                                                                 |  |      | 22 | 
|Consolidated Balance Sheets as of September 30, 2001 and 2000                                                                     |  |      | 23 | 
|Consolidated Statements of Operations for the Fiscal Years Ended September 30, 2001, 2000 and 1999                                |  |      | 24 | 
|Consolidated Statements of Changes in Shareholders Equity (Deficit) for the Fiscal Years Ended
September 30, 2001, 2000 and 1999 |  |      | 25 | 
|Consolidated Statements of Cash Flows for the Fiscal Years Ended September 30, 2001, 2000 and 1999                                |  |      | 26 | 
|Consolidated Notes to Financial Statements                                                                                        |  |      | 27 | 

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REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors
and Shareholders of
N2H2, Inc.

In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a)(1) present fairly, in all material respects, the
financial position of N2H2, Inc. and its subsidiaries at September 30, 2001 and
2000, and the results of their operations and their cash flows for each of the
three years in the period ended September 30, 2001, in conformity with
accounting principles generally accepted in the United States of America. In
addition, in our opinion, the financial statement schedule listed in the index
appearing under Item 14(a)(2) presents fairly, in all material respects, the
information set forth therein when read in conjunction with the related
consolidated financial statements. These financial statements and financial
statement schedule are the responsibility of the Companys management; our
responsibility is to express an opinion on these financial statements and the
financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with auditing standards generally accepted in
the United States of America which 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,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for the opinion expressed
above.

PricewaterhouseCoopers LLP

Seattle, Washington
November 5, 2001

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N2H2, INC.




CONSOLIDATED BALANCE SHEETS(in thousands)

|                                                  |                                                                                                                                |                                            |       |         |        |               |        |         |        |  |  | 
|------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------ | ----- | ------- | ------ | ------------- | ------ | ------- | ------ |  |  | 
|                                                  |                                                                                                                                |                                            |       |         |        | September 30,
|                                                  |                                                                                                                                |                                            |       |         |        |              
|                                                  |                                                                                                                                |                                            |       |         |        | 2001          |        | 2000   
|                                                  |                                                                                                                                |                                            |       |         |        |               |        |        
|ASSETS                                           
|Current assets                                    |                                                                                                                                |                                            |       |         |        |               |        |        
|                                                  | Cash and cash equivalents                                                                                                      |                                            | $     | 5,979   |        |               | $      | 7,993   |       
|                                                  | Restricted cash and cash equivalents                                                                                           |                                            |       | 675     |        |               |        |        |       
|                                                  | Investments                                                                                                                    |                                            |       |        |        |               |        | 17,292  |       
|                                                  | Accounts receivable (net of allowances of $284 and $313 in 2001 and 2000, respectively)                                        |                                            |       | 2,066   |        |               |        | 2,069   |       
|                                                  | Prepaid expenses and other current assets                                                                                      |                                            |       | 774     |        |               |        | 1,161   |       
|                                                  |                                                                                                                                |                                            |       |         |        |               |        |        
|                                                  |                                                                                                                                | Total current assets                       |       |         | 9,494  |               |        |         | 28,515 | 
|Long-term investments                             |                                                                                                                                |                                            |      |         |        |               | 3,000  |        
|Acquired intangible assets, net                   |                                                                                                                                |                                            |      |         |        |               | 1,490  |        
|Property and equipment, net                       |                                                                                                                                |                                            | 3,136 |         |        |               | 10,192 |        
|Other assets                                      |                                                                                                                                |                                            | 140   |         |        |               | 914    |        
|                                                  |                                                                                                                                |                                            |       |         |        |               |        |        
|                                                  |                                                                                                                                | Total assets                               |       | $       | 12,770 |               |        | $       | 44,111 | 
|                                                  |                                                                                                                                |                                            |       |         |        |               |        |        
|LIABILITIES AND SHAREHOLDERS EQUITY             
|Current liabilities                               |                                                                                                                                |                                            |       |         |        |               |        |        
|                                                  | Accounts payable                                                                                                               |                                            | $     | 807     |        |               | $      | 1,982   |       
|                                                  | Royalties payable                                                                                                              |                                            |       |        |        |               |        | 198     |       
|                                                  | Accrued payroll & benefits                                                                                                     |                                            |       | 738     |        |               |        | 989     |       
|                                                  | Other accrued liabilities                                                                                                      |                                            |       | 342     |        |               |        | 288     |       
|                                                  | Deferred revenue                                                                                                               |                                            |       | 3,422   |        |               |        | 762     |       
|                                                  | Note payable                                                                                                                   |                                            |       | 42      |        |               |        |        |       
|                                                  | Current portion of capital lease obligations                                                                                   |                                            |       | 203     |        |               |        | 205     |       
|                                                  | Current portion of long-term debt                                                                                              |                                            |       |        |        |               |        | 1,646   |       
|                                                  |                                                                                                                                |                                            |       |         |        |               |        |        
|                                                  |                                                                                                                                | Total current liabilities                  |       |         | 5,554  |               |        |         | 6,070  | 
|Deferred revenue                                  |                                                                                                                                |                                            | 4,010 |         |        |               | 184    |        
|Capital lease obligations, net of current portion |                                                                                                                                |                                            | 29    |         |        |               | 222    |        
|Long-term debt, net of current portion            |                                                                                                                                |                                            |      |         |        |               | 3,076  |        
|                                                  |                                                                                                                                |                                            |       |         |        |               |        |        
|                                                  |                                                                                                                                | Total liabilities                          |       |         | 9,593  |               |        |         | 9,552  | 
|                                                  |                                                                                                                                |                                            |       |         |        |               |        |        
|Commitments and Contingencies (Notes 9 and 20)    |                                                                                                                                |                                            |       |         |        |               |        |        
|Shareholders equity                              |                                                                                                                                |                                            |       |         |        |               |        |        
|                                                  | Preferred stock, no par value; 50,000 shares authorized, no shares issued
and outstanding                                      |                                            |       |        |        |               |        |        |       
|                                                  | Common stock, no par value; 250,000 shares authorized; 22,060 and 22,583
issued and outstanding in 2001 and 2000, respectively |                                            |       | 92,166  |        |               |        | 93,085  |       
|                                                  | Notes receivable from shareholders, net of allowances                                                                          |                                            |       | (48     | )      |               |        | (1,073  | )     
|                                                  | Deferred stock compensation                                                                                                    |                                            |       | (2,030  | )      |               |        | (6,069  | )     
|                                                  | Accumulated other comprehensive loss                                                                                           |                                            |       | (127    | )      |               |        | (61     | )     
|                                                  | Accumulated deficit                                                                                                            |                                            |       | (86,784 | )      |               |        | (51,323 | )     
|                                                  |                                                                                                                                |                                            |       |         |        |               |        |        
|                                                  |                                                                                                                                | Total shareholders equity                 |       |         | 3,177  |               |        |         | 34,559 | 
|                                                  |                                                                                                                                |                                            |       |         |        |               |        |        
|                                                  |                                                                                                                                | Total liabilities and shareholders equity |       | $       | 12,770 |               |        | $       | 44,111 | 
|                                                  |                                                                                                                                |                                            |       |         |        |               |        |        

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

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N2H2, INC.




CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except per share amounts)

|                                                                                     |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |       |        |        |  
|------------------------------------------------------------------------------------ | ------------------------------------------------ | ------------------------------------ | ------------------------ | ------ | ------------------------- | ------ | ------- | ------ | ------- | ------ | ------ | ----- | ------ | ------ | -
|                                                                                     |                                                  |                                      |                          |        | Years Ended September 30,
|                                                                                     |                                                  |                                      |                          |        |                          
|                                                                                     |                                                  |                                      |                          |        | 2001                      |        | 2000    |        | 1999   
|                                                                                     |                                                  |                                      |                          |        |                           |        |         |        |        
|Revenues:                                                                            |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|                                                                                     | Internet filtering and consulting services       |                                      | $                        | 8,612  |                           |        | $       | 8,593  |         |        | $      | 5,605 |       
|                                                                                     | Advertising                                      |                                      |                          | 509    |                           |        |         | 2,380  |         |        |        | 1,075 |       
|                                                                                     |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|                                                                                     |                                                  |                                      | Total revenues           |        |                           | 9,121  |         |        |         | 10,973 |        |       |        | 6,680  |  
|Operating expenses:                                                                  |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|                                                                                     | Internet filtering services and customer support |                                      |                          | 5,216  |                           |        |         | 6,734  |         |        |        | 2,806 |       
|                                                                                     | Educational content and advertising costs        |                                      |                          | 703    |                           |        |         | 1,495  |         |        |        | 322   |       
|                                                                                     | Sales and marketing                              |                                      |                          | 12,111 |                           |        |         | 18,971 |         |        |        | 3,973 |       
|                                                                                     | General and administrative                       |                                      |                          | 5,667  |                           |        |         | 9,652  |         |        |        | 3,840 |       
|                                                                                     | Research and development                         |                                      |                          | 4,084  |                           |        |         | 4,817  |         |        |        | 2,452 |       
|                                                                                     | Depreciation and amortization                    |                                      |                          | 4,678  |                           |        |         | 4,512  |         |        |        | 1,156 |       
|                                                                                     | Write-down of acquired intangible assets         |                                      |                          | 1,396  |                           |        |         | 6,089  |         |        |        |      |       
|                                                                                     | Write-down of technology licenses                |                                      |                          | 513    |                           |        |         |       |         |        |        |      |       
|                                                                                     | Write-down of field servers                      |                                      |                          | 3,436  |                           |        |         |       |         |        |        |      |       
|                                                                                     |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|                                                                                     |                                                  |                                      | Total operating expenses |        |                           | 37,804 |         |        |         | 52,270 |        |       |        | 14,549 |  
|                                                                                     |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|Loss from operations                                                                 |                                                  |                                      | (28,683                  | )      |                           |        | (41,297 | )      |         |        | (7,869 | )    
|Interest income, net of interest expense                                             |                                                  |                                      | 500                      |        |                           |        | 2,039   |        |         |        | 148    |      
|Loss on disposal of property and equipment                                           |                                                  |                                      | (519                     | )      |                           |        |        |        |         |        |       |      
|Write-down of investment                                                             |                                                  |                                      | (3,000                   | )      |                           |        |        |        |         |        |       |      
|Loss on sale of Iseek Communications                                                 |                                                  |                                      | (205                     | )      |                           |        |        |        |         |        |       |      
|                                                                                     |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|Loss before change in accounting policy                                              |                                                  |                                      | (31,907                  | )      |                           |        | (39,258 | )      |         |        | (7,721 | )    
|Cumulative effect of change in accounting policy                                     |                                                  |                                      | (3,554                   | )      |                           |        |        |        |         |        |       |      
|                                                                                     |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|Net loss                                                                             |                                                  | $                                    | (35,461                  | )      |                           | $      | (39,258 | )      |         | $      | (7,721 | )    
|                                                                                     |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|Basic and diluted net loss per share:                                                |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|                                                                                     | Loss before change in accounting policy          |                                      |                          | (1.47  | )                         |        |         | (1.82  | )       |        |        | (0.57 | )     
|                                                                                     | Effect of change in accounting policy            |                                      |                          | (0.16  | )                         |        |         |       |         |        |        |      |       
|                                                                                     |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|                                                                                     |                                                  |                                      | Net loss per share       |        | $                         | (1.63  | )       |        | $       | (1.82  | )      |       | $      | (0.57  | )
|                                                                                     |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|Basic and diluted weighted average shares outstanding                                |                                                  |                                      | 21,704                   |        |                           |        | 21,578  |        |         |        | 13,620 |      
|                                                                                     |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|Proforma amounts assuming the change in accounting policy was applied
retroactively: |                                                  |                                      |                          |        |                           |        |         |        |         |        |        |      
|                                                                                     |                                                  | Net loss                             |                          | $      | (32,900                   | )      |         | $      | (40,701 | )      |        | $     | (8,444 | )     
|                                                                                     |                                                  | Basic and diluted net loss per share |                          | $      | (1.52                     | )      |         | $      | (1.89   | )      |        | $     | (0.62  | )     

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

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N2H2, INC.




CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY (DEFICIT)

(in thousands, except share amounts)

