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UNITED STATESSECURITIES
 AND EXCHANGE COMMISSION
Washington, D.C. 20549




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 ended
 September 30, 2002

OR



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

For the transition period
 from ____________ to ____________ .

Commission File Number
 0-26825

N2H2, INC.
(Exact name of Registrant as specified in its charter)



|Washington(State or other jurisdiction ofincorporation or organization) | 91-1686754(I.R.S. EmployerIdentification 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
Preferred Share Purchase Rights, 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.
[   ]

Indicate by
 check mark whether the registrant is an accelerated filer (as defined in Exchange
 Act Rule 12b-2). Yes [   ] No [X]

The aggregate
 market value of the voting stock held by non-affiliates of the Registrant was approximately
 $3.7 million as of December 9, 2002, based upon the closing price as reported on
 the Over-The-Counter Bulletin Board on such date. There were 22,104,776 shares of
 the registrants common stock outstanding as of December 6, 2002.

DOCUMENTS INCORPORATED
 BY REFERENCE.

(1)  Portions of the registrants definitive
 2003 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. Business                                                                            
|                                           | 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 Consolidated 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         
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                                           | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
|PART III                                  
|                                           | 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                                     
|                                           | Item 14. Controls and Procedures                                                            
|PART IV                                   
|                                           | Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K                    
|SIGNATURES                                
|CERTIFICATIONS                            
|EXHIBIT 10.22                             
|EXHIBIT 23.1                              
|EXHIBIT 99.1                              



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PART I




Item 1. Business.

Our disclosure
 and analysis in this report contain forward-looking statements, which provide our
 current expectations or forecasts of future events. Forward-looking statements in
 this report include, without limitation:



| | statements
 about our future capital requirements, our future cash flows and the sufficiency
 of our existing cash, cash equivalents, investments and available bank borrowings
 to meet these requirements;
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                             
| | information
 concerning possible or assumed future results of operations, trends in financial
 results and business plans, including those relating to earnings growth and revenue
 growth;                 
|  |                                                                                                                                                                                                             
| | statements
 about the level of our costs and operating expenses relative to our revenues;                                                                                                                   
|  |                                                                                                                                                                                                             
| | statements
 about our future capital requirements, our future cash flows and the sufficiency
 of our existing cash, cash equivalents, investments and available bank borrowings
 to meet these requirements;
|  |                                                                                                                                                                                                             
| | other statements
 about our plans, objectives, expectations and intentions; and                                                                                                                             
|  |                                                                                                                                                                                                             
| | other statements
 that are not historical facts.                                                                                                                                                            

Words such
 as believes, anticipates and intends may identify
 forward-looking statements, but the absence of these words does not necessarily
 mean that a statement is not forward-looking. Forward-looking statements are subject
 to known and unknown risks and uncertainties and are based on potentially inaccurate
 assumptions that could cause actual results to differ materially from those expected
 or implied by the forward-looking statements. Our actual results could differ materially
 from those anticipated in the forward-looking statements for many reasons, including
 the factors described in the section entitled Important Factors That May Affect
 Our Business, Our Results of Operations and Our Stock Price in this report.
 Other factors besides those described in this report could also affect actual results.
 You should carefully consider the factors described in the section entitled Important
 Factors That May Affect Our Business, Our Results of Operations and Our Stock Price
 in evaluating our forward-looking statements.

You should
 not unduly rely on these forward-looking statements, which speak only as of the
 date of this report. We undertake no obligation to publicly revise any forward-looking
 statement to reflect circumstances or events after the date of this report, or to
 reflect the occurrence of unanticipated events. You should, however, review the
 factors and risks we describe in the reports we file from time to time with the
 Securities and Exchange Commission, or SEC.

Overview

N2H2 is a
 leading provider of Internet content filtering and monitoring solutions. We provide
 Internet filtering and monitoring solutions that are designed to allow Internet
 users to monitor and filter 41 content categories thereby increasing productivity,
 reducing bandwidth consumption, and limiting potential legal liability.

We market
 our products through our distribution agreement with Tech Data, as well as 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 enterprise
 (corporate and government) and education markets. We have two product lines: Sentian
 for corporate and government customers and Bess® for schools, libraries and non-profit
 organizations. Both Sentian and Bess are software-based filtering solutions. We
 also continue to support our legacy proxy server-based filtering solutions, which
 continue to be used by some of our customers.

N2H2 was incorporated
 in Washington on June 13, 1995 and is headquartered in Seattle, Washington. 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.

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Filtering Solutions

Bess and Sentian Internet Filtering  Our
 Software-based Filtering Solutions

N2H2 Internet
 filtering products help organizations of all sizes control, manage and understand
 their Internet use. Our versatile filtering software can help organizations to control
 costs by limiting potential legal liability, increasing productivity, and conserving
 network bandwidth. Every N2H2 product uses the filtering database rated #1 by eTesting
 Labs and the U.S. Department of Justice. Our software is available for a wide variety
 of network security devices and applications and is designed to integrate easily
 into almost any network, providing powerful features and a simple and straightforward
 user experience.

In addition
 to delivering high quality filtering, our software offers many
powerful features. These features allow network administrators great
flexibility in configuring their system for end-users. Administrators
are able to fine-tune their system by creating custom end-user
groups, filtering categories, rules, and filtering times. They can
monitor end-user activity using a wide range of detail and summary
reports. They can set the system to notify administrators via email
and provide end-user warnings. They can allow authorized end-users to
override the system, and can, if they choose, monitor this and other
authorized activity including overall web use patterns. In some
products these features can be controlled from any location on the
web using a special interface. This can be done by the super
administrator, or, in some cases, by a local one. N2H2's filtering
software is Cisco Verified, Microsoft Gold Certified and Check Point
OPSEC Certified.



Our Sentian
 solution targets the enterprise market. Our Bess solutions serve the education,
 library and non-profit organizations markets. N2H2 software applications reside
 on a customers server, behind or on the network firewall. These solutions
 are designed to be downloadable from the Internet and installed by the customer.
 Our 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.

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

During fiscal
 2001, we introduced our new software-based filtering solutions and we plan to eventually
 phase out the proxy server product line. We no longer promote the proxy server-based
 product to new customers. We plan to continue support of our existing customers
 proxy-based filtering installations. However, we are working to migrate these
 customers to one of our new software-based filtering solutions.

Our 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 customers filtering needs remotely
 from our Seattle network facility. 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.

For legacy
 customers who still use our proxy-server based filtering service, 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

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originating the request. We will provide
 third parties with log file information only pursuant to appropriate procedures
 that meet the requirements of applicable law.

N2H2 proxy
 servers are built by ISO9002 certified hardware vendors utilizing industry standard
 hardware components easily obtained from commercial sources. Our proprietary filtering
 software can be deployed on either Windows or Linux platforms. Our standard I2100 and I1100 filtering proxy servers run
 on the Linux operating system and use custom-developed filtering proxy server software.

N2H2s Client Solution (N2H2
 for Home & Internet Filtering Manager)

Until recently,
 we marketed a client-based filtering solution for individual personal computers,
 or PCs, aimed primarily at the home user, called N2H2 for Home. The
 revenue generated from sales of N2H2 for Home was insufficient to offset the costs associated with this product. As a result, we decided
 to cease the distribution of N2H2 for Home during the second quarter of fiscal 2002.
 The product and associated technology remain property of N2H2, and may at some point
 in the future be re-released if we feel that market conditions are appropriate for
 a product of this type.

Technology - Advanced Internet Content
 Categorization System

Our clients
 have the ability to select from a broad range of filtering criteria that are based
 on our list of Internet content categories. We employ a multi-step Web site categorization
 procedure to categorize Web sites that use automated search technology supplemented
 by human review. Internet content is divided 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. Through
automated categorization or human review, Web sites are identified as
fitting into one or more of our categories and stored in a database.

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.

Research and Development

During fiscal
 2002, we released multiple new Windows and Linux filtering products
that support Cisco PIX Firewall, Cisco Content Engine,
 Novell BorderManager, SonicWALL & Stratacache, as well as upgrades and enhancements
 to our filtering products for Microsoft ISA Server and Microsoft Proxy Server 2.

Fee Structure

We generate
 our revenue primarily from sales of Internet filtering subscriptions. A smaller
 portion of our revenue also comes from installation and maintenance fees. Beginning
 in November 2000, we 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. As a result, we no longer have any revenue from
 advertising.

Customers

We provide
 filtering solutions to a customer base that primarily consists of the following:

Enterprise
 Market. Our Sentian products are designed for enterprise customers, which include
 corporations and government agencies. These customers represent an increasing proportion
 of our customer base. Enterprise customers range from small to large-sized organizations.
 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
 for additional revenue growth.

ISP Market. Our Internet Service Provider, or ISP, customers purchase our solutions and
 host them for their own business and customers. ISP customers include regional,
 national, and international long distance telecommunications carriers, as well as
 Internet, cable, and wireless service providers. Some of our ISP customers may also
 serve as resellers of our services to small businesses, schools and homes.

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Education
 Market. Our Bess products serve school customers ranging from single schools
 to statewide systems. We have the largest market share in the K-12 school market,
 providing filtering solutions to millions of students in thousands of schools throughout
 the U.S., from small districts to large, statewide networks.

International. Through our strategic partnerships, we market to corporations, consumers, and
 schools internationally. We provide filtering services to customers in many countries
 including Australia, Canada, Chile, the Dominican Republic, Japan, Mexico, the United
 Kingdom and the United States. We believe the demand for filtering solutions in
 international markets will continue to present us with significant opportunities
 for additional revenue growth.

Sales and Marketing

Organization

We market
 and sell our Internet filtering solutions through a direct sales force, as well
 as through resellers.

We have achieved
 substantial market share within the education market primarily through the use of
 a direct sales force. In the future, most renewals of contracts will be handled
 direct and new education business will come from a mix of direct sales efforts and
 resellers.

We also 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. To expand our reach into the enterprise and international markets, in
 2002 we established a distribution agreement with Tech Data. Tech Data makes our
 products available to tens of thousands of technology resellers in its reseller
 network. We are continuing to work to establish relationships with additional technology
 resellers who sell into the enterprise sector.

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.

Marketing

Our promotional
 emphasis has shifted from the education to the enterprise market. We launch
 new products and promote our existing products using a variety of tactics, including:



| | Direct
 Marketing. Traditional direct mail, telemarketing and e-mail messages are targeted
 at qualified sales prospects.                                                                                                                                                                                                    
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                                                                                              
| | Online
 Marketing. Our Web site is used to provide sales prospects with relevant product
 information and downloadable demo versions of our filtering products.                                                                                                                                                              
|  |                                                                                                                                                                                                                                                                                                                              
| | Public
 Relations. We use internal public relations experts as well as consultants with
 the objective of securing favorable product reviews and general public 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 Cisco, Novell, 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 we believe collaboration
 can produce industry advancement and development of new markets. Our objectives
 and goals for strategic alliances typically include one or more of the following
 objectives: technology exchange, product development, joint sales and marketing,
 and new-market creation. We have had strategic technical alliances with Microsoft
 and Check Point. This year we expanded or entered into strategic technical alliances
 with Cisco, Novell, SonicWALL and Stratacache. Additionally, we have partnered with
 Tech Data as our exclusive broad-line distributor of N2H2 filtering

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products. This relationship gives us direct
 access to the tens of thousands of technology resellers who buy their technology
 through Tech Data.

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. 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 market, along with a number
 of smaller competitors. Our major competitors and their respective products are
 Surf Control  SuperScout and CyberPatrol, Websense  Websense Enterprise,
 Elron Software - Internet Manager, Symantec - I-Gear, Secure Computing  SmartFilter
 and 8e6 Technologies  X-Stop. We have the largest market share in the education
 market, but we have a smaller market share than most 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 implementing what we believe
 is the necessary business model for success in the enterprise market: selling software
 subscriptions through distribution 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. None of our technology is patented. We rely on United States
 trade secret and copyright law to protect our proprietary search technology. 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.

Despite our
 efforts to protect our proprietary rights, unauthorized parties may copy aspects
 of our products and obtain and use information that we regard as proprietary. Other
 parties may breach confidentiality agreements and other protective contracts we
 have entered into, and we may not become aware of, or have adequate remedies in
 the event of, any breach. Trademark, copyright, and trade secret protection may
 not be available to us in every country in which our services are available. In
 addition, 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.

N2H2, BESS
 and SEARCHOPOLIS are U.S. registered service marks. We have also applied to register
 the N2H2 and BESS logos, and DELIVERING THE WEB YOU WANT in the United States, 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.

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 U.S. 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 us. 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, or CIPA, a law mandating Internet filtering in schools and libraries
 receiving certain federal funds, among other requirements. It should be noted, however,
 that a United States District Court has declared this act as it applies to public
 libraries unconstitutional. This decision has been appealed to the United States
 Supreme Court, which has accepted the case and will rule by June, 2003. If CIPA
 is ultimately held unconstitutional, some of our current customers may decide to
 not provide

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filtering in their organizations, which
 in turn, could lead them to not renew contracts with N2H2 and thereby harm an important
 source of our revenue. A more serious potential problem is that a decision finding
 that it is unconstitutional to mandate filtering in libraries could lead to a challenge
 of the constitutionality on First Amendment grounds of mandatory filtering in public
 schools. As filtering from public schools is still the majority of N2H2s revenue,
 an ultimate finding by the Supreme Court that mandatory filtering in public schools
 is unconstitutional could drastically reduce N2H2s revenue.

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.

Employees

As of September
 30, 2002, we employed 74 full time equivalent staff worldwide. As necessary, we
 supplement our regular employees with temporary and contract personnel. During
 2002, we reduced our workforce by 36 employees as part of our restructuring. The
 significant reduction of employees contributed to a reduced cost structure. Although
 we believe that the significant changes in employee count will have a net positive
 impact on our results of operations, we cannot be certain that the benefits of the
 restructuring will outweigh the negative impact of such a significant amount of
 turnover and loss of experienced personnel. None of our employees is represented
 by a labor union, and we consider our employee relations to be good.

IMPORTANT FACTORS THAT MAY AFFECT OUR
 BUSINESS, OUR RESULTS OF OPERATIONS AND OUR STOCK PRICE

If we are unable to achieve profitability
 as planned, we may need additional funding to continue operations. We may be unable
 to obtain additional funding and any funding we do obtain could dilute our shareholders
 ownership interest in N2H2.