|                                                                           |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   |        |         |         |  
|-------------------------------------------------------------------------- | -------- | ----------------------------------------------- | ---------- | ------------ |  | ---------- | ------------ | ------------ |  | ------------ | ------ | ----------- | ----- | - | ------ | - |  | ----------- | ---- | - | --- | - | ------- | ------- | ------- | - | ------ | ------- | ------- | -
|                                                                           |          |                                                 |            |              |  |            |              |              |  |              |        | Note        |       |   |        |   |  | Accumulated |      |   |     |   |         |         |         |  
|                                                                           |          |                                                 |            | Common Stock |  | Receivable |              | Deferred     |  | Other        |        |             |       |   |        |   |  |            
|                                                                           |          |                                                 |            |              |  | From       |              | Stock Option |  | Compensation |        | Accumulated |       |   |       
|                                                                           |          |                                                 |            | Shares       |  | Amount     | Shareholders | Compensation |  | Income       |        | Deficit     | Total
|                                                                           |          |                                                 |            |              |  |            |              |              |  |              |       
|Balance at October 1, 1998                                                 |          |                                                 | 9,060,473  |              |  | $          | 1,440        |              |  |              |       |             |       |   |       |   |  |             |     |   |     | $ | (4,344  | )       |         | $ | (2,904 | )      
|Issuance of common stock, private offering,
net of issuance costs of $243  |          |                                                 | 4,131,245  |              |  |            | 10,788       |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 10,788 |        
|Issuance of common stock, public offering, net of
issuance costs of $1,409 |          |                                                 | 4,950,000  |              |  |            | 58,436       |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 58,436 |        
|Exercise of warrants                                                       |          |                                                 | 6,342      |              |  |            | 20           |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 20     |        
|Issuance of warrants                                                       |          |                                                 |            |              |  |            | 77           |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 77     |        
|Conversion of notes payable into common stock                              |          |                                                 | 1,998,622  |              |  |            | 1,693        |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 1,693  |        
|Exercise of stock options                                                  |          |                                                 | 792,603    |              |  |            | 156          |              |  |              | (25    | )           |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 131    |        
|Compensation expense recognized on issuance
of common stock                |          |                                                 | 125,000    |              |  |            | 216          |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 216    |        
|Deferred compensation expense relating to
issuance of stock options        |          |                                                 |            |              |  |            | 2,702        |              |  |              |        |             |       |   | (2,702 | ) |  |             |      |   |     |   |         |         |         |   |       |        
|Amortization of deferred stock option
compensation                         |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   | 762    |   |  |             |      |   |     |   |         |         |         |   | 762    |        
|Net loss                                                                   |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   | (7,721  | )       |         |   | (7,721 | )      
|                                                                           |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   |        |        
|Balance at September 30, 1999                                              |          |                                                 | 21,064,285 |              |  |            | 75,528       |              |  |              | (25    | )           |       |   | (1,940 | ) |  |             |     |   |     |   | (12,065 | )       |         |   | 61,498 |        
|Issuance of common stock related to acquisition,
net of purchase costs     |          |                                                 | 925,000    |              |  |            | 16,104       |              |  |              |        |             |       |   | (8,911 | ) |  |             |      |   |     |   |         |         |         |   | 7,193  |        
|Issuance of common stock related to employee
stock purchase plan           |          |                                                 | 36,453     |              |  |            | 77           |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 77     |        
|Exercise of stock options and warrants                                     |          |                                                 | 556,771    |              |  |            | 519          |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 519    |        
|Issuance of warrants                                                       |          |                                                 |            |              |  |            | 1,255        |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 1,255  |        
|Issuance of notes receivable to shareholders, net
of reserve of $805       |          |                                                 |            |              |  |            |              |              |  |              | (1,048 | )           |       |   |        |   |  |             |      |   |     |   |         |         |         |   | (1,048 | )      
|Deferred compensation relating to remeasurement
of variable stock options  |          |                                                 |            |              |  |            | 56           |              |  |              |        |             |       |   | (56    | ) |  |             |      |   |     |   |         |         |         |   |       |        
|Reversal of deferred compensation relating to
forfeiture of stock options  |          |                                                 |            |              |  |            | (454         | )            |  |              |        |             |       |   | 454    |   |  |             |      |   |     |   |         |         |         |   |       |        
|Amortization of deferred stock option
compensation                         |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   | 4,384  |   |  |             |      |   |     |   |         |         |         |   | 4,384  |        
|Comprehensive loss:                                                        |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   |        |        
|                                                                           | Net loss |                                                 |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         | (39,258 | )       |   |        | (39,258 | )      
|                                                                           |          | Unrealized loss on foreign currency
translation |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   | (61 | ) |         |         |         |   |        |         | (61     | )
|                                                                           |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   |        |        
|                                                                           |          | Total comprehensive loss                        |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   | (61 | ) |         |         | (39,258 | ) |        |         | (39,319 | )
|                                                                           |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   |        |        
|Balance at September 30, 2000                                              |          |                                                 | 22,582,509 |              |  |            | 93,085       |              |  |              | (1,073 | )           |       |   | (6,069 | ) |  |             | (61  | ) |     |   | (51,323 | )       |         |   | 34,559 |        
|Issuance of common stock related to employee
stock purchase plan           |          |                                                 | 18,722     |              |  |            | 6            |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 6      |        
|Exercise of stock options                                                  |          |                                                 | 266,716    |              |  |            | 73           |              |  |              |        |             |       |   | (5     | ) |  |             |      |   |     |   |         |         |         |   | 68     |        
|Settlement of notes receivable from shareholder                            |          |                                                 | (807,868   | )            |  |            | (645         | )            |  |              | 1,092  |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 447    |        
|Interest earned on notes receivable from
shareholders                      |          |                                                 |            |              |  |            |              |              |  |              | (71    | )           |       |   |        |   |  |             |      |   |     |   |         |         |         |   | (71    | )      
|Payments received on notes receivable from
shareholders                    |          |                                                 |            |              |  |            |              |              |  |              | 4      |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   | 4      |        
|Deferred compensation relating to remeasurement
of variable stock options  |          |                                                 |            |              |  |            | (14          | )            |  |              |        |             |       |   | 14     |   |  |             |      |   |     |   |         |         |         |   |       |        
|Reversal of deferred compensation relating to
forfeiture of stock options  |          |                                                 |            |              |  |            | (339         | )            |  |              |        |             |       |   | 339    |   |  |             |      |   |     |   |         |         |         |   |       |        
|Amortization of deferred stock option
compensation                         |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   | 3,691  |   |  |             |      |   |     |   |         |         |         |   | 3,691  |        
|Comprehensive loss:                                                        |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   |        |        
|                                                                           | Net loss |                                                 |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         | (35,461 | )       |   |        | (35,461 | )      
|                                                                           |          | Unrealized loss on foreign currency
translation |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   | (66 | ) |         |         |         |   |        |         | (66     | )
|                                                                           |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   |        |        
|                                                                           |          | Total comprehensive loss                        |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   | (66 | ) |         |         | (35,461 | ) |        |         | (35,527 | )
|                                                                           |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   |        |        
|Balance at September 30, 2001                                              |          |                                                 | 22,060,079 |              |  | $          | 92,166       |              |  | $            | (48    | )           |       | $ | (2,030 | ) |  | $           | (127 | ) |     | $ | (86,784 | )       |         | $ | 3,177  |        
|                                                                           |          |                                                 |            |              |  |            |              |              |  |              |        |             |       |   |        |   |  |             |      |   |     |   |         |         |         |   |        |        

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

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N2H2, INC.




CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

|                                                     |                                                                                   |                                                           |                                                     |         |                           |         |         |         |        |         |        |         |        |         |  
|---------------------------------------------------- | --------------------------------------------------------------------------------- | --------------------------------------------------------- | --------------------------------------------------- | ------- | ------------------------- | ------- | ------- | ------- | ------ | ------- | ------ | ------- | ------ | ------- | -
|                                                     |                                                                                   |                                                           |                                                     |         | Years Ended September 30,
|                                                     |                                                                                   |                                                           |                                                     |         |                          
|                                                     |                                                                                   |                                                           |                                                     |         | 2001                      |         | 2000    |         | 1999  
|                                                     |                                                                                   |                                                           |                                                     |         |                           |         |         |         |       
|Cash Flows from Operating Activities                 |                                                                                   |                                                           |                                                     |         |                           |         |         |         |        |         |        |        
|Net loss                                             |                                                                                   | $                                                         | (35,461                                             | )       |                           | $       | (39,258 | )       |        | $       | (7,721 | )      
|                                                     | Adjustments to reconcile net loss to net cash used by operating activities:       |                                                           |                                                     |         |                           |         |         |         |        |         |        |         |       
|                                                     |                                                                                   | Depreciation and amortization                             |                                                     |         | 4,678                     |         |         |         | 4,512  |         |        |         | 1,262  |        
|                                                     |                                                                                   | Amortization of deferred stock compensation               |                                                     |         | 3,691                     |         |         |         | 4,384  |         |        |         | 762    |        
|                                                     |                                                                                   | Provision for accounts receivable                         |                                                     |         | 308                       |         |         |         | 369    |         |        |         | 261    |        
|                                                     |                                                                                   | Write-down of acquired intangible assets                  |                                                     |         | 1,396                     |         |         |         | 6,089  |         |        |         |       |        
|                                                     |                                                                                   | Write-down of technology licenses                         |                                                     |         | 513                       |         |         |         |       |         |        |         |       |        
|                                                     |                                                                                   | Write-down of field servers                               |                                                     |         | 3,436                     |         |         |         |       |         |        |         |       |        
|                                                     |                                                                                   | Write-down of investment                                  |                                                     |         | 3,000                     |         |         |         |       |         |        |         |       |        
|                                                     |                                                                                   | Change in accounting policy, net                          |                                                     |         | 993                       |         |         |         |       |         |        |         |       |        
|                                                     |                                                                                   | Loss on disposal of property and equipment                |                                                     |         | 519                       |         |         |         |       |         |        |         |       |        
|                                                     |                                                                                   | Loss on sale of Iseek Communications                      |                                                     |         | 205                       |         |         |         |       |         |        |         |       |        
|                                                     |                                                                                   | Compensation expense for forgiveness of shareholder loans |                                                     |         | 447                       |         |         |         |       |         |        |         |       |        
|                                                     |                                                                                   | Interest earned on shareholder loans                      |                                                     |         | (71                       | )       |         |         |       |         |        |         |       |        
|                                                     |                                                                                   | Provision for shareholder loans                           |                                                     |         |                          |         |         |         | 805    |         |        |         |       |        
|                                                     |                                                                                   | Compensation expense on issuance of common stock          |                                                     |         |                          |         |         |         |       |         |        |         | 216    |        
|                                                     |                                                                                   | Debt forgiven                                             |                                                     |         |                          |         |         |         |       |         |        |         | (18    | )      
|                                                     | Change in operating assets and liabilities:                                       |                                                           |                                                     |         |                           |         |         |         |        |         |        |         |       
|                                                     |                                                                                   | Accounts receivable                                       |                                                     |         | (410                      | )       |         |         | (1,005 | )       |        |         | (1,374 | )      
|                                                     |                                                                                   | Prepaid expenses and other assets                         |                                                     |         | 495                       |         |         |         | (384   | )       |        |         | (1,619 | )      
|                                                     |                                                                                   | Accounts payable                                          |                                                     |         | (1,115                    | )       |         |         | 57     |         |        |         | 1,420  |        
|                                                     |                                                                                   | Royalties payable                                         |                                                     |         | (198                      | )       |         |         | 98     |         |        |         | (50    | )      
|                                                     |                                                                                   | Accrued liabilities                                       |                                                     |         | (197                      | )       |         |         | 215    |         |        |         | 601    |        
|                                                     |                                                                                   | Deferred revenue                                          |                                                     |         | 5,493                     |         |         |         | (661   | )       |        |         | 273    |        
|                                                     |                                                                                   |                                                           |                                                     |         |                           |         |         |         |        |         |        |        
|                                                     |                                                                                   |                                                           | Net cash used by operating activities               |         |                           | (12,278 | )       |         |        | (24,779 | )      |         |        | (5,987  | )
|                                                     |                                                                                   |                                                           |                                                     |         |                           |         |         |         |        |         |        |        
|Cash Flows from Investing Activities                 |                                                                                   |                                                           |                                                     |         |                           |         |         |         |        |         |        |        
|                                                     | Purchases of investments                                                          |                                                           |                                                     | (13,100 | )                         |         |         | (13,000 | )      |         |        | (53,636 | )     
|                                                     | Maturities of investments                                                         |                                                           |                                                     | 30,392  |                           |         |         | 45,344  |        |         |        | 1,001   |       
|                                                     | Additions to property and equipment                                               |                                                           |                                                     | (1,568  | )                         |         |         | (9,499  | )      |         |        | (2,240  | )     
|                                                     | Proceeds from sale of property and equipment                                      |                                                           |                                                     | 78      |                           |         |         |        |        |         |        |        |       
|                                                     | Notes receivable from shareholders                                                |                                                           |                                                     | 4       |                           |         |         | (1,853  | )      |         |        |        |       
|                                                     | Transaction costs incurred for N2H2 Pty Limited acquisition, net of cash acquired |                                                           |                                                     |        |                           |         |         | (229    | )      |         |        |        |       
|                                                     |                                                                                   |                                                           |                                                     |         |                           |         |         |         |        |         |        |        
|                                                     |                                                                                   |                                                           | Net cash provided by (used by) investing activities |         |                           | 15,806  |         |         |        | 20,763  |        |         |        | (54,875 | )
|                                                     |                                                                                   |                                                           |                                                     |         |                           |         |         |         |        |         |        |        
|Cash Flows from Financing Activities                 |                                                                                   |                                                           |                                                     |         |                           |         |         |         |        |         |        |        
|                                                     | Issuance of common stock, net                                                     |                                                           |                                                     | 6       |                           |         |         | 77      |        |         |        | 69,224  |       
|                                                     | Exercise of stock options and warrants                                            |                                                           |                                                     | 67      |                           |         |         | 519     |        |         |        | 151     |       
|                                                     | Payments under capital lease obligations                                          |                                                           |                                                     | (194    | )                         |         |         | (991    | )      |         |        | (1,128  | )     
|                                                     | Borrowings under notes payable                                                    |                                                           |                                                     | 54      |                           |         |         | 5,000   |        |         |        | 2,000   |       
|                                                     | Repayments of notes payable                                                       |                                                           |                                                     | (4,734  | )                         |         |         | (278    | )      |         |        | (1,763  | )     
|                                                     | Cash restricted to collateralize line of credit                                   |                                                           |                                                     | (675    | )                         |         |         |        |        |         |        |        |       
|                                                     |                                                                                   |                                                           |                                                     |         |                           |         |         |         |        |         |        |        
|                                                     |                                                                                   |                                                           | Net cash provided by (used by) financing activities |         |                           | (5,476  | )       |         |        | 4,327   |        |         |        | 68,484  |  
|                                                     |                                                                                   |                                                           |                                                     |         |                           |         |         |         |        |         |        |        
|                                                     | Effects of exchange rates                                                         |                                                           |                                                     | (66     | )                         |         |         | (61     | )      |         |        |        |       
|Net increase (decrease) in cash and cash equivalents |                                                                                   |                                                           | (2,014                                              | )       |                           |         | 250     |         |        |         | 7,622  |        
|Cash and cash equivalents, beginning of period       |                                                                                   |                                                           | 7,993                                               |         |                           |         | 7,743   |         |        |         | 121    |        
|                                                     |                                                                                   |                                                           |                                                     |         |                           |         |         |         |        |         |        |        
|Cash and cash equivalents, end of period             |                                                                                   | $                                                         | 5,979                                               |         |                           | $       | 7,993   |         |        | $       | 7,743  |        
|                                                     |                                                                                   |                                                           |                                                     |         |                           |         |         |         |        |         |        |        

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

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N2H2, INC.




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2001, 2000, and 1999

1. Description of Business

N2H2, Inc. (N2H2 or the Company), a Washington corporation, was founded in
1995. The Company is an Internet access management company, providing
filtering, reporting and usage management software and related professional
services to conserve bandwidth, increase user productivity, and seeks to limit
potential legal liability. The Companys Internet filtering is designed to
enable organizations (enterprises, government institutions, ISPs, schools) to
control costs through customizable filtering levels that are designed to allow
users only access to Web content most relevant to their specific environment.

The Company has experienced significant net operating losses from
inception. In fiscal 2001, the Company incurred operating losses of $28.7
million and used $12.3 million of cash in its operating activities. Management
expects that operating losses and negative cash flows will continue through
most or all of fiscal 2002 as the Company continues to develop its product
offerings and customer base. If the Company fails to develop revenues from new
products and expand its customer base, it will require additional debt or
equity financing to continue its operations beyond September 30, 2002. Such
financing may not be available on acceptable terms or at all.

At the time of this filing, the Companys stock price has closed below
$1.00 for more than 90 consecutive business days. A minimum bid price of $1.00
is required for continued listing on the Nasdaq National Market System. After
the events of September 11, 2001, the Nasdaq placed a moratorium on the $1.00
listing requirement, and the Companys delisting hearing was dropped. The
moratorium lasts until January 1, 2002. At that time, Nasdaq will begin again
the process of enforcement of its listing requirements. If at any time after
January 1, 2002 N2H2s common stock bid price falls below $1.00 per share for a
period of thirty consecutive business days, Nasdaq has the right to delist the
stock if within ninety days thereafter the bid price for the stock is not at
least $1.00 per share for a minimum of ten consecutive business days. In the
event N2H2s stock price does not rise above $1.00 for the required ten
consecutive business days, the Company would have the right to request a
hearing to appeal a determination that the stock should be delisted. There is
no guarantee that the Company would prevail in such a hearing. If the Companys
stock were delisted, the delisting would most likely have a material adverse
affect on the price of its common stock, would adversely affect the liquidity
of the shares held by its shareholders, and would severely restrict any ability
the Company may have to raise additional capital.

In addition, as of September 30, 2001, N2H2 has $3.2 million in net
tangible assets, which is less than the Nasdaq requirement of $4 million. If
the company fails to raise its net tangible assets to the required $4 million,
Nasdaq has the right to delist the stock or require N2H2 to move its stock to
the Nasdaq SmallCap Market System which has a net tangible asset requirement of
$2 million. In both the Nasdaq National Market System and the Nasdaq SmallCap
Market System, there is a $1.00 minimum bid price requirement and they have the
same appeal process.

2. Summary of Significant Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of N2H2, Inc.
and its wholly owned subsidiaries, N2H2, Ltd. and N2H2 Pty Limited (formerly
Iseek Pty Limited). All inter-company accounts and transactions have been
eliminated in consolidation.

Use of Estimates

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

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Foreign Currency Translation

The functional currency of the Companys foreign operations is considered
to be the local foreign currency. Financial statements of foreign subsidiaries
are translated into U.S. dollars using the exchange rate at each balance sheet
date for assets and liabilities and a weighted average exchange rate for each
period for revenues and expenses. Resulting translation adjustments are
excluded from results of operations and reported in accumulated other
comprehensive income (loss).

Cash and Cash Equivalents

Cash and cash equivalents represent funds on deposit with banks or
invested in a variety of highly liquid short-term instruments with original
maturities of less than three months. The Company invests its cash and cash
equivalents with major financial institutions, which may, at times, exceed
federally insured limits. Management believes risk of loss is minimal. To
date, the Company has not experienced any losses to cash and cash equivalents.

Investments

The Company invests primarily in debt securities, which are classified as
held-to-maturity at purchase. Investments with remaining maturities of less
than twelve months from the balance sheet date are classified as short-term
investments. Investments with remaining maturities of more than twelve months
are classified as long-term investments. Realized gains and losses are computed
based upon specific identification.

Transfer of Financial Instruments

In the fiscal year ended September 30, 1999, the Company terminated the
practice of factoring accounts receivable with a bank. Prior to that, the
Company did factor certain customer receivables with full recourse to a bank.
The transfer of accounts receivable was recorded by the Company as a sales
transaction under the provisions of Statement of Financial Accounting Standards
No. 125, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities. The receivables were sold at a discount which
was recorded upon sale, and monthly finance charges were incurred based upon
average monthly balances outstanding with the factor. These monthly fees were
recorded in the period incurred. Customer accounts repurchased from the factor
were included in accounts receivable.

Property and Equipment

Property and equipment are carried at cost less accumulated depreciation.
The Company depreciates property and equipment using the straight-line method
over the estimated useful lives of three to five years. Leasehold improvements
are amortized using the straight-line method over the shorter of the life of
the related asset or the term of the lease. Software obtained for internal use
is capitalized and amortized over three years.

The cost of normal maintenance and repairs are charged to expense as
incurred. Expenditures for major improvements are capitalized at cost. Gains or
losses on the disposition of assets are reflected in the results of operations
at the time of disposal.

Impairment of Long-lived Assets

The Company evaluates its long-lived assets for impairment and continues
to evaluate them as events or changes in circumstances indicate that the
carrying amount of such assets may not be fully recoverable. The Company
evaluates the recoverability of long-lived assets by measuring the carrying
amount of the assets against the estimated undiscounted future cash flows
associated with these assets. At the time such evaluations indicate that the
future undiscounted cash flows of certain long-lived assets are not sufficient
to recover the carrying value of such assets, the carrying value of the assets
are reduced to their estimated fair values. Fair value is determined using the
expected net discounted cash flows from the assets.

Revenue Recognition

The Companys revenues are derived from its filtering, Internet
management, and content delivery services. These primarily consist of filtering
subscriptions, installation fees, maintenance fees and historically,
advertising.

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Subscription revenues represent the fees associated with the right to use
the Companys software and hardware, and access to filtering updates.
Subscription revenues are recognized over the life of the subscription
contract. Subscription payments received in advance of revenue recognition are
recorded as deferred revenue.

Installation revenues represent fees associated with the customization and
installation of the Companys software on customer servers. Installation
revenues are recognized over the expected life of the customer relationship in
accordance with Staff Accounting Bulletin No. 101, Revenue Recognition in
Financial Statements.

Maintenance revenues represent fees associated with technical support
services provided to customers. Maintenance revenues are recognized over the
life of the maintenance contract. Maintenance payments received in advance of
revenue recognition are recorded as deferred revenue.

Advertising revenue contracts based on the number of impressions displayed
or click-throughs provided were recognized as services were rendered. Also
included in advertising revenues were barter revenues generated from exchanging
advertising services for a license. Revenues from barter transactions were
recognized at the fair value of advertisements delivered in the period when
advertising was provided, and services received were charged to expense on a
straight-line basis over the contract period. Barter revenues for fiscal year
2001 and 2000 were $0.2 million and $0.6 million, respectively. All contracts
with advertisers have been concluded or cancelled during fiscal 2001.

Advertising and Marketing Expense

All costs related to marketing and advertising the Companys products are
expensed in the periods incurred. Advertising and marketing expenses were
$1,465,000, $4,248,000, and $1,145,000 for the years ended September 30, 2001,
2000 and 1999, respectively.

Research and Development Costs

Research and development expenses consist principally of payroll and
related expenses for design and development of the Companys technologies.
Research and development costs are expensed as incurred.

Shipping and Handling Costs

Costs related to shipping and handling of customer servers are included
within Internet Filtering Services and Customer Support costs on the Statement
of Operations. Shipping and handling expenses were $81,000, $101,000 and
$60,000 for the years ended September 30, 2001, 2000 and 1999, respectively.

Income Taxes

Prior to May 1999, the Company was an S corporation for federal income tax
purposes. Effective May 11, 1999, the Company became a C corporation and began
accounting for income taxes under the liability method of accounting. Under the
liability method, deferred income taxes are determined based on the difference
between the financial statement and tax basis of assets and liabilities, and on
tax loss and credit carry-forwards, at enacted tax rates in effect in the year
in which the differences are expected to reverse. Valuation allowances are
established, when necessary, to reduce deferred tax assets to amounts expected
to be realized.

Concentration of Credit Risk

Financial instruments that potentially subject the Company to
concentration of credit risk include primarily cash and cash equivalents and
accounts receivable. The Company places its cash deposits and certain
short-term investments in bank deposits and money market funds with high credit
quality financial institutions. At September 30, 2001, the Company had cash in
one financial institution that exceeded federally insured limits. Domestic
accounts receivable consists of account balances due from customers dispersed
across the United States with industry concentrations in public institutions
such as school districts and state and local governments. International
accounts receivable represent 19%, 25%, and 7% of total accounts receivable at
September 30, 2001, 2000 and 1999, respectively, and are denominated primarily
in United States dollars. No customer accounted for 10% or more of the
Companys revenues in any year.

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Fair Value Disclosures

Recorded amounts of cash and cash equivalents, receivables, accounts
payable and other amounts included in current liabilities meeting the
definition of financial instruments approximate fair value based on the
short-term maturity of those instruments. The carrying value of long-term
capital lease obligations is based on interest rates currently available to the
Company and, accordingly, approximates fair values. The amortized cost basis of
investments held exceeded market value by $35,000 and $152,000 at September 30,
2000 and 1999, respectively (Note 4). There were no investments held at
September 30, 2001.

Stock-Based Compensation

The Company applies the provisions of Accounting Principles Board Opinion
No. 25 (APB 25) and related interpretations for transactions with employees and
provides pro forma disclosures for employee stock option grants as required by
Financial Accounting Standards No. 123 (FAS 123).

Net Loss per Share

Basic loss per share is calculated as losses available to common
shareholders divided by the weighted-average number of common shares
outstanding during the periods. Diluted loss per share is based on the
weighted-average number of shares of common stock and potential common stock
outstanding during the periods, including options and warrants computed using
the treasury stock method. Basic and diluted net loss per share are equal for
all periods presented because the impact of common stock equivalents is
anti-dilutive.

Business Segments

The Company maintains single sales, marketing, research and development
and administrative functions for all of its services and geographic regions.
Management uses one measurement of profitability and does not disaggregate its
business for internal reporting. Based on the criteria of Financial Accounting
Standard No. 131, Disclosures about Segments of an Enterprise and Related
Information, the Company has determined that it operates in one segment
providing integrated Internet management solutions.

The following presents revenue by geographic region for the year ended
September 30, 2001:

|              |  |      |           | 
|------------- |  | ---- | --------- | 
|              |  | 2001
|              |  |      |          
|United States |  | $    | 7,949,000 | 
|International |  |      | 1,172,000 | 
|              |  |      |           | 
|              |  | $    | 9,121,000 | 
|              |  |      |           | 

International revenues for the years ended September 30, 2000 and 1999
were not significant. Long-lived assets located outside the United States are
not significant.

Recently Issued Accounting Standard

In July 2001, the
FASB issued Financial Accounting Standard 141  Business
Combinations (FAS 141). FAS 141, effective for all business combinations
initiated after July 1, 2001, requires that all business combinations be
accounted for using the purchase method of accounting. Further, FAS 141
requires certain intangible assets to be recognized as assets apart from
goodwill if they meet certain criteria. FAS 141 also requires expanded
disclosures regarding the primary reason for consummation of the combination
and the allocation of the purchase price to the assets acquired and liabilities
assumed by major balance sheet caption. The Company does not expect FAS 141 to
have a material effect on its results of operations or financial position.

In July 2001, the
FASB issued Financial Accounting Standard 142  Goodwill
and Intangible Assets (FAS 142). FAS 142, effective for fiscal years beginning
after December 15, 2001, defines accounting requirements for the treatment of
goodwill. Under FAS 142, goodwill is considered to have an indefinite life and
is therefore subject to impairment accounting rather than amortization. As the
Company does not have any recorded goodwill as of September 30, 2001, FAS 142
is not expected to have a material effect on the Companys results of
operations or financial position.

In July 2001, the
FASB issued Financial Accounting Standard 143 
Accounting for Asset Retirement Obligations (FAS 143). FAS 143, effective for
fiscal years beginning after June 15, 2002, addresses financial accounting and
reporting for obligations associated

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with the retirement of tangible long-lived assets and the associated asset
retirement costs. It applies to legal obligations associated with the
retirement of long-lived assets that result from acquisition, construction,
development, and (or) the normal operation of a long-lived asset, except for
certain obligations of lessees. The Company does not expect FAS 143 to have a
material effect on its results of operations or financial position.

In August 2001, the
FASB issued Financial Accounting Standard 144 
Accounting for the Impairment or Disposal of Long-Lived Assets (FAS 144). FAS
144, effective for fiscal years beginning after December 15, 2001, addresses
financial accounting and reporting for the impairment or disposal of long-lived
assets. The Company does not expect FAS 144 to have a material effect on its
results of operations or financial position.

Reclassifications

Certain reclassifications of prior year balances have been made for
consistent presentation with the current year. These reclassifications have
not impacted previously reported net loss, shareholders equity or cash flows.

3. Change in Accounting Policy

In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB
101). SAB 101 requires that up-front installation fees be deferred and
recognized over the term of the customer relationship. In fiscal 2000 and
previous years, the Company recognized installation revenue upon completion of
the installation. Effective October 1, 2000, in accordance with the provisions
of SAB 101, the Company began deferring installation revenue over the expected
life of the customer relationship periods. The adoption of SAB 101 resulted in
a one-time, non-cash charge of $3.6 million on October 1, 2000 for the
cumulative effect of the change in accounting policy. The cumulative effect
was recorded as deferred revenue and is being recognized as revenue over the
remaining customer relationship periods. The net effect of the change on fiscal
year 2001 was to increase net losses by $1.0 million ($0.05 per share),
comprised of the $3.6 million cumulative effect of accounting change ($0.16 per
share), net of $2.6 million of the related deferred revenue which was
recognized as revenue during the year ($0.12 per share). The remainder of the
related deferred revenue will be recognized as revenue as follows: $0.8
million in fiscal 2002 and $0.2 million in fiscal 2003.

4. Investments

The Company does not hold any investments as of September 30, 2001. The
following table summarizes the composition of the Companys held-to-maturity
investments at September 30, 2000 and 1999, respectively.

|                               |  |            |            |            |  |            |       |            |  |   |          |   |  |   |            | 
|------------------------------ |  | ---------- | ---------- | ---------- |  | ---------- | ----- | ---------- |  | - | -------- | - |  | - | ---------- | 
|                               |  |            |            |            |  | Gross      |       | Gross      |  |   |          |  
|                               |  | Amortized  |            | Unrealized |  | Unrealized |       | Aggregate 
|                               |  | Cost Basis |            | Gains      |  | Losses     |       | Fair Value
|                               |  |            |            |            |  |            |       |           
|2000                           |  |            |            |            |  |            |       |            |  |   |          |   |  |   |            | 
|U.S. Corporate Debt Securities |  | $          | 7,305,000  |            |  | $          |       |            |  | $ | (20,000  | ) |  | $ | 7,285,000  | 
|Medium and Short Term Notes    |  |            | 3,599,000  |            |  |            |       |            |  |   | (13,000  | ) |  |   | 3,586,000  | 
|Euro Dollar Bonds              |  |            | 2,388,000  |            |  |            |       |            |  |   | (2,000   | ) |  |   | 2,386,000  | 
|Taxable Auction Securities     |  |            | 4,000,000  |            |  |            |       |            |  |   |          |   |  |   | 4,000,000  | 
|                               |  |            |            |            |  |            |       |            |  |   |          |   |  |   |            | 
|                               |  | $          | 17,292,000 |            |  | $          |      |            |  | $ | (35,000  | ) |  | $ | 17,257,000 | 
|                               |  |            |            |            |  |            |       |            |  |   |          |   |  |   |            | 
|1999                           |  |            |            |            |  |            |       |            |  |   |          |   |  |   |            | 
|U.S. Corporate Debt Securities |  | $          | 26,390,000 |            |  | $          | 1,000 |            |  | $ | (81,000  | ) |  | $ | 26,310,000 | 
|Medium and Short Term Notes    |  |            | 14,350,000 |            |  |            |       |            |  |   | (57,000  | ) |  |   | 14,293,000 | 
|Euro Dollar Bonds              |  |            | 3,895,000  |            |  |            |       |            |  |   | (15,000  | ) |  |   | 3,880,000  | 
|Taxable Auction Securities     |  |            | 8,000,000  |            |  |            |       |            |  |   |          |   |  |   | 8,000,000  | 
|                               |  |            |            |            |  |            |       |            |  |   |          |   |  |   |            | 
|                               |  | $          | 52,635,000 |            |  | $          | 1,000 |            |  | $ | (153,000 | ) |  | $ | 52,483,000 | 
|                               |  |            |            |            |  |            |       |            |  |   |          |   |  |   |            | 

All held-to-maturity investments at September 30, 2000 came due within
fiscal year 2001.