Our future
 revenues may be insufficient to support the expenses of our operations and the expansion
 of our business. We may therefore need to raise additional capital to finance our
 operations. If we cannot raise funds on acceptable terms, we may not be able to
 develop or enhance our products and services, take advantage of future opportunities
 or respond to competitive pressures or unanticipated requirements. In addition,
 if we cannot raise funds on acceptable terms and do not achieve profitability, we
 may be forced to reduce or cease operations.

We believe
 that our existing cash and cash equivalents will be sufficient to meet our capital
 requirements for at least the next 12 months. However, we may seek additional funds
 before that time through public or private equity financing or from other sources
 to fund our operations and pursue our business strategy. We have no commitment
 for additional financing, and we may experience difficulty in obtaining additional
 financing on favorable terms, if at all. The recent delisting of our common stock
 from the Nasdaq National Market, and commencement of trading on the OTC-BB may also
 make it even more difficult for us to obtain financing. 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.

We have a history of losses and may not
 achieve profitability, which could force us to reduce or cease operations.

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, $35.5 million for 2001 and $6.6 million for 2002. If we fail to achieve
 and maintain profitability, our stock price will decline, our future capital raising
 efforts will be impaired and we may be forced to reduce or cease operations.

Our recent
 restructuring initiatives have reduced our costs and operating expenses. However,
 despite these initiatives, our operating expenses will continue to consume a significant
 amount of our cash resources in the near term. In addition, the restructuring may
 adversely affect our business and operating results. As a result, we will need
 to significantly increase our revenues in order to achieve profitability. Although
 our revenues have grown in recent quarters, we may not be able to continue this
 growth to achieve or maintain profitability. Our continued losses and financial
 condition may cause some of our potential customers to question our viability, which
 may hamper our ability to sell our products.

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Our common stock is traded on the Over-the-Counter
 Bulletin Board and, as a result, it may be less liquid and subject to greater price
 fluctuations.

On March 20,
 2002, we received notification from the Nasdaq National Market that N2H2 had failed
 to meet Nasdaq listing requirements as set forth in Marketplace Rule 4450(a)(3).
 Our common stock was delisted from Nasdaq effective after the close of trading
 on March 20, 2002. Effective with the opening of business on March 21, 2002, our
 common stock began trading on the Over-The-Counter Bulletin Board, or OTC-BB, under
 the symbol NTWO. The OTC-BB is not an exchange, and trading in stocks
 on the OTC-BB is often more sporadic and lower in volume than that in shares on
 the national exchanges. We cannot guarantee that our shares will ever be listed
 on the Nasdaq National Market, or any other national stock exchange, in the future.
 As a result, it may be more difficult to dispose of, or to obtain adequate quotations,
 as to the price of our common stock.

You may be unable to resell your shares
 at or above the price at which you purchased them, and our stock price may be volatile.

Stocks trading
 on the OTC-BB are often subject to price fluctuations that are unrelated, or disproportional,
 to the operating performance of the companies. The price of our common stock has
 historically been volatile, even before it was delisted from Nasdaq, since our initial
 public offering in August 1999. Our common stock reached a high of $33.13 per share
 on December 14, 1999 and traded as low as $0.12 per share on March 21, 2002 and
 November 12, 2002. As a result of fluctuations in the price of our common stock,
 you may be unable to sell your shares at or above the price at which you purchased
 them. The trading price of our common stock could be subject to fluctuations for
 a number of reasons, including



| | actual or
 anticipated quarterly variations in operating results;                                
|- | -------------------------------------------------------------------------------------------------
|  |                                                                                                  
| | announcements
 of technological innovations or new services or products by us or our competitors;
|  |                                                                                                  
| | changes in
 analysts earning projections or recommendations;                                    
|  |                                                                                                  
| | our failure
 to meet or exceed analyst estimates;                                                
|  |                                                                                                  
| | announcements
 of technological innovations;                                                     
|  |                                                                                                  
| | the introduction
 of new products;                                                               
|  |                                                                                                  
| | proprietary
 rights litigation or other litigation; and                                          
|  |                                                                                                  
| | other events
 or factors, many of which are beyond our control.                                  

In addition,
 stock prices for many technology companies fluctuate widely for reasons that may
 be unrelated to operating results of these companies. These fluctuations, as well
 as general economic, market and political conditions, such as national or international
 currency and stock market volatility, recessions or military conflicts, may materially
 and adversely affect the market price of our common stock, regardless of our operating
 performance and may expose us to class action securities litigation which, even
 if unsuccessful, would be costly to defend and distracting to management.

We may be subject to third-party claims
 resulting from termination of our advertising contracts.

During 2001,
 we terminated the advertising-based revenue model that we had previously offered
 to schools. In connection with the termination of our advertising based-revenue
 model, we have unilaterally terminated certain advertising contracts. These advertising
 contracts may not allow unilateral termination by us. As a result, we may be subject
 to liabilities associated with breach of contract claims, although we have not received
 notice of any such claims. Even if none of these claims is successful, the litigation
 could result in substantial costs to the company and divert managements time
 and attention away from business operations.

Economic conditions could adversely affect
 our revenue growth and ability to forecast revenue.

Our revenue
 growth and potential for profitability depend on the overall demand for filtering
 and monitoring products, which is impacted by general economic and business conditions.
 A softening of demand for computer software caused by the weakened economy, both
 domestic and international, has affected our sales and may continue to result in
 decreased revenues and growth rates. As

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a result of the economic downturn, we may
 also experience difficulties in collecting outstanding accounts receivable from
 our customers. In addition, the terrorist attacks on the United States in 2001,
 and the armed conflicts that have followed, have added or exacerbated economic,
 political and other uncertainties, which could adversely affect our sales and thus
 our revenue growth. The slowdown in the domestic and international economies, as
 well as the effects of terrorist activity and armed conflict, may continue to cause
 customers and potential customers to delay their decisions about purchasing our
 filtering solutions, to reduce the amount they purchase or to cancel their orders,
 which could adversely affect our business and operating results.

Our quarterly financial results fluctuate
 and could fall below expectations of securities analysts and investors, resulting
 in a decrease in our stock price.

Our quarterly
 operating results have fluctuated significantly in the past and are likely continue
 to fluctuate in the future. If our operating results fall below the expectations
 of securities analysts and investors, it could result in a decrease in our stock
 price. Operating results vary from quarter to quarter, depending on a number of
 factors, many of which are outside our control, including:



| | general economic
 conditions, which may affect our customers investment levels in enterprise
 software;                                                              
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                       
| | the rate of
 market acceptance of new product introductions;                                                                                                          
|  |                                                                                                                                                                       
| | budget and
 spending decisions by our customers;                                                                                                                      
|  |                                                                                                                                                                       
| | subscription
 renewal rates of our existing customers;                                                                                                                
|  |                                                                                                                                                                       
| | our ability
 to compete in the highly competitive Internet filtering solutions market;                                                                                
|  |                                                                                                                                                                       
| | the loss of
 any key technical, sales, customer support or management personnel and the timing
 of any new hires;                                                     
|  |                                                                                                                                                                       
| | our ability
 to develop, introduce and market new products and product versions on a timely basis;                                                                    
|  |                                                                                                                                                                       
| | our ability
 to successfully expand our operations, and the amount and timing of expenditures
 related to this expansion;                                             
|  |                                                                                                                                                                       
| | the tendency
 of our educational customers to budget and make purchases on the basis of a fiscal
 school year beginning in the fourth fiscal quarter of each year; and
|  |                                                                                                                                                                       
| | the length
 of our sales cycle, which varies substantially from customer to customer.                                                                                 

As a result
 of all these factors, we cannot predict our revenues with any significant degree
 of certainty, and future product revenues may differ from historical patterns.
 Even though our revenues are difficult to predict, we base our decisions regarding
 our operating expenses on anticipated revenue trends. Many of our expenses are
 relatively fixed, and we cannot quickly reduce spending if our resources are lower
 than expected. As a result, revenue shortfalls could result in significantly lower
 income or greater loss than anticipated for any given period, which could result
 in a decrease in our stock price.

If potential customers do not accept
 our Internet and monitoring filtering solutions, our business will not succeed.

We currently
 expect the substantial majority of our future revenues to be generated through sales
 of our Bess and Sentian Internet filtering solutions. As a result, factors adversely
 affecting the pricing or demand for Internet filtering solutions, such as competition
 or technological change, could dramatically affect our operating results. In addition,
 many of our Bess and Sentian solutions were only recently introduced in fiscal 2002.
 As a result, they are relatively new and unproven and may not achieve market acceptance.
 Because these solutions are relatively new, we cannot accurately predict the rate
 at which customers will renew their annual subscriptions.

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 and
 monitoring products and services. We cannot be certain that we will be successful
 in upgrading and continuing to sell our Internet filtering products and services,
 or that any new products or services that we may develop or acquire, will achieve
 market acceptance. If we are unable to upgrade our services or products or to establish
 market acceptance of these products, our business will fail.

9



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If existing customers do not renew their
 subscription agreements, our business will not succeed.

Our future
 success depends on the rate at which our existing customers renew their subscription
 contracts. Our customers have no obligation to renew their subscriptions upon expiration.
 Because our Bess and Sentian solutions are relatively new, we cannot predict with
 certainty the rate at which our customers will renew their annual subscriptions.
 We may be unable to generate significant revenue from our renewals and, as a result,
 our operating results could fall below the expectations of analysts and investors,
 which could cause our stock price to decline.

If our solutions fail to correctly categorize
 all potentially objectionable content, public perception of our products and services
 could be harmed.

We will not
 succeed unless the marketplace is confident that our solutions effectively filter
 Internet content. We rely upon a combination of automated filtering technology and
 human review to categorize Web site content for use by our filtering solutions.
 The total number of Web sites and partial Web sites is growing rapidly.
We cannot be sure that our filtering technologies will successfully categorize all
 potentially objectionable Internet content for our clients, thus
causing over-blocking. 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
 result in lost customers and generate negative publicity that would impair the growth
 of our business and our efforts to increase positive associations with our brand.

Free speech and privacy concerns could
 adversely affect the demand for our Internet filtering solutions.

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 CIPA, a law mandating
 Internet filtering in schools and libraries receiving certain federal funds, among
 other requirements. A United States District Court, however, has declared this act
 as it applies to public libraries unconstitutional. This decision has been appealed
 to the United States Supreme Court, which has accepted the case and is expected
 to rule by June 2003. If CIPA is ultimately held unconstitutional, some of our current
 customers may decide to no longer provide filtering in their organizations. This
 in turn would lead them to not renew contracts with us and would thereby harm an
 important source of our revenues. If the Supreme Court determines that filtering
 by public libraries is unconstitutional, plaintiffs and advocacy groups may rely
 on this decision to challenge the constitutionality on First Amendment grounds of
 mandatory filtering in public schools. Because public school customers still represent
 the majority of our revenue, an ultimate finding by the Supreme Court that mandatory
 filtering in public schools is unconstitutional could have a serious adverse effect
 on our future revenues.

We have been named as a defendant in
 an action by the American Civil Liberties Union that could weaken our intellectual
 property rights and result in substantial costs to the company.

An individual
 represented by the American Civil Liberties Union has recently filed a lawsuit against
 us in federal court. The plaintiff is purportedly a computer researcher who allegedly
 seeks to conduct a quantitative analysis of the accuracy and comprehensiveness of
 our Internet filtering solutions for purposes of determining whether these solutions
 exclude some speech on the Internet that is constitutionally protected. He alleges
 that his activities in conducting this analysis, if he ever does so, would violate
 our standard license agreement and our intellectual property rights. The plaintiff
 alleges that the threat that we will enforce our license agreement and our other
 rights has deterred him from this activity, which he alleges is protected under
 the fair use doctrine of copyright law and other legal doctrines. He seeks a declaration
 to prohibit us from enforcing the license agreement against him based on his use
 of our software in his research activities. To the extent that this claim is resolved
 in the plaintiffs favor, it could materially affect our ability to enforce
 our license agreements and other intellectual property rights against certain users
 of our software filtering products. In addition, it could contribute to an increase
 in the number of people who seek to use our software in ways that we believe violate
 our proprietary rights. Even if the particular claim described above is resolved
 in our favor, the litigation could result in substantial costs to the company and
 divert managements time and attention away from business operations.

If we are unable to compete successfully
 in the Internet filtering market, our business will fail.

The market
 for our solutions is intensely competitive and rapidly changing. Many of our competitors
 are larger than we are and have substantially greater resources than we do. Our
 major competitors and their respective products are Surf Control  SuperScout
 and CyberPatrol, Websense  Websense Enterprise, Elron Software - Internet
 Manager, Symantec - I-Gear, Secure Computing  SmartFilter and 8e6 Technologies  X-Stop.
 We also face competition from a number of smaller competitors.

10



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In the future,
 we may face increased competition from vendors of Internet-related hardware and
 software that enhance their products or develop separate products that include functions
 that are currently provided in our products. If Internet filtering functions become
 standard features of Internet-related hardware or software, the demand for our products
 will decrease. Furthermore, even if our products offered greater functionality and
 are more effective than products offered by Internet-related hardware or software
 vendors, potential customers might accept this limited functionality instead of
 purchasing our products.

Some of our
 competitors filtering products are significantly less expensive than ours.
 This lower cost, along with other factors, may lead to greater market acceptance
 of our competitors products and services than for ours. Increased competition
 or our failure to compete effectively could force us to reduce our prices or the
 quality of our offerings. It could also reduce our market share and impact the profitability
 of our business. In addition, many of our competitors have longer operating histories,
 greater name recognition, larger customer bases and significantly greater financial,
 technical, marketing and other resources than we do. Furthermore, a number of our
 competitors have recently been acquired by other large technology companies, which
 enhances their resources. We believe that there will be further consolidation among
 our competitors. As a result, they may be able to adapt more quickly to new
 technologies and customer needs, devote greater resources to promoting or selling
 their products and services, initiate and withstand substantial price competition,
 take advantage of acquisition or other strategic opportunities more readily or develop
 and expand their product and service offerings more quickly than we can. In addition,
 our competitors may form strategic relationships with each other and with other
 companies in attempts to compete more successfully against us. These relationships
 may take the form of strategic investments, joint marketing agreements, licenses
 or other contractual arrangements, any of which may increase our competitors
 ability, relative to ours, to address customer needs with their software and service
 offerings and that may enable them to rapidly increase their market share.

If we are unable to develop and maintain
 effective long-term relationships with key resellers, or if our resellers fail to
 perform, our ability to sell our solutions will be limited.

During 2001,
 we significantly reduced our direct sales staff and began to develop our reseller
 channel for selling products and services to corporations and government entities.
 In order to establish market share in these markets and increase revenue, we will
 need to substantially increase the distribution of our products and services through
 successful new relationships with prestigious resellers. Because our relationships
 with our existing resellers are relatively new and unproven, we cannot predict the
 degree to which these resellers will succeed in marketing and selling our solutions.
 Many of our existing and potential resellers have similar, and often more established,
 relationships with our competitors. These existing and potential resellers, many
 of which have significantly greater resources than we have, may in the future market
 products that compete with our solutions or reduce or discontinue their relationships
 with us or their support of our solution. In addition, our sales and revenue growth
 opportunities will be limited if



| | we are unable
 to develop and maintain effective, long-term relationships with existing and potential
 key resellers;             
|- | ----------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                   
| | our existing
 and potential key resellers endorse products or technologies other than our solutions;
 or                          
|  |                                                                                                                                   
| | our existing
 and potential key resellers do not have or do not devote the resources necessary
 to effectively sell our solutions.

If we do not retain our key employees
 and management team, our ability to execute our business strategy will be limited.

Our future
 performance will depend largely on the efforts of our key technical, sales, customer
 support and managerial personnel and on our ability to attract and retain them.
 In addition, our ability to execute our business strategy will depend on our ability
 to recruit additional experienced management personnel and to retain our existing
 executive officers. Our key employees are not obligated to continue their employment
 with us and could leave at any time. If we are unable to attract and retain these
 key employees and executive officers, 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.

Competition
 for qualified personnel in the software and technology markets is particularly intense.
 Many of the companies we compete against for experienced personnel have greater
 resources than we do. In addition, due to the recent trading prices of our common
 stock and our delisting from the Nasdaq National Market, our employees may perceive
 our equity incentives such as stock options as less attractive. In that case, our
 ability to attract or retain employees may be adversely affected and we may be required
 to increase the level of cash compensation paid to existing and new employees, which
 could materially increase our operating expenses.

11



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##### Table of Contents



Our workforce reduction and financial
 performance may place additional strain on our resources and may harm the morale
 and performance of our personnel and our ability to hire new personnel.

During September
 of 2002, we reduced our employee count by about 25% to 74 employees. Our restructuring
 plan may yield unanticipated consequences, such as attrition beyond our planned
 reduction in force. Although we believe we can operate at current staffing levels,
 this workforce reduction has placed significant strain on our administrative, operational
 and financial resources and has resulted in increased responsibilities for each
 of our management personnel. As a result, our ability to respond to unexpected
 challenges may be impaired and we may be unable to take advantage of new opportunities.
 In addition, many of the employees who were terminated possessed specific knowledge
 or expertise, and that knowledge or expertise may prove to have been important to
 our operations. In that case, their absence may create significant difficulties.
 Further, the reduction in workforce may reduce employee morale and create concern
 among potential and existing employees about job security at N2H2, which may lead
 to difficulty in hiring and increased turnover in our current workforce. In addition,
 this reduction to employee count may subject us to the risk of litigation, which
 could result in substantial costs to N2H2 and could divert managements time
 and attention away from business operations.

If we do not expand our international
 operations and successfully overcome the risks inherent in international business
 activities, the growth of our business will be limited.

We currently
 have very limited international operations. To be successful, we must continue
 to expand our international operations and enter new international markets. If
 we do expand internationally, it will require significant management attention and
 financial resources to develop sales and support channels. Even if we successfully
 develop these channels, we may not be able to maintain or increase international
 market demand for our solution. In addition, our international operations are subject
 to a number of risks inherent in international business activities, including:



| | the cost and
 challenges of customizing 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;                                                      
|  |                                                                                                                                                                                  
| | longer sales
 cycles;                                                                                                                                                            
|  |                                                                                                                                                                                  
| | possible delays
 or greater difficulty in accounts receivable collection;                                                                                                        
|  |                                                                                                                                                                                  
| | import and
 export restrictions and tariffs;                                                                                                                                     
|  |                                                                                                                                                                                  
| | exposure to
 foreign currency exchange rate fluctuations;                                                                                                                        
|  |                                                                                                                                                                                  
| | reduced protection
 of intellectual property rights and increased liability exposure; and                                                                                        
|  |                                                                                                                                                                                  
| | regional,
 economic, cultural and political conditions, including the direct and indirect effects
 of terrorist activity and armed conflict in countries in which we do business.

If we are
 unable to successfully manage these risks, our international sales growth will be
 limited and our results of operations will be seriously harmed. We do not currently
 engage in currency hedging activities, but we may do so in the future.

Rapid changes in technology and industry
 standards could render our products and services unmarketable or obsolete, and we
 may be unable to introduce new products and services in a timely and successful
 way.

To succeed,
 we must continually change and improve our solutions in response to rapid technological
 developments and changes in operating systems and hardware, software, communication,
 browser and database technologies. We may be unable to successfully and promptly
 develop these new solutions or achieve and maintain market acceptance. The development
 of new, technologically advanced solutions is a complex and uncertain process that
 requires great innovation and the ability to anticipate technological and market
 trends. Because software development is complex, it can require long development
 and testing periods.

12



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##### Table of Contents



Releasing
 new solutions prematurely may result in quality problems, and releasing them late
 may result in loss of customer confidence and market share.
Unforeseen circumstances may cause schedule delays in the
introduction of new and enhanced solutions. When we do introduce new
 or enhanced solutions, we may be unable to manage the transition from the older
 solutions and may be forced to continue to support the older solutions at increased
 cost to us. In particular, our education customers often have older
technical environments,
 which require us to maintain solutions that operate on multiple platforms.

If we delay
 release of our new solutions, or if they fail to achieve market acceptance when
 released, it could harm our reputation and our ability to attract and retain customers,
 and our revenues may decline. In addition, customers may defer or forego purchases
 of our solution if we, or our competitors introduce or announce new solutions or
 solution enhancements.

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

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. None of our technology is patented. We rely on United States
 trade secret and copyright law to protect our proprietary search technology. 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.

Despite our
 efforts to protect our proprietary rights, unauthorized parties may copy aspects
 of our products and obtain and use information that we regard as proprietary. Other
 parties may breach confidentiality agreements and other protective contracts we
 have entered into, and we may not become aware of, or have adequate remedies in
 the event of, any breach. Trademark, copyright, and trade secret protection may
 not be available to us in every country in which our services are available. In
 addition, 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.

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), Novell Border Manager, Cisco PIX Firewall, Cisco Content Engine, and
 Check Point Firewall-1. We depend on these third parties abilities to deliver
 and support reliable products, enhance their current products, develop new products
 on a timely basis and respond to emerging industry standards and other technological
 changes. If any of these third parties cease production of these products, change
 the design of their product such that it becomes incompatible with
our products, delay the launch of future products or open their proprietary
interface to the public, we could lose sales and we could incur additional
 costs to design around the incompatibility.

Intellectual property claims and litigation
 could subject us to significant liability for damages and result in invalidation
 of our proprietary rights.

In the future,
 we may have to resort to litigation to protect our intellectual property rights
 or to determine the validity and scope of the proprietary rights of others. In
 particular, we expect that as competition in the market for Internet filtering increases
 and as the number of patents relating to these products continues to increase, the
 potential for patent infringement claims against us will increase. Any litigation,
 regardless of its success, would likely result in significant expense to us and
 divert the efforts of our management and development personnel. 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 technology determined to be infringing;                                                                                                                                   
|  |                                                                                                                                                                                                        
| | obtain a license for the technology, which may be on unfavorable terms;                                                                                                                                
|  |                                                                                                                                                                                                        
| | attempt to redesign our filtering services to avoid the infringement or to
 develop non-infringing technology, which we might not be able to do at an
 acceptable price, in a timely fashion or at all.

13



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Our solutions may suffer from defects
 or errors, which could result in loss of revenues, delayed or limited market acceptance
 of our products, increased costs and damage to our reputation.

Complex software
 products such as ours frequently contain errors or defects, especially when first
 introduced or when new versions are released. Our customers are particularly sensitive
 to such defects and errors because they rely on our services for providing a content-safe
 Internet environment. Any significant defects or errors in our services or products
 may result in loss of revenues or delay in market acceptance, diversion of development
 resources, negative publicity, damage to our reputation or legal claims. 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 severely damage our ability to service
existing customers and activate new customers, and would 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.

We have an
 Internet hosting agreement with a third party hosting provider, who
houses the majority
 of our servers. Our network operations center is situated at the
hosting provider in a single geographic location, and not all systems
within this location are redundant. 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 take a substantial amount of time to remedy, and
could diminish revenues, decrease customer and user confidence in
 our services and limit the growth of our business.

We may not be able to distribute our
 services abroad due to United States export laws, which could cause us to lose sales.

The encryption
 technology contained in our services and products is subject to United States export
 controls. These 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 export 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. Finally,
 some foreign competitors are subject to less stringent controls on exporting their
 encryption technologies. As a result, they may be able to compete more effectively
 than we can in U.S. and international markets.

If the use of the Internet in education
 and business does not grow, demand for our solutions will be limited.

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
 in educational settings. 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. Similarly,
 we are uncertain of the extent to which businesses will use the Internet as a means
 of communication and commerce and whether the market for Internet filtering solutions
 will continue to develop.

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 and business use of the
 Internet experiences a significant decline, demand for our solutions may be limited.

The concentrated ownership of our common
 stock could delay or prevent a change of control, which could cause a decline in
 the market price of our common stock.

As of September
 30, 2002, our directors, executive officers and their affiliated entities together
 beneficially owned approximately 40% of our outstanding common stock and stock options.
 As a result, these shareholders may, as a practical matter, be able to exert significant
 influence over all matters requiring shareholder approval, including the election
 of directors and approval of significant corporate transactions such as acquisitions,
 and to block unsolicited tender offers. This concentration of ownership may delay,
 deter or

14



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##### Table of Contents



prevent a third party from acquiring control
 over us at a premium over the then-current market price of our common stock, which
 could result in a decrease in our stock price.

Our articles of incorporation and bylaws,
 our shareholder rights plan and Washington law contain provisions that could discourage
 a takeover.

Some provisions
 of our Restated Articles of Incorporation and Amended Bylaws, our shareholder rights
 plan and Washington law, could make it more difficult for a third party to acquire
 us, even if doing so would be beneficial to our shareholders. This could limit
 the price that certain investors might be willing to pay in the future for shares
 of our common stock.




Item 2. Properties.

Our principal
 place of business is located in Seattle, Washington where, as of September 30, 2002,
 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 currently lease another sales office in Australia.




Item 3. Legal Proceedings.

An individual
 represented by the American Civil Liberties Union has recently filed a lawsuit against
 us in federal court. The plaintiff is purportedly a computer researcher who allegedly
 seeks to conduct a quantitative analysis of the accuracy and comprehensiveness of
 our Internet filtering solutions for purposes of determining whether these solutions
 exclude some speech on the Internet that is constitutionally protected. He alleges
 that his activities in conducting this analysis, if he ever does so, would violate
 our standard license agreement and our intellectual property rights. The plaintiff
 alleges that the threat that we will enforce our license agreement and our other
 rights has deterred him from this activity, which he alleges is protected under
 the fair use doctrine of copyright law and other legal doctrines. He seeks a declaration
 to prohibit us from enforcing the license agreement against him based on his use
 of our software in his research activities. To the extent that this claim is resolved
 in the plaintiffs favor, it could materially affect our ability to enforce
 our license agreements and other intellectual property rights against certain users
 of our software filtering products. In addition, it could contribute to an increase
 in the number of people who seek to use our software in ways that we believe violate
 our proprietary rights. Even if the particular claim described above is resolved
 in our favor, the litigation could result in substantial costs to the company and
 divert managements time and attention away from business operations.




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

No matters
 were submitted to a vote of security holders during the quarter ended September
 30, 2002.

15



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##### Table of Contents






PART II




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

Our common
 stock is traded on the OTC-BB under the symbol NTWO. Our common stock was traded
 on the Nasdaq National Market from July 30, 1999, the effective date of our initial
 public offering, through March 20, 2002. Effective with the opening of business
 on March 21, 2002, our common stock began trading on the OTC-BB. The following
 table sets forth the high and low closing prices of our common stock for each quarterly
 period during the last two fiscal years, as reported by Nasdaq and the OTC-BB. These
 quotations represent inter-dealer prices without retail markup, markdown or commission
 and may not necessarily represent actual transactions.



|                                                                  | High |       | Low
|----------------------------------------------------------------- | ---- | ----- | ---
|                                                                  |      |       |    
|Fiscal 2002                                                       |      |       |    
|Fourth Quarter of 2002  July 1, 2002 through September 30, 2002  | $    | 0.27  |    
|Third Quarter of 2002  April 1, 2002 through June 30, 2002       |      | 0.37  |    
|Second Quarter of 2002  January 1, 2002 through March 31, 2002   |      | 0.47  |    
|First Quarter of 2002  October 1, 2001 through December 31, 2001 |      | 0.53  |    
|Fiscal 2001                                                       |      |       |    
|Fourth Quarter of 2001  July 1, 2001 through September 30, 2001  |      | 0.720 |    
|Third Quarter of 2001  April 1, 2001 through June 30, 2001       |      | 1.420 |    
|Second Quarter of 2001  January 1, 2001 through March 31, 2001   |      | 1.813 |    
|First Quarter of 2001  October 1, 2000 through December 31, 2000 |      | 2.560 |    

As of October
 25, 2002, there were approximately 201 holders of record of our common stock. This
 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 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.