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5. Property and Equipment

Property and equipment consists of the following:

|                                                |  |               |            |      |  |   |            |  
|----------------------------------------------- |  | ------------- | ---------- | ---- |  | - | ---------- | -
|                                                |  | September 30,
|                                                |  |              
|                                                |  | 2001          |            | 2000
|                                                |  |               |            |     
|Computer equipment                              |  | $             | 5,265,000  |      |  | $ | 11,469,000 |  
|Furniture and fixtures                          |  |               | 1,058,000  |      |  |   | 1,071,000  |  
|Leasehold improvements                          |  |               | 908,000    |      |  |   | 1,033,000  |  
|Internal use software                           |  |               | 1,005,000  |      |  |   | 1,374,000  |  
|Other assets  vehicles                         |  |               | 88,000     |      |  |   | 174,000    |  
|                                                |  |               |            |      |  |   |            |  
|                                                |  |               | 8,324,000  |      |  |   | 15,121,000 |  
|Less: Accumulated depreciation and amortization |  |               | (5,188,000 | )    |  |   | (4,929,000 | )
|                                                |  |               |            |      |  |   |            |  
|                                                |  | $             | 3,136,000  |      |  | $ | 10,192,000 |  
|                                                |  |               |            |      |  |   |            |  

Depreciation and amortization expense for property and equipment was
$4,456,000, $3,301,000 and $1,159,000 for the years ended September 30, 2001,
2000, and 1999, respectively. Assets under capital lease are pledged as
collateral for the underlying lease agreements.

6. Termination of Borrowing

In April 2001, Comerica (formerly Imperial Bank) notified the Company that
it was in violation of certain covenants specified in the loan agreement dated
September 20, 2000. As a result, the company paid off the entire loan balance
of $3.9 million in May 2001.

The Company has a revolving line of credit facility with Comerica, which
allows for draws up to a maximum short-term borrowing of $2.5 million if
specified conditions are met. Current commitments against the line of credit
consist of an irrevocable standby letter of credit for our leased office space
in the amount of $665,000, which expires on July 31, 2005, and a $10,000
deposit held by Comerica for the issuance of corporate credit cards. The total
of these commitments is in excess of our borrowing base as of September 30,
2001. To cover the over-advance against the line of credit, we established a
$675,000, 30-day, automatically renewing certificate of deposit, which is
pledged as collateral to Comerica. The cash restriction will remain in effect
until such time as our over-advance is cured.

7. Severance Expense

During fiscal 2001, the Company reduced the overall level of world-wide
staffing by approximately 60%, or 164 employees, spanning across all
departments. The reduction in force resulted in severance charges of $1.5
million during the year. Accrued severance charges at September 30, 2001 of
$323,000 will be paid out during fiscal 2002.

8. Impairment Losses

Intangible assets related to the fiscal 2000 acquisition of N2H2 Pty
Limited were assessed for impairment at September 30, 2000 due to operating
results and forecasts from N2H2 Pty Limited being less than expected. This
assessment resulted in a write-down of intangible assets of $6.1 million for
fiscal 2000. During fiscal 2001, the Company recorded an additional $1.4
million write-down for the remaining carrying value of acquired intangible
assets, again due to operating results and forecasts being less than expected.
The impairment charges were calculated as the excess of the fair value, as
calculated by the present value of future cash flows from N2H2 Pty Limited,
over the carrying value of the intangible assets.

During fiscal 2001, the Company recorded a $3.0 million impairment loss on
a strategic investment in a privately held company. The loss represented the
Companys entire investment in the common stock of the company. The impairment
was recorded based on currently available financial information of the investee
company.

During fiscal 2001, the Company recorded a $0.5 million write down on
software license agreements, which will not be used as part of current or
future product offerings. The impairment charge represented the total net
carrying value of the technology licenses.

During fiscal 2001, the Company introduced its new software-based
filtering solutions and thereby plans to eventually phase out the proxy server
product line. The Company will no longer promote the proxy server-based
product to new customers. N2H2 plans to continue support of our existing
customers proxy-based filtering installations, however, an effort will be made
to migrate existing

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proxy-using customers to one of the new software-based filtering
solutions. Under the guidance provided by Financial Accounting Standard No.
121 (FAS 121), the Company concluded that an event has occurred which indicated
the recovery of the carrying amounts for related field servers should be
assessed. Consequently, management completed a cash flow analysis of the field
server assets, which showed that the estimated cash flows were less than the
carrying value of the field server assets. Accordingly, pursuant to FAS 121,
management estimated the fair value of the field server assets to be zero based
upon third party evidence, and hence recorded an impairment charge of $3.4
million.

9. Lease Commitments

The Companys property held under capital leases, which is included in
property and equipment at September 30, 2001, 2000, and 1999, consists
primarily of computer equipment in the gross amount of $606,000, $606,000, and
$2,644,000, respectively. Related accumulated amortization for those assets was
$202,000, $219,000, and $675,000 for the years then ended. The Company is also
committed under operating leases for its headquarter facilities which include
lease escalation clauses. Rent expense for the years ended September 30, 2001,
2000, and 1999 was $1,387,000, $1,311,000, and $307,000, respectively.
Effective November 1, 2001, the Company entered into an agreement to sublease a
portion of its office space. The sublease agreement is non-cancelable and
effective through August 30, 2005, the end of the original lease term.

The minimum annual rental commitments on all leases at September 30, 2001
are as follows:

|                                            |                              |   |           |           |         |   |          |         | 
|------------------------------------------- | ---------------------------- | - | --------- | --------- | ------- | - | -------- | ------- | 
|                                            |                              |   | Operating |           | Capital
|                                            |                              |   | Lease     |           | Leases 
|                                            |                              |   |           |           |        
|Years Ending September 30,                  |                              |   |           |           |         |   |          |        
|2002                                        |                              | $ | 1,190,000 |           |         | $ | 223,000  |        
|2003                                        |                              |   | 1,228,000 |           |         |   | 23,000   |        
|2004                                        |                              |   | 1,266,000 |           |         |   |         |        
|2005                                        |                              |   | 1,205,000 |           |         |   |         |        
|2006                                        |                              |   |          |           |         |   |         |        
|Thereafter                                  |                              |   |          |           |         |   |         |        
|                                            |                              |   |           |           |         |   |          |        
|                                            | Total minimum lease payments |   | $         | 4,889,000 |         |   |          | 246,000 | 
|                                            |                              |   |           |           |         |   |          |        
|Less: Amount representing interest          |                              |   |           |           |         |   | (14,000  | )      
|                                            |                              |   |           |           |         |   |          |        
|Present value of capital lease obligation   |                              |   |           |           |         |   | 232,000  |        
|Less: Current portion                       |                              |   |           |           |         |   | (203,000 | )      
|                                            |                              |   |           |           |         |   |          |        
|Long-term obligations at September 30, 2001 |                              |   |           |           |         | $ | 29,000   |        
|                                            |                              |   |           |           |         |   |          |        

The minimum annual proceeds from sublease at September 30, 2001 are as
follows:

|                           |                                 |   |           |         | 
|-------------------------- | ------------------------------- | - | --------- | ------- | 
|                           |                                 |   | Operating
|                           |                                 |   | Lease    
|                           |                                 |   |          
|Years Ending September 30, |                                 |   |           |        
|2002                       |                                 | $ | 179,000   |        
|2003                       |                                 |   | 196,000   |        
|2004                       |                                 |   | 196,000   |        
|2005                       |                                 |   | 179,000   |        
|2006                       |                                 |   |          |        
|Thereafter                 |                                 |   |          |        
|                           |                                 |   |           |        
|                           | Total minimum sublease proceeds |   | $         | 750,000 | 
|                           |                                 |   |           |        

10. Business Combination

On February 23, 2000, the Company acquired N2H2 Pty Limited (formerly
Iseek Pty Limited), a privately held company incorporated in Queensland,
Australia, in an all-stock transaction. The transaction was accounted for as a
purchase.

As consideration, the shareholders of N2H2 Pty Limited received 925,000
shares of the Companys common stock. The shares were valued using the market
price of the Companys common stock for the two days before and after the
acquisition was announced. A total of 512,000 of the shares issued were issued
to the founders of N2H2 Pty Limited and were subject to an escrow provision.
The escrowed shares are being released equally over three years, based on the
continued employment of the founders. As of September 30, 2001, 341,000 shares remain in escrow.

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The value of these shares has been
treated as deferred compensation and is being amortized over the three-year
employment period. The Company has recorded $3,713,000 and $3,176,000 of
related compensation expense in fiscal 2001 and 2000, respectively.

In addition, the Company issued a warrant for 100,000 shares of common
stock at the exercise price of $22.50 to certain N2H2 Pty Limited shareholders
in exchange for a covenant not to compete. The fair value of the warrants was
determined using the Black-Scholes option pricing model, using a 95% volatility
factor, an expected life of 5 years, and a risk-free interest rate of 6.38%.

The total purchase price was as follows:

|                           |                      |   |            |            | 
|-------------------------- | -------------------- | - | ---------- | ---------- | 
|Common stock issued        |                      | $ | 16,104,000 |           
|Warrant issued             |                      |   | 1,255,000  |           
|Acquisition costs incurred |                      |   | 287,000    |           
|Liabilities assumed        |                      |   | 54,000     |           
|                           |                      |   |            |           
|                           | Total purchase price |   | $          | 17,700,000 | 
|                           |                      |   |            |           

The total purchase price of $17,700,000 was allocated to the fair value of
the assets acquired as follows:

|                      |                          |                         |           |           |            |  |   |              |  | 
|--------------------- | ------------------------ | ----------------------- | --------- | --------- | ---------- |  | - | ------------ |  | 
|                      |                          |                         |           |           |            |  |   | Amortization
|                      |                          |                         |           |           |            |  |   | Life        
|                      |                          |                         |           |           |            |  |   |             
|Tangible assets       |                          | $                       | 210,000   |           |            |  |  |             
|Intangible assets:    |                          |                         |           |           |            |  |   |             
|                      | Client redirect software |                         |           | 919,000   |            |  |   | 5            | 
|                      | Customer lists           |                         |           | 572,000   |            |  |   | 5            | 
|                      | Covenant not to compete  |                         |           | 1,255,000 |            |  |   | 5            | 
|                      | Goodwill                 |                         |           | 5,834,000 |            |  |   | 5            | 
|                      |                          |                         |           |           |            |  |   |             
|                      |                          | Total intangible assets |           |           | 8,580,000  |  |   |              |  | 
|Deferred compensation |                          |                         | 8,910,000 |           |            |  | 3 |             
|                      |                          |                         |           |           |            |  |   |             
|                      |                          | Total purchase price    |           | $         | 17,700,000 |  |   |              |  | 
|                      |                          |                         |           |           |            |  |   |             

The results of operations of N2H2 Pty Limited have been included in the
Companys Consolidated Statement of Operations since the purchase date.

Intangible assets were amortized on a straight-line basis. In September
2000, as a result of N2H2 Pty Limiteds operations not meeting expected
forecasts, the Company recorded a $6.1 million write down of the carrying value
of the acquired intangible assets. In June 2001, the Company recorded an
additional $1.4 million write down for the full remaining carrying value of
intangible assets acquired as part of the N2H2 Pty Limited purchase. The
write-downs were applied first against goodwill, with the excess applied
against other acquired intangible assets. The impairment losses were calculated
as the excess carrying value over the present value of future cash flows and
the estimated terminal value of the intangible assets.

Deferred compensation is being amortized using an accelerated method in
accordance with Financial Accounting Standards Boards interpretation number
28.

The following pro forma financial information is unaudited and gives
effect to the acquisition, assuming that the acquisition took place on October
1, 1998:

|                                     |  |                          |             |      |  |   |             |  
|------------------------------------ |  | ------------------------ | ----------- | ---- |  | - | ----------- | -
|                                     |  | Year Ended September 30,
|                                     |  |                         
|                                     |  | 2000                     |             | 1999
|                                     |  |                          |             |     
|                                     |  | (unaudited)             
|Revenue                              |  | $                        | 10,987,000  |      |  | $ | 6,699,000   |  
|Net loss                             |  | $                        | (41,089,000 | )    |  | $ | (14,998,000 | )
|Basic and diluted net loss per share |  | $                        | (1.89       | )    |  | $ | (1.07       | )

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11. Sale of Iseek Communications

On August 31, 2001, the Company sold the assets and liabilities of Iseek
Communications for $1.00. Iseek Communications was a subsidiary of N2H2 Pty
Limited and offered a product line consisting of Internet hosting and
collocation services in Australia. The Company recorded a loss on the sale of
$205,000.

12. Related Party Transactions

During the year ended September 30, 2000, the Company entered into seven
separate note receivable agreements with four shareholders, three of which were
Officers of the Company. A total of $1,844,000 was loaned to shareholders
during fiscal 2000, bearing interest at 8% per annum and maturing between
October 2000 and November 2001. The carrying value of these loans had been
reduced in fiscal 2000 by a provision of $805,000 to reflect amounts which may
not be collectible.

During the year ended September 30, 2001, the Company entered into
agreements with two of the former officers to accept shares of N2H2 common
stock held by the officers in exchange for forgiveness of amounts due to the
Company under shareholder loans. As a result of these transactions, a total of
808,000 shares of common stock were repurchased by the Company at prices
between $1.00 and $1.50 per share. The excess of the repurchase price over the
market value of the common stock at the date of repurchase was $417,000, of
which $343,000 was applied against the previously recorded reserve for
shareholder loans and the remainder was charged to compensation expense.

The Company also entered into an agreement with another former officer of
the Company to withhold severance consideration due to the officer under
employment contract in exchange for forgiveness of amounts owed to the Company
under shareholder loans. The Company recorded a charge to compensation expense
of $374,000 in fiscal 2001 representing the portion of the loans forgiven. The
remaining loan balance at September 30, 2001 of $294,000 is due under a revised
promissory note, which bears interest at 6.875% per annum. The balance due at
September 30, 2001 is almost entirely offset by the reserve for shareholder
loans.

In August and September of 1999, the Company entered into four separate
recourse note receivable agreements bearing interest at 6% per annum with
employees totaling $25,000 in connection with the exercise of options. The
notes matured and were paid in February 2000.

13. Income Taxes

A provision for income taxes was not recorded for the periods ended
September 30, 2001, 2000 or 1999 due to taxable losses incurred during those
periods. A valuation allowance has been recorded for deferred tax assets as it
has been determined that it is more likely than not that these deferred tax
assets will not be realized.