EQUITY COMPENSATION PLAN INFORMATION

The following
 table provides information regarding our existing compensation plans and individual
 compensation arrangements pursuant to which our equity securities may be issued
 to employees, directors, consultants, advisors or other persons, in exchange for
 consideration in the form of services:



|                                                           |  |                               |  |                               |      |                                     | Number of securities          
|---------------------------------------------------------- |  | ----------------------------- |  | ----------------------------- | ---- | ----------------------------------- | ------------------------------
|                                                           |  | Number of Securities to be    |  |                               |      |                                     | remaining available for future
|                                                           |  | issued upon exercise of       |  | Weighted average exercise     |      | issuance under equity              
|                                                           |  | outstanding options, warrants |  | price of outstanding options, |      | compensation plans (excluding      
|                                                           |  | and rights                    |  | warrants and rights           |      | securities reflected in column (a))
|Plan Category                                              |  | (a)(#)                        |  | (b)($)                        |      | (c)(#)                             
|                                                           |  |                               |  |                               |      |                                    
|Equity compensation plans
 approved by security holders    |  | 3,795,198 (1)                 |  | $                             | 1.50 |                                     | 2,355,204                     
|Equity compensation plans not approved by security holders |  | 1,939,283 (2)                 |  | $                             | 3.04 |                                     | 10,000                        
|                                                           |  |                               |  |                               |      |                                     |                               
|Total                                                      |  | 5,734,481                     |  | $                             | 2.02 |                                     | 2,365,204                     
|                                                           |  |                               |  |                               |      |                                     |                               



|   
|---
|   
|(1)
|   
|(2)

16



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##### Table of Contents






Item 6. Selected Consolidated Financial
 Data.

The following
 selected consolidated financial data should be read in conjunction with the section
 of this report entitled 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 report.



|                                                      | Fiscal Year Ended September 30,      
|----------------------------------------------------- | -------------------------------------
|                                                      |                                      
|                                                      | 1998                                 
|                                                      |                                      
|                                                      | (In thousands, except per share data)
|Consolidated Statement of Operations Data:            |                                      
|Revenues                                              | $                                    
|Loss from operations                                  |                                      
|Interest income (expense), net                        |                                      
|Net loss                                              |                                      
|Basic and diluted net loss per share                  | $                                    
|Basic and diluted weighted average shares outstanding |                                      



|                                                 | Fiscal Year Ended September 30,
|------------------------------------------------ | -------------------------------
|                                                 |                                
|                                                 | 1998                           
|                                                 |                                
|                                                 | (In thousands)                 
|Consolidated Balance Sheet Data:                 |                                
|Cash and cash equivalents                        | $                              
|Working capital (deficit) (3)                    |                                
|Property and equipment, net                      |                                
|Total assets                                     |                                
|Deferred revenue                                 |                                
|Long-term obligations, excluding current portion |                                
|Total shareholders equity (deficit)             |                                



|   
|---
|   
|(1)
|   
|(2)
|   
|(3)




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 report. 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 as a result of various factors, including
 those discussed in Important Factors That May Affect Our Business, Our Results
 of Operations and Our Stock Price. 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 a
 leading provider of content filtering for the Internet. We provide solutions that
 are designed to allow Internet users to filter 41 content categories thereby increasing
 productivity, reducing bandwidth consumption, and limiting potential legal liability.

As a leading
 provider of Internet content filtering to schools, we are attempting to leverage
 our 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 Australia,
 Canada, Chile, the Dominican Republic, Japan, Mexico, the United Kingdom and the
 United States. To cover these markets, we use a combination of our own sales force
 and various resellers, both domestic and international.

17



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##### Table of Contents



During fiscal
 2002, we released multiple new Windows and Linux filtering products
that support Cisco PIX Firewall, Cisco Content Engine,
 Novell BorderManager, SonicWALL and Stratacache, as well as releasing upgrades and
 enhancements to our filtering products for Microsoft ISA Server and Microsoft Proxy
 Server 2.

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, 2002, had incurred aggregate operating losses
 of approximately $93.4 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.

Critical Accounting Policies

The preparation
 of financial statements and related disclosures in conformity with accounting principles
 generally accepted in the United States requires management to make judgments, assumptions,
 and estimates that affect the amounts reported in the Consolidated Financial Statements
 and accompanying notes. Note 2 to the Consolidated Financial Statements contained
 in this report describes the significant accounting policies and methods used in
 the preparation of the Consolidated Financial Statements. We believe the following
 critical accounting policies affect our more significant judgments, assumptions
 and estimates used in the preparation of the Consolidated Financial Statements.

Revenue Recognition

We derive
 our revenue primarily from sales of Internet filtering subscriptions. A smaller
 portion of our revenue also comes from installation and maintenance fees, and historically,
 advertising. We recognize revenue in accordance with Statement of Position No. 97-2,
 Software Revenue Recognition (SOP 97-2). Accordingly, revenue is recognized when
 persuasive evidence of an arrangement exists, the product or service has been delivered,
 the fee is fixed and determinable, and collection is reasonably assured.

Subscription
 revenues represent the fees associated with the right to use our software and/or
 hardware, and to access our filtering updates. Maintenance revenues represent fees
 associated with technical support services provided to customers. Subscription agreements
 and most maintenance services are evidenced by signed contracts, which are generally
 12, 24 or 36 months in duration. Subscription and maintenance revenues are recognized
 on a straight-line basis over the life of the contract. Contracts billed in advance
 of services provided are recorded as deferred revenue. Our revenue growth is significantly
 influenced by subscription renewals, and a decrease in renewals could negatively
 impact our revenue.

Installation
 revenues represent one-time fees associated with the customization and installation
 of our software on customer servers. Installation services are billed upon completion
 and are recognized over the expected life of the customer relationship in accordance
 with Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements.
 We estimate the expected life of our customer relationships based on a number of
 factors, including customer type and customer history. Estimates of expected customer
 lives are assessed on an ongoing basis. A material change in the estimated customer
 life could significantly impact the rate at which we recognize these revenues.

Allowance for Doubtful Accounts

We maintain
 an allowance for doubtful accounts for estimated losses resulting from the inability
 of our customers to make required payments. We estimate the allowance based on a
 number of factors, including historical collection and write-off experience, the
 overall credit-worthiness of our customer base, the aging of our accounts receivable
 and current market trends. If the financial condition of our customers deteriorates,
 additional allowances may be required.

Deferred Tax Assets

We have experienced
 significant net operating losses since inception. These losses have generated sizeable
 net operating loss carry-forwards potentially available to offset future taxable
 income. A full valuation allowance has been recorded against the deferred tax assets
 available to us for use in future periods to reduce these assets to the amount expected
 to be realized. However, if we determined that we could realize our deferred tax
 assets in the future, an adjustment to the deferred tax assets would increase our
 income in the period such determination was made.

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##### Table of Contents



Contingencies

We are subject
 to the possibility of various loss contingencies arising in the ordinary course
 of business. We consider the likelihood of loss or impairment of an asset or the
 incurrence of a liability, as well as our ability to reasonably estimate the amount
 of loss in evaluating loss contingencies. An estimated loss contingency is accrued
 when it is probable that an asset has been impaired or a liability has been incurred
 and the amount of loss can be reasonably estimated. We regularly evaluate current
 information available to us to determine whether such accruals should be adjusted.

Comparison of Fiscal 2002 to 2001

Internet filtering and consulting service
 revenues

Internet filtering
 and consulting service revenues accounted for 100% of our revenues for fiscal 2002
 and 94% of our revenues for fiscal 2001. Internet filtering and consulting service
 revenues increased by 30% to $11.1 million, compared to $8.6 million for fiscal
 2001. Fiscal 2002 revenue reflects our increased base of paying education customers,
 resulting from conversions from our advertising-based filtering model to our subscription
 fee-based model during the second half of fiscal 2001, combined with additional
 new sales to the education market during the year. Sales to corporate customers
 made by our growing network of resellers have also contributed to our increased
 revenue. In addition, sales of our new software-based solutions have added to
 our revenue for fiscal 2002. The increase in revenue was partially offset by a decline
 in revenue recognized under SAB 101. The amount of SAB 101 revenue recognized during
 the year was $0.8 million, down from $2.6 million in the prior year.

Advertising revenues

During fiscal
 2001, we terminated our advertising-based fee structure previously offered to schools
 and converted over 70% of those customers to a fee-paying subscription model. Accordingly,
 advertising has been eliminated as a source of revenue.

Internet filtering services and customer
 support

Internet filtering
 services and customer support costs consist of the costs of Web site review, technical
 support, costs associated with building and maintaining our database, collocation,
 bandwidth, and an allocation of corporate facilities costs. Costs of Internet filtering
 services and customer support decreased by 35% to $3.4 million, compared to $5.2
 million for fiscal 2001. The decrease is largely due to savings from reductions
 to the employee count made in late 2001, and Internet connectivity and collocation
 cost savings realized by changing vendors and negotiating more favorable terms.
 We expect Internet filtering services and customer support costs to decrease in
 the next fiscal year as we realize the cost savings from reductions in the employee
 count that took place in the fourth quarter of fiscal 2002.

Educational content and advertising costs

Educational
 content and advertising costs previously consisted of product license fees and advertiser
 commissions. Educational content and advertising costs have been eliminated due
 to the termination of our advertising-based filtering model.

Sales and marketing

Sales and
 marketing expenses consist primarily of salaries, commissions and stock compensation
 expense for personnel engaged in selling and marketing functions, and various marketing
 programs such as public relations, advertising, and lead generation. Sales and marketing
 also includes an allocation of corporate facilities costs. Sales and marketing
 expenses decreased 42%, to $7.1 million, compared to $12.1 million for fiscal 2001.
 The decrease is due in large part to reduced deferred stock compensation expense.
 Deferred stock compensation is being amortized using an accelerated method, which
 resulted in higher expense in 2001 as compared to 2002. The decrease is also due
 in part to our reduced direct sales staff and related expenses, as we continue to
 shift a large portion of our sales efforts to an indirect sales channel in which
 we attempt to leverage distributors and resellers to increase our customer base.
 With our focus channeled toward our core competencies of filtering, monitoring,
 and reporting solutions, we have eliminated sales and marketing expenditures related
 to non-core products. This has further contributed to the decrease in total sales
 and marketing expense. We expect sales and marketing costs to decrease slightly
 in the next year as we realize the cost savings from reductions in the employee
 count that took place in the fourth quarter of fiscal 2002. However, such savings
 will be partially offset as we continue to build, train, and support our distribution
 channels.

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##### Table of Contents



General and administrative

General and
 administrative expenses consist primarily of salaries, benefits and related costs
 for executive, finance, human resources and administrative personnel, third party
 professional service fees, insurance costs, and an allocation of corporate facilities
 costs. General and administrative expenses decreased by 38% to $3.5 million, compared
 to $5.7 million for fiscal 2001. This decrease is primarily due to reductions in
 our administrative staff that took place late in fiscal 2001. We also incurred
 less bad debt expense in fiscal 2002, as the improved health of our customer base
 resulted in better collection rates for fiscal 2002. In addition, we have reduced
 our spending on professional services and other support functions and negotiated
 more favorable contract terms. We expect general and administrative expenses to
 remain materially consistent in the next fiscal year.

Research and development

Research and
 development costs 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 filtering products and enhancing
 existing products. Product costs related to internal research and development have
 been expensed as incurred. Research and development expenses decreased by 55% to
 $1.9 million, compared to $4.1 million for fiscal 2001. This decrease is primarily
 due to reductions in our development staff that took place late in fiscal 2001,
 and reducing our use of contractors and third-party service providers in the development
 of our products. We expect research and development expenses to continue to decrease
 slightly in the next fiscal year.

Depreciation and amortization

Depreciation
 consists of depreciation on all fixed assets and leasehold improvements. Amortization
 previously consisted of amortization of technology licenses and acquired intangible
 assets. Depreciation and amortization expenses decreased by 59% to $1.9 million,
 compared to $4.7 million for fiscal 2001. In fiscal 2001, as a result of changes
 in the Companys service model, we performed an impairment test as required
 by SFAS 121 and recorded a full write-down of remaining field servers, acquired
 intangible assets, and technology licenses. Accordingly, no depreciation or amortization
 associated with those assets was recorded in fiscal 2002.

Interest income and expense

Interest income
 consists primarily of interest earned on our cash equivalents. Interest expense
 consists of interest paid on our capital leases. Net interest income has decreased
 by 76% to $120,000, compared to $500,000 fiscal 2001. The decrease is due to our
 reduced cash and investment balance. Interest expense has been substantially eliminated
 due to the repayment of all of our outstanding bank debt during fiscal 2001.

Comparison of Fiscal 2001 to 2000

Internet filtering and consulting service
 revenues

Internet filtering
 and consulting service revenues accounted for 94% of our revenues for fiscal 2001
 and 78% of our revenues for fiscal 2000. Internet filtering and consulting service
 revenues remained flat at $8.6 million for both fiscal 2001 and 2000, despite the
 adoption of Staff Accounting Bulletin No. 101, Revenue Recognition in Financial
 Statements, or SAB 101, in 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. 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 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.

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##### Table of Contents



Internet filtering services and customer
 support

Costs of Internet
 filtering services and customer support decreased by 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 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 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 shifted a large portion of our sales efforts
 to the indirect sales channel. We 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 declined due
 to an accelerated method of amortization.

General and administrative

General and
 administrative expenses decreased by 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 severance-related
 costs for employees and certain terminated officers. In addition, amortization
 of deferred stock compensation declined significantly due to the cancellation of
 certain stock options for employees who are no longer employed by us. Further,
 we reduced our spending on contractors and third-party professional service providers.

Research and development

Research and
 development expenses decreased by 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 updated 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.

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 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 once
 it was determined that the licenses would not be used as part of our product offerings.
 The impairment charge represented the total net carrying value of the intangible
 assets.

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##### Table of Contents



Write-down of field servers

During fiscal
 2001, we introduced our new software-based filtering solutions and developed a plan
 to eventually phase out the proxy server product line. The proxy server-based product
 will no longer be promoted to new customers. Under the guidance provided by Financial
 Accounting Standard No. 121 (FAS 121), we concluded that an event has occurred that
 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.

Liquidity and Capital Resources

Cash and cash
 equivalents were $4.7 million (including restricted cash of $675,000) or 54% of
 total assets at September 30, 2002, compared to $6.7 million (including restricted
 cash of $675,000) or 52% of total assets at September 30, 2001. The decrease in
 cash and cash equivalents is primarily due to cash used to fund operations, combined
 with minor purchases of computer equipment and payments under capital lease and
 note payable obligations. Operating activities consumed $1.8 million for the year,
 compared to $12.3 million for fiscal 2001.

Investing
 activities provided $9,000 in fiscal 2002, compared to $15.8 million in fiscal 2001.
 Cash provided from investing activities has substantially decreased due to our
 decreased cash and investment balances. Fiscal 2002 investing activities consist
 of amounts collected on notes receivable and proceeds from sales of fixed assets,
 partially offset by capital expenditures. Additions to property and equipment totaled
 $147,000 during the year, compared to $1.6 million for fiscal 2001. The additions
 to property and equipment during fiscal 2002 primarily consisted of computer equipment
 purchased to provide additional backup and storage capacity for electronic data.
 We anticipate a small increase in equipment purchases during fiscal 2003 to support
 our internal operations and our growing customer base.

Financing
 activities consumed $185,000 in fiscal 2002, compared to $5.5 million in fiscal
 2001. Financing activities primarily consist of payments under capital lease and
 note payable obligations. Restricted cash of $675,000 is pledged as collateral for
 a letter of credit related to our leased office space in the amount of $665,000,
 expiring on July 31, 2005, and a $10,000 deposit held by Comerica for the issuance
 of corporate credit cards. The restriction will remain in effect through the term
 of these commitments.

We have experienced
 significant net operating losses from inception. In fiscal 2002, we incurred operating
 losses of $6.6 million. We anticipate that operating losses will continue at least
 through a portion of fiscal 2003 as we continue to develop our distribution channels
 and customer base. Given our reduced level of employees and operating expenses,
 and our customer renewal rates, we believe that our cash on hand, together with
 cash generated from operations, will be sufficient to meet our anticipated cash
 needs for at least the next twelve months. If cash generated from operations is
 insufficient to satisfy our short-term or long-term liquidity requirements, we may
 seek to further reduce expenses, sell additional equity or debt securities, obtain
 a credit facility, or sell N2H2. 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 revenues generated from operations are insufficient to satisfy our long-term
 liquidity requirements and we are not successful in further reducing expenses, raising
 additional funds, or finding a buyer for N2H2 on acceptable terms when needed, our
 business would fail.

Following
 is a summary of our significant unconditional contractual obligations and commercial
 commitments:



|                         | Payments Due by Period
|------------------------ | ----------------------
|                         |                       
|                         |                       
|                         |                       
|Contractual Obligations: |                       
|Operating Lease          | $                     
|Capital Leases           | $                     
|                         |                       
|Total                    | $                     
|                         |                       

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##### Table of Contents



Recently Issued Accounting Standards

In July 2001,
 the Financial Accounting Standards Board, or FASB, issued Financial Accounting Standard
 141  Business Combinations, or 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 adoption of FAS 141 did not have a material effect on our results of operations
 or financial position.

In July 2001,
 the FASB issued Financial Accounting Standard 142  Goodwill and Intangible
 Assets, or 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. The adoption of FAS 142 did
 not 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, or 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. The
 adoption of FAS 143 did not 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, or 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 the adoption of FAS 144 to have a material effect on our results of
 operations or financial position.

In July 2002,
 the FASB issued Financial Accounting Standards 146  Accounting for Costs Associated
 with Exit or Disposal Activities, or FAS 146. FAS 146 requires that a liability
 for costs associated with an exit or disposal activity be recognized and measured
 initially at fair value only when the liability is incurred. FAS 146 is effective
 for exit or disposal activities that are initiated after December 31, 2002. The
 Company does not expect the adoption of FAS 146 to have a material impact on its
 operating results 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, 2002
 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                                                                                                  | 24  
|Consolidated Balance Sheets as of September 30, 2002 and 2001                                                                      | 25  
|Consolidated Statements of Operations for the Fiscal Years Ended September 30, 2002,
 2001 and 2000                                | 26  
|Consolidated Statements of Changes in Shareholders Equity (Deficit) for the
 Fiscal Years Ended September 30, 2002, 2001 and 2000 | 27  
|Consolidated Statements of Cash Flows for the Fiscal Years Ended September 30, 2002,
 2001 and 2000                                | 28  
|Consolidated Notes to Financial Statements                                                                                         | 29  

23



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##### Table of Contents






REPORT OF INDEPENDENT
 ACCOUNTANTS

To the Board of Directorsand Shareholders
 ofN2H2, 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, 2002 and 2001, and the results of their operations
 and their cash flows for each of the three years in the period ended September 30,
 2002, 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.

As discussed in note 3 to the
consolidated financial statements, the Company changed its method of
accounting for installation revenue effective October 1, 2000.

PricewaterhouseCoopers LLP

Seattle, WashingtonDecember 10, 2002

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##### Table of Contents



N2H2, INC.CONSOLIDATED BALANCE
 SHEETS(in thousands)



|                                                                                                                                | September 30,
|------------------------------------------------------------------------------------------------------------------------------- | -------------
|                                                                                                                                |              
|                                                                                                                                | 2002         
|                                                                                                                                |              
|ASSETS                                                                                                                         
|Current assets                                                                                                                  |              
|Cash and cash equivalents                                                                                                       | $            
|Restricted cash and cash equivalents                                                                                            |              
|Accounts receivable (net of allowances of $265 and $284 in
 2002 and 2001, respectively)                                        |              
|Prepaid expenses and other current assets                                                                                       |              
|                                                                                                                                |              
|Total current assets                                                                                                            |              
|Property and equipment, net                                                                                                     |              
|Other assets                                                                                                                    |              
|                                                                                                                                |              
|Total assets                                                                                                                    | $            
|                                                                                                                                |              
|LIABILITIES AND
 SHAREHOLDERS EQUITY (DEFICIT)                                                                                
|Current liabilities                                                                                                             |              
|Accounts payable                                                                                                                | $            
|Accrued payroll and benefits                                                                                                    |              
|Other accrued liabilities                                                                                                       |              
|Deferred revenue                                                                                                                |              
|Note payable                                                                                                                    |              
|Current portion of capital lease obligations                                                                                    |              
|                                                                                                                                |              
|Total current liabilities                                                                                                       |              
|Deferred revenue                                                                                                                |              
|Capital lease and other obligations, net of current portion                                                                     |              
|                                                                                                                                |              
|Total liabilities                                                                                                               |              
|                                                                                                                                |              
|Commitments and contingencies                                                                                                   |              
|Shareholders equity (deficit)                                                                                                  |              
|Preferred stock, no par
 value; 50,000 shares authorized, no shares issued and outstanding                                      |              
|Common stock, no par value; 250,000 shares authorized; 22,104 and
 22,060 issued and outstanding in 2002 and 2001, respectively |              
|Notes receivable from shareholders, net of allowances                                                                           |              
|Deferred stock compensation                                                                                                     |              
|Accumulated other comprehensive loss                                                                                            |              
|Accumulated deficit                                                                                                             |              
|                                                                                                                                |              
|Total shareholders equity (deficit)                                                                                            |              
|                                                                                                                                |              
|Total liabilities and shareholders equity (deficit)                                                                            | $            
|                                                                                                                                |              
|                                                                                                                                |              
|The accompanying
 notes are an integral part of these consolidated financial statements.                                       

25



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##### Table of Contents



N2H2, INC.CONSOLIDATED STATEMENTS
 OF OPERATIONS(in thousands, except per share amounts)



|                                                                                         | Years Ended
 September 30,
|---------------------------------------------------------------------------------------- | --------------------------
|                                                                                         |                           
|                                                                                         | 2002                      
|                                                                                         |                           
|Revenues:                                                                                |                           
|Internet filtering and consulting services                                               | $                         
|Advertising                                                                              |                           
|                                                                                         |                           
|Total revenues                                                                           |                           
|                                                                                         |                           
|Operating expenses:                                                                      |                           
|Internet filtering services and customer support                                         |                           
|Educational content and advertising costs                                                |                           
|Sales and marketing                                                                      |                           
|General and administrative                                                               |                           
|Research and development                                                                 |                           
|Depreciation and amortization                                                            |                           
|Write-down of acquired intangible assets                                                 |                           
|Write-down of technology licenses                                                        |                           
|Write-down of field servers                                                              |                           
|                                                                                         |                           
|Total operating expenses                                                                 |                           
|                                                                                         |                           
|Loss from operations                                                                     |                           
|Interest income, net of interest expense                                                 |                           
|Loss on disposal of property and equipment                                               |                           
|Write-down of investment                                                                 |                           
|Loss on sale of Iseek Communications                                                     |                           
|                                                                                         |                           
|Loss before change in accounting policy                                                  |                           
|Cumulative effect of change in accounting policy                                         |                           
|                                                                                         |                           
|Net loss                                                                                 | $                         
|                                                                                         |                           
|Basic and diluted net loss per share:                                                    |                           
|Loss before change in accounting policy                                                  | $                         
|Effect of change in accounting policy                                                    |                           
|                                                                                         |                           
|Net loss per share                                                                       | $                         
|                                                                                         |                           
|Basic and diluted weighted average shares outstanding                                    |                           
|                                                                                         |                           
|Pro forma amounts assuming the change in accounting policy
 was applied retroactively:   |                           
|Net loss                                                                                 |                           
|Basic and diluted net loss per share                                                     |                           
|                                                                                         |                           
|The accompanying
 notes are an integral part of these consolidated financial statements.

26



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##### Table of Contents



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, 1999                                                |  |              | 21,064,285 |            |  | $            | 75,528 |              |  | $           | (25    | )       |  | $     | (1,940 | )           |  |   |     |   |  | $ | (12,065 | )
|Issuance of common stock related to acquisition, net of purchase costs    |  |              | 925,000    |            |  |              | 16,104 |              |  |             |        |         |  |       | (8,911 | )           |  |   |      |   |  |   |         |  
|Issuance of common stock related to employee stock purchase plan          |  |              | 36,453     |            |  |              | 77     |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Exercise of stock options and warrants                                    |  |              | 556,771    |            |  |              | 519    |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Issuance of warrants                                                      |  |              |            |            |  |              | 1,255  |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Issuance of notes receivable to shareholders, net of reserve of $805      |  |              |            |            |  |              |        |              |  |             | (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  |             |  |   |      |   |  |   |         |  
|Comprehensive loss:                                                       |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Net loss                                                                  |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   | (39,258 | )
|Unrealized loss on foreign currency translation                           |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   | (61  | ) |  |   |         |  
|                                                                          |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Total comprehensive loss                                                  |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   | (61  | ) |  |   | (39,258 | )
|                                                                          |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Balance at September 30, 2000                                             |  |              | 22,582,509 |            |  |              | 93,085 |              |  |             | (1,073 | )       |  |       | (6,069 | )           |  |   | (61  | ) |  |   | (51,323 | )
|Issuance of common stock related to employee stock purchase plan          |  |              | 18,722     |            |  |              | 6      |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Exercise of stock options                                                 |  |              | 266,716    |            |  |              | 73     |              |  |             |        |         |  |       | (5     | )           |  |   |      |   |  |   |         |  
|Settlement of notes receivable from shareholder                           |  |              | (807,868   | )          |  |              | (645   | )            |  |             | 1,092  |         |  |       |        |             |  |   |      |   |  |   |         |  
|Interest earned on notes receivable from shareholders                     |  |              |            |            |  |              |        |              |  |             | (71    | )       |  |       |        |             |  |   |      |   |  |   |         |  
|Payments received on notes receivable from shareholders                   |  |              |            |            |  |              |        |              |  |             | 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  |             |  |   |      |   |  |   |         |  
|Comprehensive loss:                                                       |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Net loss                                                                  |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   | (35,461 | )
|Unrealized loss on foreign currency translation                           |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   | (66  | ) |  |   |         |  
|                                                                          |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Total comprehensive loss                                                  |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   | (66  | ) |  |   | (35,461 | )
|                                                                          |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Balance at September 30, 2001                                             |  |              | 22,060,079 |            |  |              | 92,166 |              |  |             | (48    | )       |  |       | (2,030 | )           |  |   | (127 | ) |  |   | (86,784 | )
|Issuance of common stock related to employee stock purchase plan          |  |              | 36,077     |            |  |              | 8      |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Exercise of stock options                                                 |  |              | 7,920      |            |  |              | 2      |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Stock awards granted                                                      |  |              | 300        |            |  |              | 0      |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Change in reserve for notes receivable from shareholders                  |  |              |            |            |  |              |        |              |  |             | (95    | )       |  |       |        |             |  |   |      |   |  |   |         |  
|Interest earned on notes receivable
 from shareholders                    |  |              |            |            |  |              |        |              |  |             | (22    | )       |  |       |        |             |  |   |      |   |  |   |         |  
|Payments received on notes receivable from shareholders                   |  |              |            |            |  |              |        |              |  |             | 124    |         |  |       |        |             |  |   |      |   |  |   |         |  
|Amortization of deferred stock option compensation                        |  |              |            |            |  |              |        |              |  |             |        |         |  |       | 1,615  |             |  |   |      |   |  |   |         |  
|Comprehensive loss:                                                       |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Net loss                                                                  |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   | (6,606  | )
|Unrealized gain on foreign currency translation                           |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   | 25   |   |  |   |         |  
|                                                                          |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Total comprehensive loss                                                  |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   | 25   |   |  |   | (6,606  | )
|                                                                          |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  
|Balance at September 30, 2002                                             |  |              | 22,104,376 |            |  | $            | 92,176 |              |  | $           | (41    | )       |  | $     | (415   | )           |  | $ | (102 | ) |  | $ | (93,390 | )
|                                                                          |  |              |            |            |  |              |        |              |  |             |        |         |  |       |        |             |  |   |      |   |  |   |         |  

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

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##### Table of Contents



N2H2, INC.CONSOLIDATED STATEMENTS
 OF CASH FLOWS(in thousands)



|                                                                                         | Years Ended
 September 30,
|---------------------------------------------------------------------------------------- | --------------------------
|                                                                                         |                           
|                                                                                         | 2002                      
|                                                                                         |                           
|Cash Flows from Operating Activities                                                     |                           
|Net loss                                                                                 | $                         
|Adjustments to reconcile net loss to net cash used by operating
 activities:             |                           
|Depreciation and amortization                                                            |                           
|Amortization of deferred stock compensation                                              |                           
|Provision for accounts receivable                                                        |                           
|Write-down of acquired intangible assets                                                 |                           
|Write-down of technology licenses                                                        |                           
|Write-down of field servers                                                              |                           
|Write-down of investment                                                                 |                           
|Change in accounting policy, net                                                         |                           
|Loss on disposal of property and equipment                                               |                           
|Loss on sale of Iseek Communications                                                     |                           
|Compensation expense for forgiveness of shareholder loans                                |                           
|Interest earned on shareholder loans                                                     |                           
|Provision for (recovery of) shareholder loans                                            |                           
|Change in operating assets and liabilities:                                              |                           
|Accounts receivable                                                                      |                           
|Prepaid expenses and other assets                                                        |                           
|Accounts payable                                                                         |                           
|Royalties payable                                                                        |                           
|Accrued liabilities                                                                      |                           
|Deferred revenue                                                                         |                           
|Other non-current liabilities                                                            |                           
|                                                                                         |                           
|Net cash used by operating activities                                                    |                           
|                                                                                         |                           
|Cash Flows from Investing Activities                                                     |                           
|Purchases of investments                                                                 |                           
|Maturities of investments                                                                |                           
|Additions to property and equipment                                                      |                           
|Proceeds from sale of property and equipment                                             |                           
|Notes receivable from shareholders                                                       |                           
|Transaction costs incurred for N2H2 Pty Limited acquisition, net
 of cash acquired       |                           
|                                                                                         |                           
|Net cash provided by investing activities                                                |                           
|                                                                                         |                           
|Cash Flows from Financing Activities                                                     |                           
|Issuance of common stock, net                                                            |                           
|Exercise of stock options and warrants                                                   |                           
|Payments under capital lease obligations                                                 |                           
|Borrowings under notes payable                                                           |                           
|Repayments of notes payable                                                              |                           
|Cash restricted to collateralize letter of credit                                        |                           
|                                                                                         |                           
|Net cash provided by (used by) financing activities                                      |                           
|                                                                                         |                           
|Effects of exchange rates                                                                |                           
|Net increase (decrease) in cash and cash equivalents                                     |                           
|Cash and cash equivalents, beginning of period                                           |                           
|                                                                                         |                           
|Cash and cash equivalents, end of period                                                 | $                         
|                                                                                         |                           
|                                                                                        
|The accompanying
 notes are an integral part of these consolidated financial statements.
|                                                                                        

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N2H2, INC.