The provision for federal income tax differs from the amount computed by
applying the statutory federal income tax rate for the following reasons:

|                                             |  |               |       |               |  |  |       |   
|-------------------------------------------- |  | ------------- | ----- | ------------- |  |  | ----- | --
|                                             |  | September 30, |       | September 30,
|                                             |  | 2001          |       | 2000         
|                                             |  |               |       |              
|Federal income tax benefit at statutory rate |  |               | (34.0 | )%            |  |  | (34.0 | )%
|Other                                        |  |               | (0.6  | )             |  |  | (0.2  | ) 
|Change in valuation allowance                |  |               | 33.4  |               |  |  | 34.2  |   
|                                             |  |               |       |               |  |  |       |   
|                                             |  |               | 0     | %             |  |  | 0     | % 
|                                             |  |               |       |               |  |  |       |   

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Deferred tax assets and liabilities at September 30, 2001 consist of the
following:

|                     |                                   |                                |   |               |            |               |   |             |            | 
|-------------------- | --------------------------------- | ------------------------------ | - | ------------- | ---------- | ------------- | - | ----------- | ---------- | 
|                     |                                   |                                |   | September 30, |            | September 30,
|                     |                                   |                                |   | 2001          |            | 2000         
|                     |                                   |                                |   |               |            |              
|Deferred tax assets: |                                   |                                |   |               |            |               |   |            
|                     | Net operating loss carryforwards  |                                | $ | 18,811,000    |            |               | $ | 11,880,000  |           
|                     | Cash to accrual adjustment        |                                |   | 3,106,000     |            |               |   |            |           
|                     | Allowance for doubtful accounts   |                                |   | 89,000        |            |               |   | 98,000      |           
|                     | Accrued compensation and benefits |                                |   | 2,775,000     |            |               |   | 130,000     |           
|                     | Depreciation and amortization     |                                |   | 154,000       |            |               |   | 630,000     |           
|                     |                                   |                                |   |               |            |               |   |            
|                     |                                   | Total deferred tax assets      |   |               | 24,935,000 |               |   |             | 12,738,000 | 
|                     | Cash to accrual adjustments       |                                |   | 718,000       |            |               |   | 338,000     |           
|                     |                                   | Total deferred tax liabilities |   |               | 718,000    |               |   |             | 338,000    | 
|                     | Valuation allowance               |                                |   | (24,217,000   | )          |               |   | (12,400,000 | )         
|                     |                                   |                                |   |               |            |               |   |            
|                     | Net deferred tax asset            |                                | $ |              |            |               | $ |            |           
|                     |                                   |                                |   |               |            |               |   |            

As of September 30, 2001, the Company had net operating loss
carry-forwards of approximately $55 million to offset future taxable income for
Federal income tax purposes, which will expire through 2020. Should certain
changes in the Companys ownership occur, there could be a limitation on the
utilization of its net operating losses.

14. Factoring Agreement

During fiscal 1999, the Company terminated its factoring agreement with
the bank. Prior to that, pursuant to a factoring agreement entered into in
September 1997 and amended July 14, 1998, the Companys bank acted as its
factor for the majority of its receivables, assigned on a pre-approved, full
recourse basis, up to $1,000,000. The Company sold its eligible receivables at
a 0.3% discount to face value and was charged 1.6% of uncollected assigned
balances per month. Pursuant to the agreement, the Company repurchased any
assigned receivables outstanding 90 days after the invoice date. Total interest
paid on factored receivables was $35,000 for fiscal 1999.

15. Common Stock

On September 30, 1997, September 30, 1998, and July 8, 1999, the Board of
Directors declared a one hundred twenty five-for-one, a seven-for-one, and a
five-for-two stock split, respectively, on the Companys common stock effected
in the form of a stock dividend to holders of record on these dates. Common
stock issued and stock option information in these financial statements have
been restated to reflect these splits.

As of May 10, 1999, the Company amended its Articles of Incorporation to
authorize the issuance of 50,000,000 shares of preferred stock and 250,000,000
shares of common stock at no par value. The terms of the preferred stock are to
be determined by the Board of Directors.

On May 11, 1999, the Company completed a private equity financing in which
2,443,215 shares of common stock were sold to investors at $3.70 per share for
an aggregate of $8,830,122, net of issuance costs. In connection with this
financing, the Company satisfied promissory notes plus accrued interest
totaling $970,005 by issuing 262,447 shares of common stock.

On July 29, 1999, the Company completed its initial public offering of
5,000,000 shares of common stock at a purchase price of $13.00 per share. Of
the shares sold, 4,950,000 were sold by the Company, and 50,000 were offered by
a group of selling shareholders. Net proceeds received by the Company were
$58.4 million.

On February 23, 2000, the Company issued 925,000 shares of common stock in
connection with the acquisition of N2H2 Pty Limited (Note 10).

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16. Stock Purchase Warrants

On March 11, 1999, the Company redeemed an outstanding warrant for 50,000
shares of its common stock, and recorded a redemption charge of $185,000 in
fiscal 1999.

Pursuant to the acquisition of N2H2 Pty Limited, the Company issued a
warrant on February 23, 2000 for the purchase of 100,000 shares of common stock
at an exercise price of $22.50 per share. The warrant expires on February 23,
2004 and may be exercised at any time. The fair value of the warrant on the
date of grant was $1,254,800 and has been accounted for in the purchase of N2H2
Pty Limited.

The following summarizes stock warrant activity for fiscal 1999, 2000 and
2001:

|                              |  |  |            |  
|----------------------------- |  |  | ---------- | -
|Balance at September 30, 1998 |  |  | 1,506,058  |  
|Warrants issued               |  |  | 558,000    |  
|Warrants canceled             |  |  | (1,599,058 | )
|Warrants exercised            |  |  | (6,342     | )
|                              |  |  |            |  
|Balance at September 30, 1999 |  |  | 458,658    |  
|Warrants issued               |  |  | 100,000    |  
|Warrants canceled             |  |  |           |  
|Warrants exercised            |  |  | (19,375    | )
|                              |  |  |            |  
|Balance at September 30, 2000 |  |  | 539,283    |  
|                              |  |  |            |  
|Warrants issued               |  |  |           |  
|Warrants canceled             |  |  |           |  
|Warrants exercised            |  |  |           |  
|                              |  |  |            |  
|Balance at September 30, 2001 |  |  | 539,283    |  
|                              |  |  |            |  

The Company recorded compensation expense of $77,000 in fiscal 1999
related to the issuance of these warrants. No compensation expense was incurred
for fiscal 2000 and 2001. Additionally, the Company has issued options to
certain non-employees under the 1999 Stock Option Plan as described below.

17. Stock Option Plans

Effective September 30, 1997, the Company adopted the 1997 Stock Option
Plan (the 1997 Plan) for employees, directors, consultants or independent
contractors under which 2,187,500 shares of common stock are reserved for stock
option grants. Effective April 2, 1999, the Company adopted the 1999 Stock
Option Plan (the 1999 Plan) for employees, directors, consultants or
independent contractors under which 1,329,625 shares of common stock are
reserved for stock option grants. Effective September 14, 1999 the Company
adopted the 1999/2000 Transition Plan (the 1999/2000 Plan) for employees,
consultants, and independent contractors under which 750,000 shares of common
stock are reserved for stock option grants. On November 8, 1999 the number of
shares was increased by 500,000 shares to 1,250,000 by the Board of Directors.
Effective November 8, 1999, the Company adopted the 2000 Stock Option Plan (the
2000 Plan) for employees and consultants under which 4,000,000 shares of common
stock are reserved for stock option grants. Pursuant to all plans, the Board of
Directors may grant nonqualified and incentive stock options. The vesting
period, exercise price and expiration period of options are established at the
discretion of the Board of Directors, except that the exercise price of
incentive stock options must equal the fair market value of the underlying
common stock on the date of the grant. Option grants to date generally vest
over a two, three, or four-year period and expire ten years from the date of
grant.

Effective July 30, 1999 the Company adopted the Non-Employee Director
Stock Option Plan, under which the Board of Directors has provided for the
automatic grant of options to purchase shares of common stock to non-employee
directors of the Company. The Company has reserved a total of 87,500 shares of
common stock for issuance as nonqualified stock options to non-employee
directors. The options are priced based on the fair market value on the date of
grant and become fully exercisable following the sixth month after grant date.
Options granted under this plan are exercisable at any time prior to the
expiration date of the stock option or within three months after the date the
grantee ceases to be a director, whichever is shorter.

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During fiscal 1999 and 2000 the Company issued 900,000 and 460,000
options, respectively, to employees outside of the authorized plans referenced
above which, when exercised, constitute securities which have not been
registered under the Securities Act of 1933, as amended. The vesting period,
exercise price and expiration period of these nonqualified options are
established at the discretion of the Board of Directors.

On November 29, 2001, the Company allowed eligible employees to cancel
certain outstanding stock option grants to purchase 675,505 shares of common
stock. The Company has agreed to grant to these same employees options to
purchase 347,267 shares of common stock (the New Options) six months plus one
day after the cancellation date, or June 1, 2002 (the Grant Date), provided
that the exercise price of the new options will be the fair value of the common
stock at the Grant Date, the related employees do not receive any additional
grants of options prior to the Grant Date, and the related employees are common
law employees of N2H2 on the Grant Date. The Company accounts for stock-based
compensation using the intrinsic value method prescribed by APB 25.
Accordingly, compensation cost for stock options is measured as the excess, if
any, of the fair value of N2H2s common stock at the date of grant over the
exercise price to acquire the stock. Therefore, the Company will not recognize
compensation expense related to the grant of New Options.

The following summarizes the activity under our Stock Option Plans:

|                              |                   |      |           |          |      |      |           |           |           |      |        |        |         |       |           |           |   |  |           |            |   |  |         |            |   |  |           |            |  
|----------------------------- | ----------------- | ---- | --------- | -------- | ---- | ---- | --------- | --------- | --------- | ---- | ------ | ------ | ------- | ----- | --------- | --------- | - |  | --------- | ---------- | - |  | ------- | ---------- | - |  | --------- | ---------- | -
|                              |                   |      |           |          |      |      |           |           |           |      |        |        |         |       |           |           |   |  |           |            |   |  | Options |            |   |  |          
|                              |                   |      |           |          |      |      |           |           |           |      |        |        |         |       |           |           |   |  |           |            |   |  | Issued  |            |   |  |          
|                              |                   |      | 1997      |          | 1999 |      | Directors |           | 1999/2000 |      | 2000   |        | Outside |       |           |           |  
|Options Outstanding           |                   | Plan |           | Plan     |      | Plan |           | Plan      |           | Plan |        | Plans  |         | Total
|                              |                   |      |           |          |      |      |           |           |           |      |        |        |         |      
|Balance at October 1, 1998    |                   |      | 1,683,938 |          |      |      |           |           |           |      |        |        |         |       |           |           |   |  |           |            |   |  |         |            |   |  | 1,683,938 |           
|                              | Options granted   |      |           | 198,249  |      |      |           | 1,327,624 |           |      |        | 3,750  |         |       |           |           |   |  |           |            |   |  |         | 900,000    |   |  |           | 2,429,623  |  
|                              | Options exercised |      |           | (792,603 | )    |      |           |           |           |      |        |        |         |       |           |           |   |  |           |            |   |  |         |            |   |  |           | (792,603   | )
|                              | Options cancelled |      |           | (83,500  | )    |      |           | (11,250   | )         |      |        |        |         |       |           |           |   |  |           |            |   |  |         |            |   |  |           | (94,750    | )
|                              |                   |      |           |          |      |      |           |           |           |      |        |        |         |       |           |           |   |  |           |            |   |  |         |            |   |  |           |           
|Balance at September 30, 1999 |                   |      | 1,006,084 |          |      |      | 1,316,374 |           |           |      | 3,750  |        |         |       |           |           |   |  |           |            |   |  | 900,000 |            |   |  | 3,226,208 |           
|                              | Options granted   |      |           | 63,400   |      |      |           | 66,233    |           |      |        |        |         |       |           | 1,496,625 |   |  |           | 1,366,385  |   |  |         | 460,000    |   |  |           | 3,452,643  |  
|                              | Options exercised |      |           | (384,539 | )    |      |           | (152,857  | )         |      |        |        |         |       |           |           |   |  |           |            |   |  |         |            |   |  |           | (537,396   | )
|                              | Options cancelled |      |           | (58,925  | )    |      |           | (136,879  | )         |      |        |        |         |       |           | (449,750  | ) |  |           | (72,165    | ) |  |         | (1,080,000 | ) |  |           | (1,797,719 | )
|                              |                   |      |           |          |      |      |           |           |           |      |        |        |         |       |           |           |   |  |           |            |   |  |         |            |   |  |           |           
|Balance at September 30, 2000 |                   |      | 626,020   |          |      |      | 1,092,871 |           |           |      | 3,750  |        |         |       | 1,046,875 |           |   |  | 1,294,220 |            |   |  | 280,000 |            |   |  | 4,343,736 |           
|                              | Options granted   |      |           | 101,000  |      |      |           |           |           |      |        | 83,750 |         |       |           |           |   |  |           | 2,485,371  |   |  |         |            |   |  |           | 2,670,121  |  
|                              | Options exercised |      |           | (266,716 | )    |      |           |           |           |      |        |        |         |       |           |           |   |  |           |            |   |  |         |            |   |  |           | (266,716   | )
|                              | Options cancelled |      |           | (208,037 | )    |      |           | (601,571  | )         |      |        |        |         |       |           | (567,950  | ) |  |           | (1,374,622 | ) |  |         | (150,000   | ) |  |           | (2,902,180 | )
|                              |                   |      |           |          |      |      |           |           |           |      |        |        |         |       |           |           |   |  |           |            |   |  |         |            |   |  |           |           
|Balance at September 30, 2001 |                   |      | 252,267   |          |      |      | 491,300   |           |           |      | 87,500 |        |         |       | 478,925   |           |   |  | 2,404,969 |            |   |  | 130,000 |            |   |  | 3,844,961 |           
|                              |                   |      |           |          |      |      |           |           |           |      |        |        |         |       |           |           |   |  |           |            |   |  |         |            |   |  |           |           

|                              |                   |      |         |          |      |      |           |            |           |      |        |         |         |       |         |            |   |  |           |            |   |  |          |           |   |  |           |            |  
|----------------------------- | ----------------- | ---- | ------- | -------- | ---- | ---- | --------- | ---------- | --------- | ---- | ------ | ------- | ------- | ----- | ------- | ---------- | - |  | --------- | ---------- | - |  | -------- | --------- | - |  | --------- | ---------- | -
|                              |                   |      |         |          |      |      |           |            |           |      |        |         |         |       |         |            |   |  |           |            |   |  | Options  |           |   |  |          
|                              |                   |      |         |          |      |      |           |            |           |      |        |         |         |       |         |            |   |  |           |            |   |  | Issued   |           |   |  |          
|                              |                   |      | 1997    |          | 1999 |      | Directors |            | 1999/2000 |      | 2000   |         | Outside |       |         |            |  
|Options Available             |                   | Plan |         | Plan     |      | Plan |           | Plan       |           | Plan |        | Plans   |         | Total
|                              |                   |      |         |          |      |      |           |            |           |      |        |         |         |      
|
|Balance at October 1, 1998    |                   |      | 129,500 |          |      |      |           |            |           |      |        |         |         |       |         |            |   |  |           |            |   |  |          |           |   |  | 129,500   |           
|                              | Shares authorized |      |         |          |      |      |           | 1,329,625  |           |      |        | 87,500  |         |       |         | 750,000    |   |  |           |            |   |  |          |           |   |  |           | 2,167,125  |  
|                              | Options granted   |      |         | (198,249 | )    |      |           | (1,327,624 | )         |      |        | (3,750  | )       |       |         |            |   |  |           |            |   |  |          | (900,000  | ) |  |           | (2,429,623 | )
|                              | Options cancelled |      |         | 83,500   |      |      |           | 11,250     |           |      |        |         |         |       |         |            |   |  |           |            |   |  |          |           |   |  |           | 94,750     |  
|                              |                   |      |         |          |      |      |           |            |           |      |        |         |         |       |         |            |   |  |           |            |   |  |          |           |   |  |           |           
|Balance at September 30, 1999 |                   |      | 14,751  |          |      |      | 13,251    |            |           |      | 83,750 |         |         |       | 750,000 |            |   |  |           |            |   |  | (900,000 | )         |   |  | (38,248   | )         
|                              | Shares authorized |      |         |          |      |      |           |            |           |      |        |         |         |       |         | 500,000    |   |  |           | 4,000,000  |   |  |          |           |   |  |           | 4,500,000  |  
|                              | Options granted   |      |         | (63,400  | )    |      |           | (66,233    | )         |      |        |         |         |       |         | (1,496,625 | ) |  |           | (1,366,385 | ) |  |          | (460,000  | ) |  |           | (3,452,643 | )
|                              | Options cancelled |      |         | 58,925   |      |      |           | 136,879    |           |      |        |         |         |       |         | 449,750    |   |  |           | 72,165     |   |  |          | 1,080,000 |   |  |           | 1,797,719  |  
|                              |                   |      |         |          |      |      |           |            |           |      |        |         |         |       |         |            |   |  |           |            |   |  |          |           |   |  |           |           
|Balance at September 30, 2000 |                   |      | 10,276  |          |      |      | 83,897    |            |           |      | 83,750 |         |         |       | 203,125 |            |   |  | 2,705,780 |            |   |  | (280,000 | )         |   |  | 2,806,828 |           
|                              | Shares authorized |      |         |          |      |      |           |            |           |      |        |         |         |       |         |            |   |  |           |            |   |  |          |           |   |  |           |            |  
|                              | Options granted   |      |         | (101,000 | )    |      |           |            |           |      |        | (83,750 | )       |       |         |            |   |  |           | (2,485,371 | ) |  |          |           |   |  |           | (2,670,121 | )
|                              | Options cancelled |      |         | 208,037  |      |      |           | 601,571    |           |      |        |         |         |       |         | 567,950    |   |  |           | 1,374,622  |   |  |          | 150,000   |   |  |           | 2,902,180  |  
|                              |                   |      |         |          |      |      |           |            |           |      |        |         |         |       |         |            |   |  |           |            |   |  |          |           |   |  |           |           
|Balance at September 30, 2001 |                   |      | 117,313 |          |      |      | 685,468   |            |           |      | 0      |         |         |       | 771,075 |            |   |  | 1,595,031 |            |   |  | (130,000 | )         |   |  | 3,038,887 |           
|                              |                   |      |         |          |      |      |           |            |           |      |        |         |         |       |         |            |   |  |           |            |   |  |          |           |   |  |           |           

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|                                 |                   |      |      |       |      |      |           |      |      |      |       |       |         |       |       |       |  |   |      |      |        |   |         |       |  |   |      |       | 
|-------------------------------- | ----------------- | ---- | ---- | ----- | ---- | ---- | --------- | ---- | ---- | ---- | ----- | ----- | ------- | ----- | ----- | ----- |  | - | ---- | ---- | ------ | - | ------- | ----- |  | - | ---- | ----- | 
|                                 |                   |      |      |       |      |      |           |      |      |      |       |       |         |       |       |       |  |   |      |      |        |   | Options |       |  |   |     
|                                 |                   |      |      |       |      |      |           |      |      |      |       |       |         |       | 1999/ |       |  |   |      |      | Issued |   |         |       | 
|                                 |                   |      | 1997 |       | 1999 |      | Directors |      | 2000 |      | 2000  |       | Outside |       |       |       | 
|Weighted Average Exercise Prices |                   | Plan |      | Plan  |      | Plan |           | Plan |      | Plan |       | Plans |         | Total
|                                 |                   |      |      |       |      |      |           |      |      |      |       |       |         |      
|Balance at October 1, 1998       |                   | $    | 0.21 |       |      | $    |          |      |      | $    |      |       |         | $     |      |       |  | $ |     |      |        | $ |        |       |  | $ | 0.21 |      
|                                 | Options granted   |      |      | 1.46  |      |      |           | 3.08 |      |      |       | 11.00 |         |       |       |       |  |   |      |      |        |   |         | 9.48  |  |   |      | 5.33  | 
|                                 | Options exercised |      |      | 0.20  |      |      |           |      |      |      |       |       |         |       |       |       |  |   |      |      |        |   |         |       |  |   |      | 0.20  | 
|                                 | Options cancelled |      |      | 0.77  |      |      |           | 3.70 |      |      |       |       |         |       |       |       |  |   |      |      |        |   |         |       |  |   |      | 1.12  | 
|                                 |                   |      |      |       |      |      |           |      |      |      |       |       |         |       |       |       |  |   |      |      |        |   |         |       |  |   |      |      
|Balance at September 30, 1999    |                   | $    | 0.42 |       |      | $    | 3.07      |      |      | $    | 11.00 |       |         | $     |      |       |  | $ |     |      |        | $ | 9.48    |       |  | $ | 4.04 |      
|                                 | Options granted   |      |      | 14.00 |      |      |           | 5.47 |      |      |       |       |         |       |       | 11.63 |  |   |      | 3.11 |        |   |         | 14.04 |  |   |      | 8.50  | 
|                                 | Options exercised |      |      | 0.27  |      |      |           | 2.20 |      |      |       |       |         |       |       |       |  |   |      |      |        |   |         |       |  |   |      | 0.82  | 
|                                 | Options cancelled |      |      | 0.67  |      |      |           | 3.35 |      |      |       |       |         |       |       | 12.30 |  |   |      | 2.91 |        |   |         | 11.35 |  |   |      | 10.29 | 
|                                 |                   |      |      |       |      |      |           |      |      |      |       |       |         |       |       |       |  |   |      |      |        |   |         |       |  |   |      |      
|Balance at September 30, 2000    |                   | $    | 1.88 |       |      | $    | 3.31      |      |      | $    | 11.00 |       |         | $     | 11.34 |       |  | $ | 3.12 |      |        | $ | 9.74    |       |  | $ | 5.40 |      
|                                 | Options granted   |      |      | 0.48  |      |      |           |      |      |      |       | 0.56  |         |       |       |       |  |   |      | 0.67 |        |   |         |       |  |   |      | 0.66  | 
|                                 | Options exercised |      |      | 0.25  |      |      |           |      |      |      |       |       |         |       |       |       |  |   |      |      |        |   |         |       |  |   |      | 0.25  | 
|                                 | Options cancelled |      |      | 1.63  |      |      |           | 3.17 |      |      |       |       |         |       |       | 10.89 |  |   |      | 2.13 |        |   |         | 10.28 |  |   |      | 4.45  | 
|                                 |                   |      |      |       |      |      |           |      |      |      |       |       |         |       |       |       |  |   |      |      |        |   |         |       |  |   |      |      
|Balance at September 30, 2001    |                   | $    | 3.25 |       |      | $    | 3.48      |      |      | $    | 1.01  |       |         | $     | 11.87 |       |  | $ | 1.15 |      |        | $ | 9.13    |       |  | $ | 3.19 |      
|                                 |                   |      |      |       |      |      |           |      |      |      |       |       |         |       |       |       |  |   |      |      |        |   |         |       |  |   |      |      

The Company applies the accounting provisions prescribed in APB 25 and
related interpretations. In fiscal 1999, the Company issued certain stock
options with an exercise price less than the deemed fair value of the Companys
common stock at the date of grant. Deferred compensation related to these stock
options of approximately $2,151,000 was recorded during fiscal 1999 and is
being amortized over the vesting period of the options of three to four years.
Amortization of unearned compensation costs of approximately, $108,000,
$423,000, and $815,000 has been recognized as an expense for in fiscal 2001,
1999, and 2000 respectively. During fiscal 2000, the Company accelerated the
vesting of options for 354,167 shares relating to the termination of certain
employees, which resulted in recognition of $148,000 of compensation expense in
fiscal 2000.

During fiscal 1999, deferred compensation costs of $551,000 was recorded
on warrants issued to non-employees, of which $339,000 was amortized. During
fiscal 2000, the warrants were re-priced and vesting accelerated resulting in
an additional deferred compensation of $56,000 and amortization of $243,000.

In connection with the issuance of 512,000 shares to N2H2 Pty Limited
personnel, the Company recorded deferred compensation of $8.9 million. The
Company recognized compensation expense of $3,713,000 and $3,176,000 associated
with these shares during fiscal 2001 and 2000, respectively (Note 10).

Pro forma information regarding net loss is required by FAS 123, and has
been determined as if the Company had accounted for its stock options and stock
purchase plan under the minimum value method of that statement for all periods
prior to the Company becoming a public entity and fair value method of that
statement for all periods subsequent to the Company becoming a public entity.
The fair value of each option is estimated at the date of grant using the
Black-Scholes model with the following weighted-average assumptions for the
years ended September 30, 2001, 2000 and 1999:

|                                                 |  |                          |       |         |  |         |       |   |  |  |       |  
|------------------------------------------------ |  | ------------------------ | ----- | ------- |  | ------- | ----- | - |  |  | ----- | -
|                                                 |  | Year Ended September 30,
|                                                 |  |                         
|                                                 |  | 2001                     |       | 2000    |  | 1999   
|                                                 |  |                          |       |         |  |        
|Risk-free interest rate                          |  |                          | 5.25  | %       |  |         | 6.50  | % |  |  | 5.30  | %
|Dividend yield                                   |  |                          | 0.00  | %       |  |         | 0.00  | % |  |  | 0.00  | %
|Expected term of option                          |  | 4 years                  |       | 5 years |  | 5 years
|Volatility subsequent to initial public offering |  |                          | 90.00 | %       |  |         | 95.00 | % |  |  | 95.30 | %

For purposes of pro forma disclosures, the estimated fair value of the
option is amortized over the options vesting periods. The Companys pro forma
net loss would have been as follows:

|                               |  |                          |         |      |  |      |         |   |  |   |        |  
|------------------------------ |  | ------------------------ | ------- | ---- |  | ---- | ------- | - |  | - | ------ | -
|                               |  | Year Ended September 30,
|                               |  |                         
|                               |  | 2001                     |         | 2000 |  | 1999
|                               |  |                          |         |      |  |     
|Net loss as reported           |  | $                        | (35,461 | )    |  | $    | (39,258 | ) |  | $ | (7,721 | )
|Net loss pro forma             |  |                          | (37,429 | )    |  |      | (46,025 | ) |  |   | (8,447 | )
|Net loss per share as reported |  |                          | (1.63   | )    |  |      | (1.82   | ) |  |   | (0.57  | )
|Net loss per share pro forma   |  |                          | (1.72   | )    |  |      | (2.13   | ) |  |   | (0.62  | )

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The weighted-average fair values and weighted-average exercise prices per
share at the date of grant for options granted for the years ended September
30, 2001, 2000 and 1999 were as follows:

|                                                                                                                                        |  |                          |      |      |  |      |       |  |  |   |      | 
|--------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------ | ---- | ---- |  | ---- | ----- |  |  | - | ---- | 
|                                                                                                                                        |  | Year Ended September 30,
|                                                                                                                                        |  |                         
|                                                                                                                                        |  | 2001                     |      | 2000 |  | 1999
|                                                                                                                                        |  |                          |      |      |  |     
|Weighted-average fair value of options granted with exercise prices equal to
the market value of the stock at the date of grant         |  | $                        | 0.49 |      |  |      | $6.34 |  |  | $ | 2.66 | 
|Weighted-average fair value of options granted with exercise prices less
than the market value of the stock at the date of grant        |  |                          | 0.33 |      |  |      |      |  |  |   | 8.05 | 
|Weighted-average fair value of options granted with exercise prices greater
than
the market value of the stock at the date of grant     |  |                          | 0.77 |      |  |      | 9.34  |  |  |   | 2.18 | 
|Weighted-average exercise price of options granted with exercise prices
equal to
the market value of the stock at the date of grant     |  |                          | 0.65 |      |  |      | 8.43  |  |  |   | 3.59 | 
|Weighted-average exercise price of options granted with exercise prices less
than the market value of the stock at the date of grant    |  |                          | 0.43 |      |  |      |      |  |  |   | 9.30 | 
|Weighted-average exercise price of options granted with exercise prices
greater
than the market value of the stock at the date of grant |  |                          | 1.50 |      |  |      | 11.43 |  |  |   | 3.37 | 

The following table summarizes information about fixed-price options
outstanding at September 30, 2001 as follows:

|               |                 |             |         |                  |  |          |           |             |           |             |       |      |  |  |           |         |  |   |       |      | 
|-------------- | --------------- | ----------- | ------- | ---------------- |  | -------- | --------- | ----------- | --------- | ----------- | ----- | ---- |  |  | --------- | ------- |  | - | ----- | ---- | 
|               |                 |             |         |                  |  |          | Weighted- |             | Weighted- |             |       |      |  |  | Weighted-
|               |                 |             |         |                  |  |          | Average   |             | Average   |             |       |      |  |  | Average  
|Exercise       |                 | Number      |         | Remaining        |  | Exercise |           | Number      |           | Exercisable
|Prices         |                 | Outstanding |         | Contractual Life |  | Price    |           | Exercisable |           | Price      
|               |                 |             |         |                  |  |          |           |             |           |            
|               | $0.18
 $  0.36 |             |         | 740,395          |  |          |           | 9.42        |           |             | $     | 0.34 |  |  |           | 247,759 |  |   | $     | 0.33 | 
|               | $0.40
 $  0.47 |             |         | 449,000          |  |          |           | 9.48        |           |             | $     | 0.43 |  |  |           | 5,000   |  |   | $     | 0.43 | 
|               | $0.55
 $  0.86 |             |         | 731,752          |  |          |           | 9.15        |           |             | $     | 0.83 |  |  |           |        |  |   |       |     | 
|               | $0.91
 $  3.06 |             |         | 677,713          |  |          |           | 8.31        |           |             | $     | 2.19 |  |  |           | 322,213 |  |   | $     | 2.43 | 
|               | $3.34
 $  4.88 |             |         | 668,675          |  |          |           | 8.04        |           |             | $     | 3.59 |  |  |           | 354,350 |  |   | $     | 3.50 | 
|$4.91
 $21.75 |                 |             | 577,425 |                  |  |          | 8.20      |             |           | $           | 12.64 |      |  |  | 184,260   |         |  | $ | 12.07 |     

18. Employee Stock Purchase Plan

Effective November 8, 1999, the Company adopted the Employee Stock
Purchase Plan. The plan authorizes the issuance of a maximum of 750,000 shares
of common stock. All employees who work more than twenty hours per week or five
months per year and have been employed longer than six months are eligible to
participate, with the exception of those owning 5% or more of the combined
voting power of the Companys stock. Employees may elect to deduct from 1% to
10% of their base compensation, with a maximum deduction of $25,000 per
calendar year. The purchase price is the lesser of 85% of the fair market value
of the common stock on the first or last day of the six-month offering period.
Previously, each purchase was limited to 1,000 shares of common stock per
employee. Effective September 27, 2001, the Employee Stock Purchase Plan was
amended to increase the share purchase limit to 10,000 shares per employee for
each offering period. Actual shares purchased by participating employees as of
September 30, 2001 totaled 55,175 at an average exercise price of $0.31.