NOTES TO CONSOLIDATED
 FINANCIAL STATEMENTS

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 services to conserve bandwidth, increase user productivity,
 and seeks to limit potential legal liabilities of its customers relating to inappropriate
 employee Internet use. 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 and has an accumulated
 shareholders deficit. In fiscal 2002, the Company incurred operating losses
 of $6.6 million and used $1.8 million of cash in its operating activities. Management
 anticipates that operating losses will continue at least through a portion of fiscal
 2003 as the Company continues to develop its distribution channels and customer
 base. If cash generated from operations is insufficient to satisfy the Companys
 short-term or long-term liquidity requirements, management may seek to further reduce
 expenses, sell additional equity or debt securities, or obtain a credit facility
 to continue its operations beyond September 30, 2003. Alternatively, management
 may seek to sell the Company. The incurring of indebtedness would result in increased
 fixed obligations and could result in covenants that would restrict the Companys
 operations. The Company has not made arrangements to obtain additional financing
 and there can be no assurance that financing will be available in amounts or on
 acceptable terms, if at all.

On March 20,
 2002, the Company received notification from the Nasdaq National Market that the
 Company had failed to meet Nasdaq listing requirements as set forth in Marketplace
 Rule 4450(a)(3). The Companys common stock was delisted from Nasdaq after
 the close of trading on March 20, 2002. Effective with the opening of business
 on March 21, 2002, the Companys common stock began trading on the Over-The-Counter
 Bulletin Board under the symbol NTWO. As a result of the delisting,
 it may be more difficult to achieve liquidity of shares of N2H2 common stock, and
 the delisting may also impair the Companys ability to raise additional capital.

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.

Revenue Recognition

The Companys
 revenues are derived primarily from sales of Internet filtering subscriptions.
 A smaller portion of its revenue also comes from installation and maintenance fees,
 and historically, advertising. The Company recognizes revenue in accordance with
 Statement of Position No. 97-2, Software Revenue Recognition (SOP 97-2). Accordingly,
 revenue is recognized when persuasive evidence of an arrangement exists, the product
 or service has been delivered, the fee is fixed and determinable, and collection
 is reasonably assured.

Subscription
 revenues represent the fees associated with the right to use the Companys
 software and/or hardware, and to access the Companys filtering updates. Maintenance
 revenues represent fees associated with technical support services provided to customers.
 Subscription agreements and most maintenance services are evidenced by signed contracts,
 which are generally 12, 24 or 36 months in

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##### Table of Contents



duration. Subscription and maintenance
 revenues are recognized on a straight-line basis over the life of the contract.
 Contracts billed in advance of services provided are recorded as deferred revenue.
 Upon expiration of the contract, customers who wish to renew must do so at the
 Companys then current rates. The Companys revenue growth is significantly
 influenced by subscription renewals, and a decrease in renewals could negatively
 impact the Companys revenue.

Installation
 revenues represent one-time fees associated with the customization and installation
 of the Companys software on customer servers. Installation services are billed
 upon completion and are recognized over the expected life of the
 customer relationship in accordance with Staff Accounting Bulletin
 No. 101, Revenue Recognition in Financial Statements.
 The Company estimates the expected life of its customer relationships based
 on a number of factors, including customer type and customer history. Estimates
 of expected customer lives are assessed on an ongoing basis. A material change
 in the estimated customer life could significantly impact the rate
 at which the Company recognizes
 these revenues.

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. There were no barter revenues in fiscal 2002. All contracts with advertisers
 were concluded or cancelled during fiscal 2001.

Allowance for Doubtful Accounts

The Company
 maintains an allowance for doubtful accounts for estimated losses resulting from
 the inability of customers to make required payments. The Company estimates the
 allowance based on a number of factors, including historical collection and write-off
 experience, the overall credit-worthiness of its customer base, the aging of the
 Companys accounts receivable and current market trends. If the financial
 condition of customers deteriorates, additional allowances may be required.

Deferred Tax Assets

The Company
 has experienced significant net operating losses since inception. These losses
 have generated sizeable net operating loss carry-forwards potentially available
 to offset future taxable income. A full valuation allowance has been recorded against
 the deferred tax assets available to us for use in future periods to reduce these
 assets to the amount expected to be realized. However, if it was determined that
 the Company could realize these deferred tax assets in the future, an adjustment
 to the deferred tax assets would increase income or reduce losses in the period
 such determination was made.

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. The
 company did not hold any investments at September 30, 2002 or 2001.

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##### Table of Contents



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.

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 $1,404,000, $1,465,000
 and $4,248,000 for the years ended September 30, 2002, 2001 and 2000, 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, including returns, exchanges and replacement
 parts, are included within Internet Filtering Services and Customer Support costs
 on the Statement of Operations. Shipping and handling expenses were $37,000, $81,000
 and $101,000 for the years ended September 30, 2002, 2001 and 2000, respectively.

Income Taxes

The Company
 accounts 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, 2002, 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 school
 districts and Internet service providers. International accounts receivable represent
 32%, 19%, and 25% of total accounts receivable at September 30, 2002, 2001 and 2000,
 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.

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 years ended September 30, 2002, 2001
 and 2000:



|              |  | 2002 |            | 2001 |   | 2000     
|------------- |  | ---- | ---------- | ---- | - | ---------
|              |  |      |            |      |   |          
|United States |  | $    | 9,362,000  |      | $ | 7,949,000
|International |  |      | 1,773,000  |      |   | 1,172,000
|              |  |      |            |      |   |          
|              |  | $    | 11,135,000 |      | $ | 9,121,000
|              |  |      |            |      |   |          

Long-lived
 assets located outside the United States are not significant.

Recently Issued Accounting Standards

In July 2001,
 the Financial Accounting Standards Board, or FASB, issued Financial Accounting Standard
 141  Business Combinations, or 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 adoption of FAS 141 did not have a material effect on our 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. The adoption of FAS 142 did not
 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
 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
 adoption of FAS 143 did not have a material effect on its results of operations
 or financial position.

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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
 the adoption of FAS 144 to have a material effect on its results of operations or
 financial position.

In July 2002,
 the FASB issued Financial Accounting Standards 146  Accounting for Costs Associated
 with Exit or Disposal Activities, or FAS 146. FAS 146 requires that a liability
 for costs associated with an exit or disposal activity be recognized and measured
 initially at fair value only when the liability is incurred. FAS 146 is effective
 for exit or disposal activities that are initiated after December 31, 2002. The
 Company does not expect the adoption of FAS 146 to have a material impact on its
 operating results 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 its customer relationships. The adoption of SAB 101 resulted
 in a one-time, non-cash charge of $3,554,000 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 amount of related deferred revenue that was recognized
 as revenue during fiscal 2002 and 2001 was $764,000 and $2,561,000, respectively.
 The remaining $229,000 of related deferred revenue will be recognized in fiscal
 2003.

4. Property and Equipment

Property and
 equipment consists of the following:



|                                                | September 30,
|----------------------------------------------- | -------------
|                                                |              
|                                                | 2002         
|                                                |              
|Computer equipment                              | $            
|Furniture and fixtures                          |              
|Leasehold improvements                          |              
|Internal use software                           |              
|Other assets  vehicles                         |              
|                                                |              
|                                                |              
|Less: Accumulated depreciation and amortization |              
|                                                |              
|                                                | $            
|                                                |              

Depreciation
 and amortization expense for property and equipment was $1,904,000, $4,456,000 and
 $3,301,000 for the years ended September 30, 2002, 2001, and 2000, respectively.

5. Borrowings and Restricted Cash

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

The Company
 has $675,000 of restricted cash pledged as collateral for a letter of credit related
 to the Companys leased office space in the amount of $665,000, expiring on
 July 31, 2005, and a $10,000 deposit held by Comerica for the issuance of corporate
 credit cards. The restriction will remain in effect through the term of these commitments.

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6. Severance Expense

During fiscal
 2002, the Company reduced the overall level of worldwide staffing by approximately
 33%, or 36 employees, spanning across all departments. The reduction in force resulted
 in severance charges of $322,000 during the year. Accrued severance charges at
 September 30, 2002 of $110,000 will be paid out during the first quarter of fiscal
 2003.

7. 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 updated 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-based product line. The Company will no
 longer promote the proxy server-based product to new customers. The Company plans
 to continue support of existing customers proxy-based filtering installations,
 however, an effort will be made to migrate existing proxy-using customers to one
 of the new software-based filtering solutions service. Under the guidance provided
 by Financial Accounting Standard No. 121 (FAS 121), the Company concluded that an
 event has occurred that 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.

8. Lease Commitments

The Company
 held property under capital leases, which is included in property and equipment
 at September 30, 2002, 2001 and 2000, in the gross amount of $52,000, $606,000 and
 $606,000, respectively. Related accumulated amortization for those assets was $51,000,
 $202,000 and $219,000 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, 2002, 2001, and 2000 was $1,144,000,
 $1,387,000 and $1,311,000, respectively. 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 Company
 recorded a loss in connection with this sub lease arrangement of $148,000 in the
 year ended September 30, 2002.

The minimum
 annual rental commitments on all leases at September 30, 2002 are as follows:



|                                            |  | Operating |           | Capital
|------------------------------------------- |  | --------- | --------- | -------
|                                            |  | Lease     |           | Leases 
|                                            |  |           |           |        
|Years Ending September 30,                  |  |           |           |        
|2003                                        |  | $         | 1,228,000 |        
|2004                                        |  |           | 1,266,000 |        
|2005                                        |  |           | 1,205,000 |        
|Thereafter                                  |  |           |          |        
|                                            |  |           |           |        
|Total minimum lease payments                |  |           | 3,699,000 |        
|Less: Sublease proceeds                     |  |           | (571,000  | )      
|                                            |  |           |           |        
|                                            |  | $         | 3,128,000 |        
|                                            |  |           |           |        
|Less: Amount representing interest          |  |           |           |        
|                                            |  |           |           |        
|Present value of capital lease obligation   |  |           |           |        
|Less: Current portion                       |  |           |           |        
|                                            |  |           |           |        
|Long-term obligations at September 30, 2002 |  |           |           |        
|                                            |  |           |           |        

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The minimum annual
 proceeds from sublease at September 30, 2002 are as follows:



|                                |  | Operating
|------------------------------- |  | ---------
|                                |  | Lease    
|                                |  |          
|Years Ending September 30,      |  |          
|2003                            |  | $        
|2004                            |  |          
|2005                            |  |          
|Thereafter                      |  |          
|                                |  |          
|Total minimum sublease proceeds |  | $        
|                                |  |          

9. 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, 2002, 171,000 shares remain in escrow. 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 $1,609,000, $3,713,000 and $3,176,000
 of related compensation expense in fiscal 2002, 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:



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

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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, 1999:



|                                     |  | Year Ended   
|------------------------------------ |  | -------------
|                                     |  | September 30,
|                                     |  | 2000         
|                                     |  |              
|                                     |  | (unaudited)  
|Revenue                              |  | $            
|Net loss                             |  | $            
|Basic and diluted net loss per share |  | $            

10. 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.

11. Related Party Transactions

During the
 year ended September 30, 2000, the Company entered into seven separate note receivable
 agreements with four shareholders, three of whom 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 considered uncollectible.

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 settlement 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.

During fiscal
 2001, the Company also entered into an agreement with another former officer of
 the Company to withhold severance consideration due to the officer under an employment
 contract in exchange for settlement 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
 is due under a revised promissory note, which bears interest at 6.875% per annum.
 The balance due at September 30, 2002 of $283,000 is almost entirely offset by
 the reserve for shareholder loans.

During fiscal
 2002, the Company pursued collection of delinquent notes receivable from shareholders
 of $219,000. The Company recovered $95,000 of the balance, and the remaining $124,000
 was considered uncollectible and written off against the reserve for shareholder
 loans.

12. Income Taxes

A provision
 for income taxes was not recorded for the years ended September 30, 2002, 2001 or
 2000 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.

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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,
|-------------------------------------------- |  | ------------- | -- | -------------
|                                             |  | 2002          |    | 2001         
|                                             |  |               |    |              
|Federal income tax benefit at statutory rate |  | (34.0         | )% |              
|Other                                        |  | 4.0           |    |              
|Change in valuation allowance                |  | 30.0          |    |              
|                                             |  |               |    |              
|                                             |  | 0             | %  |              
|                                             |  |               |    |              

Deferred tax assets
 and liabilities at September 30, 2002 and 2001 consist of the following:



|                                  |  | September 30, |             | September 30,
|--------------------------------- |  | ------------- | ----------- | -------------
|                                  |  | 2002          |             | 2001         
|                                  |  |               |             |              
|Deferred tax assets:              |  |               |             |              
|Net operating loss carryforwards  |  | $             | 17,594,000  |              
|Cash to accrual adjustment        |  |               | 0           |              
|Allowance for doubtful accounts   |  |               | 90,000      |              
|Accrued compensation and benefits |  |               | 3,284,000   |              
|Deferred revenue                  |  |               | 1,813,000   |              
|Impairment on investment          |  |               | 1,020,000   |              
|Depreciation and amortization     |  |               | 2,115,000   |              
|                                  |  |               |             |              
|Total deferred tax assets         |  |               | 25,916,000  |              
|Cash to accrual adjustments       |  |               | 0           |              
|                                  |  |               |             |              
|Total deferred tax liabilities    |  |               | 0           |              
|Valuation allowance               |  |               | (25,916,000 | )            
|                                  |  |               |             |              
|Net deferred tax asset            |  | $             |            |              
|                                  |  |               |             |              

As of September
 30, 2002, the Company had net operating loss carry-forwards of approximately $52
 million to offset future taxable income for Federal income tax purposes, which will
 expire through 2022. Should certain changes in the Companys ownership occur,
 there could be a limitation on the utilization of its net operating losses.

13. Shareholders Equity

Common Stock

On February
 23, 2000, the Company issued 925,000 shares of common stock in connection with the
 acquisition of N2H2 Pty Limited (Note 9).

Preferred Stock

Under the
 terms of the Companys Articles of Incorporation, the Board of Directors may
 determine the rights, preferences, and terms of the Companys authorized but
 unissued shares of preferred stock.

Shareholders Rights Plan

On May 24,
 2002, the Board of Directors approved a Shareholders Rights Plan (Rights Plan).
 The Rights Plan is intended to protect shareholders rights in the event of
 an unsolicited takeover attempt. It is not intended to prevent a takeover of the
 Company on terms that are favorable and fair to all shareholders and will not interfere
 with a merger approved by the Board of Directors. Each right entitles its registered
 holder to purchase one one-thousandth of a share of Series A Participating Cumulative
 Preferred Stock of the Company. The rights will be exercisable only if a person
 or a group acquires or announces a tender or exchange offer to acquire 15% or more
 of the Companys common stock.

In the event
 the rights become exercisable, the Rights Plan allows for N2H2 shareholders to acquire,
 at an exercise price of $2.75 per right owned, stock of the surviving corporation
 having a then-current market value of twice the exercise price, whether or not N2H2
 is the surviving corporation. The rights, which expire on May 24,
2012, are redeemable
 for $.001 per right at the approval of the Board of Directors.

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##### Table of Contents



Stock Purchase Warrants

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. All other warrants
 to purchase shares of common stock have an exercise price of $7.84 and expire on
 December 31, 2003.

The following
 summarizes stock warrant activity for fiscal 2000, 2001 and 2002:



|Balance at October 1, 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 |  
|                              |  |         |  
|Warrants issued               |  |        |  
|Warrants canceled             |  |        |  
|Warrants exercised            |  |        |  
|                              |  |         |  
|Balance at September 30, 2002 |  | 539,283 |  
|                              |  |         |  

No compensation
 expense was incurred for fiscal 2000, 2001 or 2002 related to warrants.

14. 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. In November 1999, the
 Board of Directors increased the total number of shares reserved to 1,250,000.
 This plan was terminated on September 13, 2000 per the terms of the Plan.

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. A total
 of 87,500 shares of common stock were initially reserved for issuance as nonqualified
 stock options to non-employee directors. In March 2002, the Board of Directors increased
 the total number of shares reserved to 487,500. 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.

Effective
 August 2, 2002, the Company adopted the Stock Award Plan for employees other than
 officers or directors, under which 10,000 shares of common stock are reserved for
 stock awards. No awards have been issued under this plan as of September 30, 2002.

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Effective
 May 18, 2002, the Company granted Howard P. Welt, Chief Executive Officer of N2H2,
 a nonqualified stock option to purchase up to 1,400,000 shares of common stock of
 the Company. The option was granted under an individual nonqualified stock option
 agreement and 1,400,000 shares of common stock are reserved for issuance upon exercise
 of the option. The vesting period of this option begins on May 18, 2002, and the
 option vests ratably over a twelve-month period, to become fully exercisable on
 May 18, 2003. The option exercise price is $0.145, the fair market value on the
 date that the option was granted by the Board of Directors. The option expires
 10 years from the date of grant.

On November
 29, 2001 (the Cancellation Date), the Company allowed eligible employees to cancel
 certain outstanding stock option grants to purchase 675,505 shares of common stock
 pursuant to an option exchange program. Six months plus five days after the Cancellation
 Date, the Company granted to these same employees new options under its 2000 Stock
 Option Plan (the Replacement Options) to purchase 331,916 shares of common stock
 on June 3, 2002 (the Grant Date). The exercise price of the Replacement Options
 was the fair value of the common stock on the Grant Date. The employees who canceled
 options did not receive any additional grants of options prior to the Grant Date
 of the Replacement Options, and all employees who received Replacement Options were
 employees of N2H2 on the Grant Date. Since the Company accounts for stock-based
 compensation using the intrinsic value method prescribed by APB 25, compensation
 cost for stock options is measured as the excess, if any, of the fair value of the
 Company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 Replacement Options. In addition, consistent with the guidance
 of FASB Interpretation 44, variable accounting is not required for the replacement
 options.

At September
 30, 2001, the Company had additional nonqualified stock options to purchase 130,000
 shares of its common stock outstanding outside of the plans described above. These
 options were cancelled during fiscal 2002, pursuant to the Companys option
 exchange program.

The following
 summarizes the activity under the Companys Stock Option Plans:



|Options Outstanding           |  | 1997Plan |           | 1999Plan |  | DirectorsPlan |           | 1999/2000Plan |  | 2000Plan |         | StockAwardPlan |  | WeltNon-qualifiedStockOptionAgreement |           | OptionsIssuedOutsidePlans |  | Total
|----------------------------- |  | -------- | --------- | -------- |  | ------------- | --------- | ------------- |  | -------- | ------- | -------------- |  | ------------------------------------- | --------- | ------------------------- |  | -----
|                              |  |          |           |          |  |               |           |               |  |          |         |                |  |                                       |           |                           |  |      
|Balance at October 1, 1999    |  |          | 1,006,084 |          |  |               | 1,316,374 |               |  |          | 3,750   |                |  |                                       | 1,496,625 |                           |  |      
|Options granted               |  |          | 63,400    |          |  |               | 66,233    |               |  |          |         |                |  |                                       |           |                           |  |      
|Options exercised             |  |          | (384,539  | )        |  |               | (152,857  | )             |  |          |         |                |  |                                       |           |                           |  |      
|Options cancelled             |  |          | (58,925   | )        |  |               | (136,879  | )             |  |          |         |                |  |                                       | (449,750  | )                         |  |      
|                              |  |          |           |          |  |               |           |               |  |          |         |                |  |                                       |           |                           |  |      
|Balance at September 30, 2000 |  |          | 626,020   |          |  |               | 1,092,871 |               |  |          | 3,750   |                |  |                                       | 1,046,875 |                           |  |      
|Options granted               |  |          | 101,000   |          |  |               | 400,000   |               |  |          | 83,750  |                |  |                                       |           |                           |  |      
|Options exercised             |  |          | (266,716  | )        |  |               |           |               |  |          |         |                |  |                                       |           |                           |  |      
|Options cancelled             |  |          | (208,037  | )        |  |               | (601,571  | )             |  |          |         |                |  |                                       | (567,950  | )                         |  |      
|                              |  |          |           |          |  |               |           |               |  |          |         |                |  |                                       |           |                           |  |      
|Balance at September 30, 2001 |  |          | 252,267   |          |  |               | 891,300   |               |  |          | 87,500  |                |  |                                       | 478,925   |                           |  |      
|Options granted               |  |          | 100,000   |          |  |               |           |               |  |          | 80,000  |                |  |                                       |           |                           |  |      
|Options exercised             |  |          | (7,920    | )        |  |               |           |               |  |          |         |                |  |                                       |           |                           |  |      
|Options cancelled             |  |          | (204,665  | )        |  |               | (53,250   | )             |  |          |         |                |  |                                       | (354,451  | )                         |  |      
|                              |  |          |           |          |  |               |           |               |  |          |         |                |  |                                       |           |                           |  |      
|Balance at September 30, 2002 |  |          | 139,682   |          |  |               | 838,050   |               |  |          | 167,500 |                |  |                                       | 124,474   |                           |  |      
|                              |  |          |           |          |  |               |           |               |  |          |         |                |  |                                       |           |                           |  |      



|Options Available             |  | 1997Plan |          | 1999Plan |  | DirectorsPlan |          | 1999/2000Plan |  | 2000Plan |         | StockAwardPlan |  | WeltNon-qualifiedStockOptionAgreement |           | OptionsIssuedOutsidePlans |  | Total
|----------------------------- |  | -------- | -------- | -------- |  | ------------- | -------- | ------------- |  | -------- | ------- | -------------- |  | ------------------------------------- | --------- | ------------------------- |  | -----
|                              |  |          |          |          |  |               |          |               |  |          |         |                |  |                                       |           |                           |  |      
|Balance at October 1, 1999    |  |          | 14,751   |          |  |               | 13,251   |               |  |          | 83,750  |                |  |                                       | 750,000   |                           |  |      
|Shares authorized             |  |          |          |          |  |               |          |               |  |          |         |                |  |                                       | 500,000   |                           |  |      
|Options granted               |  |          | (63,400  | )        |  |               | (66,233  | )             |  |          |         |                |  |                                       | (1,496,62 | )                         |  |      
|Options cancelled             |  |          | 58,925   |          |  |               | 136,879  |               |  |          |         |                |  |                                       | 449,750   |                           |  |      
|                              |  |          |          |          |  |               |          |               |  |          |         |                |  |                                       |           |                           |  |      
|Balance at September 30, 2000 |  |          | 10,276   |          |  |               | 83,897   |               |  |          | 83,750  |                |  |                                       | 203,125   |                           |  |      
|Shares authorized             |  |          |          |          |  |               |          |               |  |          |         |                |  |                                       |           |                           |  |      
|Options granted               |  |          | (101,000 | )        |  |               | (400,000 | )             |  |          | (83,750 | )              |  |                                       |           |                           |  |      
|Options cancelled             |  |          | 208,037  |          |  |               | 601,571  |               |  |          |         |                |  |                                       | 567,950   |                           |  |      
|Shares expired                |  |          |          |          |  |               |          |               |  |          |         |                |  |                                       | (771,075  | )                         |  |      
|                              |  |          |          |          |  |               |          |               |  |          |         |                |  |                                       |           |                           |  |      
|Balance at September 30, 2001 |  |          | 117,313  |          |  |               | 285,468  |               |  |          | 0       |                |  |                                       | 0         |                           |  |      
|Shares authorized             |  |          |          |          |  |               |          |               |  |          | 400,000 |                |  |                                       |           |                           |  |      
|Options granted               |  |          | (100,000 | )        |  |               |          |               |  |          | (80,000 | )              |  |                                       |           |                           |  |      
|Options cancelled             |  |          | 204,665  |          |  |               | 53,250   |               |  |          |         |                |  |                                       | 354,451   |                           |  |      
|Shares expired                |  |          |          |          |  |               |          |               |  |          |         |                |  |                                       | (354,451  | )                         |  |      
|                              |  |          |          |          |  |               |          |               |  |          |         |                |  |                                       |           |                           |  |      
|Balance at September 30, 2002 |  |          | 221,978  |          |  |               | 338,718  |               |  |          | 320,000 |                |  |                                       | 0         |                           |  |      
|                              |  |          |          |          |  |               |          |               |  |          |         |                |  |                                       |           |                           |  |      

39



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##### Table of Contents





|Weighted AverageExercise Prices |  | 1997Plan |       | 1999Plan |  | DirectorsPlan |      | 1999/2000Plan |  | 2000Plan |       | StockAwardPlan |  | WeltNon-QualifiedStockOptionAgreement |       | OptionsIssuedOutsidePlans |  | Total
|------------------------------- |  | -------- | ----- | -------- |  | ------------- | ---- | ------------- |  | -------- | ----- | -------------- |  | ------------------------------------- | ----- | ------------------------- |  | -----
|                                |  |          |       |          |  |               |      |               |  |          |       |                |  |                                       |       |                           |  |      
|Balance at October 1, 1999      |  | $        | 0.42  |          |  | $             | 3.07 |               |  | $        | 11.00 |                |  | $                                     |      |                           |  | $    
|Options granted                 |  |          | 14.00 |          |  |               | 5.47 |               |  |          |       |                |  |                                       | 11.63 |                           |  |      
|Options exercised               |  |          | 0.27  |          |  |               | 2.20 |               |  |          |       |                |  |                                       |       |                           |  |      
|Options cancelled               |  |          | 0.67  |          |  |               | 3.35 |               |  |          |       |                |  |                                       | 12.30 |                           |  |      
|                                |  |          |       |          |  |               |      |               |  |          |       |                |  |                                       |       |                           |  |      
|Balance at September 30, 2000   |  |          | 1.88  |          |  |               | 3.31 |               |  |          | 11.00 |                |  |                                       | 11.34 |                           |  |      
|Options granted                 |  |          | 0.48  |          |  |               |      |               |  |          | 0.56  |                |  |                                       |       |                           |  |      
|Options exercised               |  |          | 0.25  |          |  |               |      |               |  |          |       |                |  |                                       |       |                           |  |      
|Options cancelled               |  |          | 1.63  |          |  |               | 3.17 |               |  |          |       |                |  |                                       | 10.89 |                           |  |      
|                                |  |          |       |          |  |               |      |               |  |          |       |                |  |                                       |       |                           |  |      
|Balance at September 30, 2001   |  |          | 3.25  |          |  |               | 3.48 |               |  |          | 1.01  |                |  |                                       | 11.87 |                           |  |      
|Options granted                 |  |          | 0.45  |          |  |               |      |               |  |          | 0.17  |                |  |                                       |       |                           |  |      
|Options exercised               |  |          | 0.21  |          |  |               |      |               |  |          |       |                |  |                                       |       |                           |  |      
|Options cancelled               |  |          | 0.58  |          |  |               | 3.59 |               |  |          |       |                |  |                                       | 11.94 |                           |  |      
|                                |  |          |       |          |  |               |      |               |  |          |       |                |  |                                       |       |                           |  |      
|Balance at September 30, 2002   |  | $        | 5.33  |          |  | $             | 1.98 |               |  | $        | 0.61  |                |  | $                                     | 11.68 |                           |  | $    
|                                |  |          |       |          |  |               |      |               |  |          |       |                |  |                                       |       |                           |  |      

During fiscal
 1999, the Company issued certain stock options with an exercise price less than
 the estimated 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 $6,000, $108,000 and $815,000 has been recognized as an expense
 in fiscal 2002, 2001, and 2000 respectively. During fiscal 2001, the company also
 reversed approximately $130,000 of previously recorded amortization for shares that
 were cancelled due to termination of certain employees in fiscal 2001.