19. Net Loss Per Share

A reconciliation of the basic and diluted earnings per share computation
is as follows:

|                                                 |  |               |             |      |  |      |             |   |  |   |            |  
|------------------------------------------------ |  | ------------- | ----------- | ---- |  | ---- | ----------- | - |  | - | ---------- | -
|                                                 |  | September 30,
|                                                 |  |              
|                                                 |  | 2001          |             | 2000 |  | 1999
|                                                 |  |               |             |      |  |     
|Net loss                                         |  | $             | (35,461,000 | )    |  | $    | (39,258,000 | ) |  | $ | (7,721,000 | )
|Weighted-average shares outstanding  basic      |  |               | 21,704,000  |      |  |      | 21,578,000  |   |  |   | 13,620,000 |  
|Weighted-effect of dilutive options and warrants |  |               |            |      |  |      |            |   |  |   |           |  
|                                                 |  |               |             |      |  |      |             |   |  |   |            |  
|Weighted-average shares outstanding  diluted    |  |               | 21,704,000  |      |  |      | 21,578,000  |   |  |   | 13,620,000 |  
|                                                 |  |               |             |      |  |      |             |   |  |   |            |  
|Basic and diluted net loss per share             |  | $             | (1.63       | )    |  | $    | (1.82       | ) |  | $ | (.57       | )
|                                                 |  |               |             |      |  |      |             |   |  |   |            |  

A total of 341,000 restricted shares and warrants and options to purchase
a total of 539,280 and 3,844,960 shares of common stock, respectively, have
been excluded from the calculation of net loss per share for fiscal 2001
because their effect is anti-dilutive. Warrants and options to purchase a total
of 539,280 and 4,343,735 shares of common stock, respectively, for fiscal 2000
and 458,658 and

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3,226,207 shares of common stock, respectively for fiscal 1999 have been
excluded from the calculation because of their effect is anti-dilutive.

20. Contingencies

The Company is from time to time involved in various claims and legal
proceedings of a nature considered by management to be routine and incidental
to its business. In the opinion of the Companys management, after consultation
with outside legal counsel, the ultimate disposition of such matters is not
expected to have a material adverse effect on the Companys financial position,
results of operations or liquidity.

On June 25, 1999, Spyglass, Inc. filed a patent infringement lawsuit
against the Company in United States District Court for the Northern District
of California. The suit alleged that the making, use and sale of the Companys
internet filtering systems infringed a United States patent held by Spyglass.
In December 1999, the Company settled the lawsuit with Spyglass, Inc. The
settlement resulted in a nonexclusive, nontransferable, nonrefundable lump-sum
license agreement for the Company to make, use, sell or otherwise distribute
the products and services which Spyglass alleged infringement. The Company paid
$650,000 in consideration of the license granted. In fiscal 2001, the Company
recorded a write-down for the remaining value of this license agreement, as it
will not be used as part of our current or future product offerings (Note 8).

21. Supplemental Cash Flow Information

Supplemental disclosure of cash flow information is summarized below for
the years ended September 30, 2001, 2000, and 1999:

|                                             |                                                          |                                           |   |                           |         |      |  |         |            |  |   |           |  | 
|-------------------------------------------- | -------------------------------------------------------- | ----------------------------------------- | - | ------------------------- | ------- | ---- |  | ------- | ---------- |  | - | --------- |  | 
|                                             |                                                          |                                           |   | Years Ended September 30,
|                                             |                                                          |                                           |   |                          
|                                             |                                                          |                                           |   | 2001                      |         | 2000 |  | 1999   
|                                             |                                                          |                                           |   |                           |         |      |  |        
|Non-Cash Investing and Financing Activities: |                                                          |                                           |   |                           |         |      |  |         |            |  |   |          
|                                             | Stock received for notes receivable from shareholders    |                                           | $ | 645,000                   |         |      |  |         |            |  |   |           | 
|                                             | Impact of sale of Iseek Communications:                  |                                           |   |                           |         |      |  |         |            |  |   |           | 
|                                             |                                                          | Property and other assets sold            |   |                           | 265,000 |      |  |         |            |  |   |           |  | 
|                                             |                                                          | Liabilities sold                          |   |                           | 60,000  |      |  |         |            |  |   |           |  | 
|                                             | Acquisition of N2H2 Pty Limited in non-cash transaction: |                                           |   |                           |         |      |  |         |            |  |   |           | 
|                                             |                                                          | Stock and warrants issued                 |   |                           |         |      |  | $       | 17,359,000 |  |   |           |  | 
|                                             |                                                          | Acquired intangibles                      |   |                           |         |      |  |         | 8,580,000  |  |   |           |  | 
|                                             |                                                          | Additions to deferred compensation        |   |                           |         |      |  |         | 8,910,000  |  |   |           |  | 
|                                             |                                                          | Additions to property and equipment       |   |                           |         |      |  |         | 101,000    |  |   |           |  | 
|                                             |                                                          | Additions to intangibles and other assets |   |                           |         |      |  |         | 51,000     |  |   |           |  | 
|                                             |                                                          | Additions to accounts payable             |   |                           |         |      |  |         | 54,000     |  |   |           |  | 
|                                             | Equipment obtained through capital lease                 |                                           |   |                           |         |      |  |         |            |  | $ | 1,638,000 | 
|                                             | Value ascribed to warrants issued with note payable      |                                           |   |                           |         |      |  |         |            |  |   | 77,000    | 
|                                             | Conversion of notes payable to common stock              |                                           |   |                           |         |      |  |         |            |  |   | 1,693,000 | 
|                                             | Note receivable from shareholder for exercise of options |                                           |   |                           |         |      |  |         |            |  |   | 25,000    | 
|                                             | Unearned compensation                                    |                                           |   |                           |         |      |  |         |            |  |   | 2,702,000 | 
|                                             | Cash paid for interest                                   |                                           |   | 313,000                   |         |      |  | 376,000 |            |  |   | 541,000   | 

22. Quarterly Financial Information (Unaudited)

The following table sets forth the Companys unaudited quarterly financial
information for the years ending September 30, 2001, 2000 and 1999:

|                    |                   |   |                                          |       |         |   |          |       |             |   |        |       |   |   |        |       |  
|------------------- | ----------------- | - | ---------------------------------------- | ----- | ------- | - | -------- | ----- | ----------- | - | ------ | ----- | - | - | ------ | ----- | -
|                    |                   |   | Fiscal Year 2001                        
|                    |                   |   |                                         
|                    |                   |   | September 30                             |       | June 30 |   | March 31 |       | December 31
|                    |                   |   |                                          |       |         |   |          |       |            
|                    |                   |   | (in thousands, except per share amounts)
|Revenue             |                   | $ | 2,731                                    |       |         | $ | 2,015    |       |             | $ | 1,890  |       |   | $ | 2,485  |      
|Net loss            |                   |   | 6,847                                    |       |         |   | 7,533    |       |             |   | 10,189 |       |   |   | 10,892 |      
|Earnings per share: |                   |   |                                          |       |         |   |          |       |             |   |        |       |   |   |        |      
|                    | Basic and diluted |   | $                                        | (0.32 | )       |   | $        | (0.35 | )           |   | $      | (0.47 | ) |   | $      | (0.50 | )

41



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##### Table of Contents



|                    |                   |   |                                          |       |         |   |          |       |             |   |       |       |   |   |       |       |  
|------------------- | ----------------- | - | ---------------------------------------- | ----- | ------- | - | -------- | ----- | ----------- | - | ----- | ----- | - | - | ----- | ----- | -
|                    |                   |   | Fiscal Year 2000                        
|                    |                   |   |                                         
|                    |                   |   | September 30                             |       | June 30 |   | March 31 |       | December 31
|                    |                   |   |                                          |       |         |   |          |       |            
|                    |                   |   | (in thousands, except per share amounts)
|Revenue             |                   | $ | 2,468                                    |       |         | $ | 3,324    |       |             | $ | 2,925 |       |   | $ | 2,256 |      
|Net loss            |                   |   | 16,894                                   |       |         |   | 10,326   |       |             |   | 6,919 |       |   |   | 5,119 |      
|Earnings per share: |                   |   |                                          |       |         |   |          |       |             |   |       |       |   |   |       |      
|                    | Basic and diluted |   | $                                        | (0.77 | )       |   | $        | (0.47 | )           |   | $     | (0.32 | ) |   | $     | (0.24 | )

|                    |                   |   |                                          |       |         |   |          |       |             |   |       |       |   |   |       |       |  
|------------------- | ----------------- | - | ---------------------------------------- | ----- | ------- | - | -------- | ----- | ----------- | - | ----- | ----- | - | - | ----- | ----- | -
|                    |                   |   | Fiscal Year 1999                        
|                    |                   |   |                                         
|                    |                   |   | September 30                             |       | June 30 |   | March 31 |       | December 31
|                    |                   |   |                                          |       |         |   |          |       |            
|                    |                   |   | (in thousands, except per share amounts)
|Revenue             |                   | $ | 2,126                                    |       |         | $ | 1,873    |       |             | $ | 1,453 |       |   | $ | 1,228 |      
|Net loss            |                   |   | 3,793                                    |       |         |   | 1,915    |       |             |   | 1,363 |       |   |   | 649   |      
|Earnings per share: |                   |   |                                          |       |         |   |          |       |             |   |       |       |   |   |       |      
|                    | Basic and diluted |   | $                                        | (0.20 | )       |   | $        | (0.13 | )           |   | $     | (0.11 | ) |   | $     | (0.07 | )

The Company revised its originally recorded purchase accounting for the
acquisition of N2H2 Pty Limited and has accordingly amended its Forms 10-Q for
the second and third quarters of fiscal 2000, ended March 31, 2000 and June 30,
2000, respectively. The effect on the second and third quarter results of
operations and financial position are summarized as follows:

|                                       |             |  |                                          |        |         |  |   |        |  
|-------------------------------------- | ----------- |  | ---------------------------------------- | ------ | ------- |  | - | ------ | -
|                                       |             |  | Fiscal Year 2000                        
|                                       |             |  |                                         
|                                       |             |  | Third                                    |        | Second 
|                                       |             |  | Quarter                                  |        | Quarter
|                                       |             |  |                                          |        |        
|                                       |             |  | (in thousands, except per share amounts)
|Net loss:                              |             |  |                                          |        |         |  |   |       
|                                       | As reported |  | $                                        | 9,347  |         |  | $ | 6,593  |  
|                                       | As restated |  | $                                        | 10,326 |         |  | $ | 6,919  |  
|Earnings per share, basic and diluted: |             |  |                                          |        |         |  |   |       
|                                       | As reported |  | $                                        | (0.42  | )       |  | $ | (0.31  | )
|                                       | As restated |  | $                                        | (0.47  | )       |  | $ | (0.32  | )
|Total assets:                          |             |  |                                          |        |         |  |   |       
|                                       | As reported |  | $                                        | 63,658 |         |  | $ | 70,531 |  
|                                       | As restated |  | $                                        | 56,513 |         |  | $ | 63,003 |  
|Total shareholders equity:            |             |  |                                          |        |         |  |   |       
|                                       | As reported |  | $                                        | 57,286 |         |  | $ | 66,953 |  
|                                       | As restated |  | $                                        | 50,141 |         |  | $ | 59,425 |  

The changes made consist of a reclassification of goodwill to deferred
compensation in recognition of the founders shares held in employment escrow
and an addition to acquired intangible assets in recognition of warrants issued
as part of the purchase consideration. The increase in net loss is the result
of an accelerated amortization method used for deferred compensation. None of
these changes had a cash impact to the Company.

42



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##### Table of Contents



(a)(2)

N2H2, Inc.

VALUATION AND QUALIFYING ACCOUNTS AND RESERVES

|                                                              |                         |               |              |             |            |                |            |               |        |  |            |  |  |  |          |             |  
|------------------------------------------------------------- | ----------------------- | ------------- | ------------ | ----------- | ---------- | -------------- | ---------- | ------------- | ------ |  | ---------- |  |  |  | -------- | ----------- | -
|                                                              |                         |               | Balance at   |             | Charges to |                |            |               |        |  | Balance at
|                                                              |                         |               | Beginning of |             | Costs and  |                | Charges to |               | End of
|Description                                                   |                         | Fiscal Period |              | Expenses    |            | Other Accounts |            | Fiscal Period
|                                                              |                         |               |              |             |            |                |            |              
|Year Ended September 30, 1998 Allowance for
doubtful accounts |                         |               |             |             |            |                | (8,000     | )             |        |  |            |  |  |  | (8,000   | )          
|Year Ended September 30, 1999 Allowance for
doubtful accounts |                         |               | (8,000       | )           |            |                | (261,000   | )             |        |  | 127,000    |  |  |  | (142,000 | )          
|                                                              | Tax valuation allowance |               |              |            |            |                |            | (2,475,000    | )      |  |            |  |  |  |          | (2,475,000  | )
|Year Ended September 30, 2000 Allowance for
doubtful accounts |                         |               | (142,000     | )           |            |                | (369,000   | )             |        |  | 198,000    |  |  |  | (313,000 | )          
|                                                              | Tax valuation allowance |               |              | (2,475,000  | )          |                |            | (9,925,000    | )      |  |            |  |  |  |          | (12,400,000 | )
|Year Ended September 30, 2001 Allowance for
doubtful accounts |                         |               | (313,000     | )           |            |                | (308,000   | )             |        |  | 337,000    |  |  |  | (284,000 | )          
|                                                              | Tax valuation allowance |               |              | (12,400,000 | )          |                |            | (11,817,000   | )      |  |            |  |  |  |          | (24,217,000 | )

43



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##### Table of Contents






PART III




Item 9.Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.

Not applicable




Item 10.Directors and Executive Officers of the Registrant.

The information required by this item with respect to the Companys
directors and compliance with Section 16(a) of the Exchange Act is included in
the following sections of the Companys Proxy Statement for its 2002 Annual
Meeting of Shareholders which sections are incorporated by reference herein and
will be filed within 120 days after the end of the Companys fiscal year:



| | Executive Officers of the Company
Election of Directors
Compliance with Section 16(a) of the Exchange Act of 1934
| | -----------------------------------------------------------------------------------------------------------------




Item 11.Executive Compensation.

The information required under this item is included in the following
sections of the Companys Proxy Statement for its 2002 Annual Meeting of
Shareholders, which sections are incorporated by reference herein and will be
filed within 120 days after the end of the Companys fiscal year:



| | Compensation of Executive Officers in the Year Ended September 30, 2001
Compensation Committee Report on Executive Compensation
Stock Price Performance
Director Compensation
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------




Item 12.Security Ownership of Certain Beneficial Owners and Management.

The information required under this item is included in the following
section of the Companys Proxy Statement for its 2002 Annual Meeting of
Shareholders, which section is incorporated by reference herein and will be
filed within 120 days after the end of the Companys fiscal year:



| | Security Ownership of Certain Beneficial Owners and Management
| | --------------------------------------------------------------




Item 13.Certain Relationships and Related Transactions.

The information required under this item is included in the following
sections of the Companys Proxy Statement for its 2002 Annual Meeting of
Shareholders, which sections are incorporated by reference herein and will be
filed within 120 days after the end of the Companys fiscal year:



| | Election of Directors
Transactions with Management, Certain Transactions
| | ------------------------------------------------------------------------

44



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##### Table of Contents






PART IV




Item 14.Exhibits, Financial Statement Schedules and Reports on Form 8-K.

a. The following documents are filed as part of this report under Item 8:

|    |  |                                   |                                                                                                                                   |  |  |      |  |  | 
|--- |  | --------------------------------- | --------------------------------------------------------------------------------------------------------------------------------- |  |  | ---- |  |  | 
|    |  |                                   |                                                                                                                                   |  |  | Page
|    |  |                                   |                                                                                                                                   |  |  |     
|(1) |  | Consolidated Financial Statements |                                                                                                                                   |  |  |     
|    |  |                                   | Report of PricewaterhouseCoopers LLP., Independent Accountants                                                                    |  |  | 22   | 
|    |  |                                   | Consolidated Balance Sheets as of September 30, 2001 and 2000                                                                     |  |  | 23   | 
|    |  |                                   | Consolidated Statements of Operations for the Fiscal Years Ended September 30, 2001, 2000 and 1999                                |  |  | 24   | 
|    |  |                                   | Consolidated Statements of Changes in Shareholders' Equity (Deficit) for the Fiscal Years Ended September 30, 2001, 2000 and 1999 |  |  | 25   | 
|    |  |                                   | Consolidated Statements of Cash Flows for the Fiscal Years Ended September 30, 2001, 2000 and 1999                                |  |  | 26   | 
|    |  |                                   | Notes to Consolidated Financial Statements                                                                                        |  |  | 27   | 
|(2) |  | Financial Statement Schedule      |                                                                                                                                   |  |  |     
|    |  |                                   | Valuation and qualifying accounts and reserves                                                                                    |  |  | 43   | 

b. Reports on Form 8-K

There were no reports on Form 8-K filed during the fourth quarter ended
September 30, 2001.

c. Exhibits. The following exhibits are filed or incorporated by reference
pursuant to Item 601 of Regulation S-K:

|        |  |                                                                                                                                                                                     
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                                                                                     
|Number  |  | Description of Document                                                                                                                                                             
|        |  |                                                                                                                                                                                     
|3.1     |  | Form of Restated Articles of Incorporation of the registrant. (3.1)(1)                                                                                                              
|3.2     |  | Amended Bylaws of the registrant. (3.2)(filed herewith)                                                                                                                             
|4.1     |  | Form of common stock certificate. (4.1)(1)                                                                                                                                          
|10.1    |  | Union Bank of California Center Office Lease dated March 12, 1999, between Walton Seattle
Investors I, L.L.C. and the registrant.(10.3)(1)                                          
|10.2    |  | 1997 Stock Option Plan, as amended. (10.5)(1)                                                                                                                                       
|10.3    |  | 1999 Stock Option Plan. (10.6)(1)                                                                                                                                                   
|10.4    |  | 1999 Nonemployee Director Stock Option Plan. (10.7)(1)                                                                                                                              
|10.5    |  | Registration Rights Agreement dated effective as of December 31, 1998. (10.12)(1)                                                                                                   
|10.6    |  | First Amendment, dated June 16, 1999, to Union Bank of California Office Lease of March 12,
1999, between Walton Seattle Investors I, L.L.C. and the registrant. (10.1)(2)          
|10.7    |  | Second Amendment, dated August 10, 1999, to Union Bank of California Center Office Lease of
March 12, 1999, between Walton Seattle Investors I, L.L.C. and the registrant. (10.2)(2)
|10.8    |  | Promissory Note dated April 17, 2000 between Peter Keane, Former Vice President of
Advertising, and the registrant. (10.4)(3)                                                       
|10.9    |  | Promissory Note dated May 18, 2000 between Peter Keane, Former Vice President of Advertising,
and the registrant. (10.5)(3)                                                         
|10.10   |  | Employment Agreement of Farzeen Mohazzabfar, dated November 5, 1999. (10.22)(4)                                                                                                     
|10.11   |  | Nonqualified Stock Option Agreement for Farzeen Mohazzabfar, dated November 5, 1999. (10.23)(4)                                                                                     
|10.12   |  | 2000 Stock Option Plan. (10.29)(4)                                                                                                                                                  
|10.13   |  | Letter of employment for Paul Quinn, dated November 14, 2000. (10.30)(4)                                                                                                            
|10.14   |  | Redemption agreement dated November 3, 2000, between John Duncan and the registrant. (10.31)(4)                                                                                     
|10.15   |  | Employment Separation Agreement of John Duncan, dated November 15, 2000. (10.32)(4)                                                                                                 

45



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##### Table of Contents



|        |  |                                                                                                                                                                          
|------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                                                                          
|Number  |  | Description of Document                                                                                                                                                  
|        |  |                                                                                                                                                                          
|10.16   |  | Letter of Employment/Promotion dated December 22, 2000 between Frank Fulton, Chief Operating
Officer, and the registrant (10.1)(5)                                       
|10.17   |  | Severance Agreement and Release dated January 4, 2001 between Richard Giacchetti, Vice
President of Education, and the registrant (10.2)(5)                              
|10.18   |  | Severance Agreement and Release dated February 13, 2001 between James OHalloran, Vice
President of Marketing, and the registrant (10.1)(6)                              
|10.19   |  | Letter of Employment/Promotion dated February 15, 2001 between Craig Blessing, Vice President
of Sales, and the registrant (10.2)(6)                                     
|10.20   |  | Severance Agreement and Release dated March 16, 2001 between Neil McIrvin, Vice President of
Enterprise, and the registrant (10.3)(6)                                    
|10.21   |  | Addendum to Executive Employment Agreement dated March 22, 2001 between Peter H. Nickerson,
Chairman, President and Chief Executive Officer, and the registrant (10.4)(6)
|10.22   |  | Severance Agreement and Release dated May 18, 2001 between Peter H. Nickerson, Chairman,
President and Chief Executive Officer, and the registrant (10.1)(7)             
|10.23   |  | Stock Option Agreement dated May 18, 2001 between Philip Welt, President and Chief Executive
Officer, and the registrant (10.2)(7)                                       
|10.24   |  | Severance Agreement and Release dated June 15, 2001 between Kevin Fink, Chief Technology
Officer, and the registrant (10.3)(7)                                           
|10.25   |  | Eighth Amendment, dated May 31, 2001, to Union Bank of California Office Lease of March 12,
1999, between Walton Seattle Investors I, L.L.C. and the registrant (10.4)(7)
|10.26   |  | Sublease Agreement dated October 22, 2001 between Widevine Technologies, Inc. and the
registrant (filed herewith)                                                        
|10.27   |  | First Amendment, dated November 8, 2001, to Sublease Agreement dated October 22, 2001 between
Widevine Technologies, Inc. and the registrant (filed herewith)            
|10.28   |  | Letter of Employment dated August 23, 2001 between Cher Paige, Vise President of Marketing,
and the registrant (filed herewith)                                          
|10.29   |  | Letter of Employment dated October 31, 2001 between Betsy Hall, Director of U.S. Sales, and
the registrant (filed herewith)                                              
|23.1    |  | Consent of Independent Auditors dated December 21, 2001 (filed herewith)                                                                                                 



---

|(1) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Registration Statement on Form
S-1 (File No. 333-78495).             
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|   
|   
|   
|(2) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Form 10-Q for the quarter
ended June 30, 1999 (File No. 0-26825).    
|   
|   
|   
|   
|(3) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Form 10-Q for the quarter
ended June 30, 2000 (File No. 0-26825).    
|   
|   
|   
|   
|(4) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Form 10-K for the year ended
September 30, 2000 (File No. 0-26825).  
|   
|   
|   
|   
|(5) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Form 10-Q for the quarter
ended December 31, 2000 (File No. 0-26825).
|   
|   
|   
|   
|(5) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Form 10-Q for the quarter
ended March 31, 2001 (File No. 0-26825).   
|   
|   
|   
|   
|(6) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Form 10-Q for the quarter
ended June 30, 2001 (File No. 0-26825).    

46



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized, in the City of
Seattle, State of Washington, on December 14, 2001.

| |                                                                   |                  
| | ----------------------------------------------------------------- | -----------------
| | N2H2, Inc.                                                       
|
| | By:                                                               | /s/ J. Paul Quinn
| |                                                                  
| | Vice President  Chief Financial Officer,
Secretary and Treasurer



|                       |  |                                                                                                               
|---------------------- |  | --------------------------------------------------------------------------------------------------------------
|Signature              |  | Title                                                                                                         
|                       |  |                                                                                                               
|                      
|/s/ Howard Philip Welt |  | President, Chief Executive Officer
and Director (principal executive officer)                                 
|                      
|/s/ J. Paul Quinn      |  | Vice
President  Chief Financial Officer,
Secretary and Treasurer (principal financial
and accounting officer)
|                      
|/s/ Peter H. Nickerson |  | Chairman and Director                                                                                         
|                      
|/s/ Hollis R. Hill     |  | Director                                                                                                      
|                      
|/s/ Mark A. Segale     |  | Director                                                                                                      
|                      
|/s/ Richard R. Rowe    |  | Director                                                                                                      
|                      
|/s/ Alan J. Higginson  |  | Director                                                                                                      
|                      
|/s/ Michael T. Lennon  |  | Director                                                                                                      

47



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##### Table of Contents






EXHIBIT INDEX

|        |  |                                                                                                                                                                                     
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                                                                                     
|Number  |  | Description of Document                                                                                                                                                             
|        |  |                                                                                                                                                                                     
|3.1     |  | Form of Restated Articles of Incorporation of the registrant. (3.1)(1)                                                                                                              
|3.2     |  | Amended Bylaws of the registrant. (3.2)(filed herewith)                                                                                                                             
|4.1     |  | Form of common stock certificate. (4.1)(1)                                                                                                                                          
|10.1    |  | Union Bank of California Center Office Lease dated March 12, 1999, between Walton Seattle
Investors I, L.L.C. and the registrant.(10.3)(1)                                          
|10.2    |  | 1997 Stock Option Plan, as amended. (10.5)(1)                                                                                                                                       
|10.3    |  | 1999 Stock Option Plan. (10.6)(1)                                                                                                                                                   
|10.4    |  | 1999 Nonemployee Director Stock Option Plan. (10.7)(1)                                                                                                                              
|10.5    |  | Registration Rights Agreement dated effective as of December 31, 1998. (10.12)(1)                                                                                                   
|10.6    |  | First Amendment, dated June 16, 1999, to Union Bank of California Office Lease of March 12,
1999, between Walton Seattle Investors I, L.L.C. and the registrant. (10.1)(2)          
|10.7    |  | Second Amendment, dated August 10, 1999, to Union Bank of California Center Office Lease of
March 12, 1999, between Walton Seattle Investors I, L.L.C. and the registrant. (10.2)(2)
|10.8    |  | Promissory Note dated April 17, 2000 between Peter Keane, Former Vice President of
Advertising, and the registrant. (10.4)(3)                                                       
|10.9    |  | Promissory Note dated May 18, 2000 between Peter Keane, Former Vice President of Advertising,
and the registrant. (10.5)(3)                                                         
|10.10   |  | Employment Agreement of Farzeen Mohazzabfar, dated November 5, 1999. (10.22)(4)                                                                                                     
|10.11   |  | Nonqualified Stock Option Agreement for Farzeen Mohazzabfar, dated November 5, 1999. (10.23)(4)                                                                                     
|10.12   |  | 2000 Stock Option Plan. (10.29)(4)                                                                                                                                                  
|10.13   |  | Letter of employment for Paul Quinn, dated November 14, 2000. (10.30)(4)                                                                                                            
|10.14   |  | Redemption agreement dated November 3, 2000, between John Duncan and the registrant. (10.31)(4)                                                                                     
|10.15   |  | Employment Separation Agreement of John Duncan, dated November 15, 2000. (10.32)(4)                                                                                                 

48



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##### Table of Contents



|        |  |                                                                                                                                                                          
|------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                                                                          
|Number  |  | Description of Document                                                                                                                                                  
|        |  |                                                                                                                                                                          
|10.16   |  | Letter of Employment/Promotion dated December 22, 2000 between Frank Fulton, Chief Operating
Officer, and the registrant (10.1)(5)                                       
|10.17   |  | Severance Agreement and Release dated January 4, 2001 between Richard Giacchetti, Vice
President of Education, and the registrant (10.2)(5)                              
|10.18   |  | Severance Agreement and Release dated February 13, 2001 between James OHalloran, Vice
President of Marketing, and the registrant (10.1)(6)                              
|10.19   |  | Letter of Employment/Promotion dated February 15, 2001 between Craig Blessing, Vice President
of Sales, and the registrant (10.2)(6)                                     
|10.20   |  | Severance Agreement and Release dated March 16, 2001 between Neil McIrvin, Vice President of
Enterprise, and the registrant (10.3)(6)                                    
|10.21   |  | Addendum to Executive Employment Agreement dated March 22, 2001 between Peter H. Nickerson,
Chairman, President and Chief Executive Officer, and the registrant (10.4)(6)
|10.22   |  | Severance Agreement and Release dated May 18, 2001 between Peter H. Nickerson, Chairman,
President and Chief Executive Officer, and the registrant (10.1)(7)             
|10.23   |  | Stock Option Agreement dated May 18, 2001 between Philip Welt, President and Chief Executive
Officer, and the registrant (10.2)(7)                                       
|10.24   |  | Severance Agreement and Release dated June 15, 2001 between Kevin Fink, Chief Technology
Officer, and the registrant (10.3)(7)                                           
|10.25   |  | Eighth Amendment, dated May 31, 2001, to Union Bank of California Office Lease of March 12,
1999, between Walton Seattle Investors I, L.L.C. and the registrant (10.4)(7)
|10.26   |  | Sublease Agreement dated October 22, 2001 between Widevine Technologies, Inc. and the
registrant (filed herewith)                                                        
|10.27   |  | First Amendment, dated November 8, 2001, to Sublease Agreement dated October 22, 2001 between
Widevine Technologies, Inc. and the registrant (filed herewith)            
|10.28   |  | Letter of Employment dated August 23, 2001 between Cher Paige, Vise President of Marketing,
and the registrant (filed herewith)                                          
|10.29   |  | Letter of Employment dated October 31, 2001 between Betsy Hall, Director of U.S. Sales, and
the registrant (filed herewith)                                              
|23.1    |  | Consent of Independent Auditors dated December 21, 2001 (filed herewith)                                                                                                 



---

|(1) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Registration Statement on Form
S-1 (File No. 333-78495).             
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|   
|   
|   
|(2) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Form 10-Q for the quarter
ended June 30, 1999 (File No. 0-26825).    
|   
|   
|   
|   
|(3) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Form 10-Q for the quarter
ended June 30, 2000 (File No. 0-26825).    
|   
|   
|   
|   
|(4) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Form 10-K for the year ended
September 30, 2000 (File No. 0-26825).  
|   
|   
|   
|   
|(5) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Form 10-Q for the quarter
ended December 31, 2000 (File No. 0-26825).
|   
|   
|   
|   
|(5) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Form 10-Q for the quarter
ended March 31, 2001 (File No. 0-26825).   
|   
|   
|   
|   
|(6) |  | Incorporated by reference from the exhibit shown in the preceding
parentheses and filed with the registrants Form 10-Q for the quarter
ended June 30, 2001 (File No. 0-26825).    

49