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.

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
 2000, the Company recorded deferred compensation of $8.9 million in connection with
 the issuance of 512,000 shares to N2H2 Pty Limited personnel (Note 9). The Company
 recognized compensation expense of $1,609,000, $3,713,000 and $3,176,000 associated
 with these shares in fiscal 2002, 2001 and 2000, respectively

The Company
 is required under Statement of Financial Accounting Standards No. 123, Accounting
 for Stock-Based Compensation (SFAS 123), to disclose pro forma information regarding
 option grants made to its employees based on specified valuation techniques that
 produce estimated compensation charges. Pro forma results have been determined
 as if the Company had accounted for its stock options and stock purchase plan under
 the minimum value method for all periods prior to the Company becoming a public
 entity, and the fair value method 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, 2002, 2001 and 2000:



|                                                 | Year Ended September 30,
|------------------------------------------------ | ------------------------
|                                                 |                         
|                                                 | 2002                    
|                                                 |                         
|Risk-free interest rate                          |                         
|Dividend yield                                   |                         
|Expected term of option                          | 4 years                 
|Volatility subsequent to initial public offering |                         

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,
|------------------------------ |  | ------------------------
|                               |  |                         
|                               |  | 2002                    
|                               |  |                         
|Net loss as reported           |  | $                       
|Net loss pro forma             |  |                         
|Net loss per share as reported |  |                         
|Net loss per share pro forma   |  |                         

40



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##### Table of Contents



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, 2002, 2001 and 2000 were as
 follows:



|                                                                                                                                         |  | Year Ended September 30,
|---------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------
|                                                                                                                                         |  |                         
|                                                                                                                                         |  | 2002                    
|                                                                                                                                         |  |                         
|Weighted-average fair value of options granted
 with exercise prices equal to the market value of the stock at the date of grant         |  | $                       
|Weighted-average fair value of options granted
 with exercise prices less than the market value of the stock at the date of grant        |  |                         
|Weighted-average fair value of options granted
 with exercise prices greater than the market value of the stock at the date of grant     |  |                         
|Weighted-average exercise price of options granted
 with exercise prices equal to the market value of the stock at the date of grant     |  |                         
|Weighted-average exercise price of options granted
 with exercise prices less than the market value of the stock at the date of grant    |  |                         
|Weighted-average exercise price of options granted
 with exercise prices greater than the market value of the stock at the date of grant |  |                         

The following
 table summarizes information about fixed-price options outstanding at September
 30, 2002 as follows:



|ExercisePrices |       | NumberOutstanding |           | Weighted-AverageRemainingContractual Life |  | Weighted-AverageExercisePrice |           | NumberExercisable |  | Weighted-AverageExercisablePrice
|-------------- | ----- | ----------------- | --------- | ----------------------------------------- |  | ----------------------------- | --------- | ----------------- |  | --------------------------------
|               |       |                   |           |                                           |  |                               |           |                   |  |                                 
|$              | 0.15  |                  | $         | 0.15                                      |  |                               | 1,400,000 |                   |  |                                 
|$              | 0.15  |                  | $         | 0.33                                      |  |                               | 1,004,342 |                   |  |                                 
|$              | 0.33  |                  | $         | 0.36                                      |  |                               | 936,432   |                   |  |                                 
|$              | 0.36  |                  | $         | 0.91                                      |  |                               | 941,827   |                   |  |                                 
|$              | 0.92  |                  | $         | 16.66                                     |  |                               | 884,596   |                   |  |                                 
|$              | 18.94 |                  | $         | 21.75                                     |  |                               | 28,000    |                   |  |                                 
|               |       |                   |           |                                           |  |                               |           |                   |  |                                 
|TOTAL          |       |                   | 5,195,197 |                                           |  |                               |           |                   |  |                                 
|               |       |                   |           |                                           |  |                               |           |                   |  |                                 

15. Employee Stock Purchase Plan

The Company
 has an Employee Stock Purchase Plan under which 750,000 shares of common stock have
 been reserved for issuance. 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. Eligible 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, 2002 totaled 91,252 at an average
 exercise price of $1.01.

16. Employee 401(k) Plan

The Company
 sponsors the N2H2, Inc. 401(k) Plan (the 401(k) Plan) to provide retirement benefits
 for its employees. As allowed under Section 401(k) of the Internal Revenue Code,
 the 401(k) Plan provides tax-deferred salary deductions for eligible employees.
 Through December 31, 2001, employees could contribute from 2% to 20% of their annual
 compensation to the 401(k) Plan. Effective January 1, 2002, the employee contribution
 limit was increased to 80% of the employees annual compensation. Employee
 contributions are limited to a maximum annual amount as set periodically by the
 Internal Revenue Service. The 401(k) Plan allows for discretionary matching contributions
 equal to a percentage of each participants contributions, up to 4% of participants
 annual compensation, to be determined each year by the Company. The 401(k)
 Plan also provides for discretionary profit sharing contributions as determined
 by the Company. Such profit sharing contributions to the 401(k) Plan will be allocated
 among eligible participants in the proportion of their salaries to the total salaries
 of all participants. There were no matching contributions or discretionary profit
 sharing contributions made pursuant to the 401(k) in fiscal 2002, 2001, or 2000.

41



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##### Table of Contents



17. Net Loss Per Share

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



|                                                 | Years Ended
 September 30,
|------------------------------------------------ | --------------------------
|                                                 |                           
|                                                 | 2002                      
|                                                 |                           
|Net loss                                         | $                         
|Weighted-average shares outstanding  basic      |                           
|Weighted-effect of dilutive options and warrants |                           
|                                                 |                           
|Weighted-average shares outstanding  diluted    |                           
|                                                 |                           
|Basic and diluted net loss per share             | $                         
|                                                 |                           

A total of
 171,000 restricted shares, warrants to purchase 539,280 shares of common stock and
 options to purchase 5,195,198 shares of common stock have been excluded from the
 calculation of net loss per share for fiscal 2002 because their effect is anti-dilutive.
 Warrants and options to purchase a total of 539,280 and 3,844,961 shares of common
 stock, respectively, for fiscal 2001 and 539,280 and 4,343,735 shares of common
 stock, respectively for fiscal 2000 have been excluded from the calculation because
 of their effect is anti-dilutive.

18. Contingencies

The Company
 is subject to legal proceedings, claims, and litigation arising in the ordinary
 course of business. While the outcome of these matters is currently not determinable,
 management does not expect that the ultimate costs to resolve these matters will
 have a material adverse effect on the Companys consolidated financial position,
 results of operations, or cash flows.

An individual
 represented by the American Civil Liberties Union has recently filed a lawsuit against
 N2H2 in federal court. The plaintiff is purportedly a computer researcher who allegedly
 seeks to conduct a quantitative analysis of the accuracy and comprehensiveness of
 the Companys Internet filtering solutions for purposes of determining whether these solutions
 exclude some speech on the Internet that is constitutionally protected. He alleges
 that his activities in conducting this analysis, if he ever does so, would violate
 the Companys standard license agreement and intellectual property rights.
 The plaintiff alleges that the threat that N2H2 will enforce the license agreement
 and other rights has deterred him from this activity, which he alleges is protected
 under the fair use doctrine of copyright law and other legal doctrines. He seeks
 a declaration to prohibit N2H2 from enforcing the license agreement against him
 based on his use of the Companys software in his research activities. To the extent that
 this claim is resolved in the plaintiffs favor, it could materially affect
 the Companys ability to enforce its license agreements and other intellectual
 property rights against certain users of its software filtering products. In addition,
 it could contribute to an increase in the number of people who seek to use the Companys
 software in ways that management believes violate the Companys proprietary rights.
 Even if the particular claim described above is resolved in the Companys
 favor, the litigation could result in substantial costs to the company and divert
 managements time and attention away from business operations. Management
 intends to defend the validity of the Companys license agreement and to enforce
 the provisions of this agreement to protect the Companys proprietary rights.

19. Supplemental Cash Flow Information

Supplemental
 disclosure of cash flow information is summarized below for the years ended September
 30, 2002, 2001 and 2000:



|                                                               |  | Years Ended September 30,
|-------------------------------------------------------------- |  | -------------------------
|                                                               |  |                          
|                                                               |  | 2002                     
|                                                               |  |                          
|Non-Cash Investing and Financing Activities:                   |  |                          
|Notes receivable from shareholders written off against reserve |  | $                        
|Stock received for notes receivable from shareholders          |  |                          
|Impact of sale of Iseek Communications:                        |  |                          
|Property and other assets sold                                 |  |                          
|Liabilities sold                                               |  |                          
|Acquisition of N2H2 Pty Limited in non-cash transaction:       |  |                          
|Stock and warrants issued                                      |  |                          
|Acquired intangibles                                           |  |                          
|Additions to deferred compensation                             |  |                          
|Additions to property and equipment                            |  |                          
|Additions to intangibles and other assets                      |  |                          
|Additions to accounts payable                                  |  |                          
|Cash paid for interest                                         |  |                          

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##### Table of Contents



20. Quarterly Financial Information
 (Unaudited)

The following
 table sets forth the Companys unaudited quarterly financial information for
 the years ending September 30, 2002, 2001 and 2000:



|                    |  | Fiscal Year 2002                         
|------------------- |  | -----------------------------------------
|                    |  |                                          
|                    |  | September 30                             
|                    |  |                                          
|                    |  | (in thousands,
 except per share amounts)
|Revenue             |  | $                                        
|Net loss            |  |                                          
|Earnings per share: |  |                                          
|Basic and diluted   |  | $                                        
|                    |  |                                          
|                    |  |                                          
|                    |  | Fiscal Year 2001                         
|                    |  |                                          
|                    |  | September 30                             
|                    |  |                                          
|                    |  | (in
 thousands, except per share amounts)
|Revenue             |  | $                                        
|Net loss            |  |                                          
|Earnings per share: |  |                                          
|Basic and diluted   |  | $                                        
|                    |  |                                          
|                    |  |                                          
|                    |  | Fiscal Year 2000                         
|                    |  |                                          
|                    |  | September 30                             
|                    |  |                                          
|                    |  | (in thousands, except per share amounts) 
|Revenue             |  | $                                        
|Net loss            |  |                                          
|Earnings per share: |  |                                          
|Basic and diluted   |  | $                                        

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                         
|-------------------------------------- |  | -----------------------------------------
|                                       |  |                                          
|                                       |  | ThirdQuarter                             
|                                       |  |                                          
|                                       |  | (in thousands,
 except per share amounts)
|Net loss:                              |  |                                          
|As reported                            |  | $                                        
|As restated                            |  | $                                        
|Earnings per share, basic and diluted: |  |                                          
|As reported                            |  | $                                        
|As restated                            |  | $                                        
|Total assets:                          |  |                                          
|As reported                            |  | $                                        
|As restated                            |  | $                                        
|Total shareholders equity:            |  |                                          
|As reported                            |  | $                                        
|As restated                            |  | $                                        

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.

43



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##### Table of Contents



N2H2, Inc.
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES



|Description                                                   |  | Balance at
Beginning ofFiscal Period |             | Charges toCosts andExpenses |  | Charges toOtherAccounts |             | Balance at
End ofFiscal Period
|------------------------------------------------------------- |  | ------------------------------------ | ----------- | --------------------------- |  | ----------------------- | ----------- | ------------------------------
|                                                              |  |                                      |             |                             |  |                         |             |                               
|Year Ended September 30, 2000 Allowance for doubtful accounts |  |                                      | (142,000    | )                           |  |                         | (369,000    | )                             
|Tax valuation allowance                                       |  |                                      | (2,475,000  | )                           |  |                         | (9,925,000  | )                             
|Year Ended September 30, 2001 Allowance for doubtful accounts |  |                                      | (313,000    | )                           |  |                         | (308,000    | )                             
|Tax valuation allowance                                       |  |                                      | (12,400,000 | )                           |  |                         | (11,817,000 | )                             
|Year Ended September 30, 2002 Allowance for doubtful accounts |  |                                      | (284,000    | )                           |  |                         | (30,000     | )                             
|Tax valuation allowance                                       |  |                                      | (24,217,000 | )                           |  |                         | (1,699,000  | )                             

44



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##### Table of Contents






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

Not applicable




PART III




Item 10. Directors and Executive Officers
 of the Registrant.

The information
 required by this item is included in the following sections of the Companys
 Proxy Statement for its 2003 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 2003 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, 2002


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 2003 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 and Related Stockholder Matters





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 2003 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





Item 14. Controls and Procedures

Evaluation of disclosure controls and
 procedures

The term disclosure
 controls and procedures is defined in Rules 13a-14(c) and 15d-14(c) of the Securities
 Exchange Act of 1934, or the Exchange Act. These rules refer to the controls and
 other procedures of a company that are designed to ensure that the information required
 to be disclosed by a company in the reports that it files under the Exchange Act
 is recorded, processed, summarized and reported within required time periods. Disclosure
 controls and procedures include, without limitation, controls and procedures designed
 to ensure that information required to be disclosed in our Exchange Act reports
 is accumulated and communicated to management, including our chief executive officer
 and chief financial officer, as appropriate to allow timely decisions regarding
 required disclosure.

45



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##### Table of Contents



Our chief
 executive officer and our chief financial officer have evaluated the effectiveness
 of our disclosure controls and procedures as of the Evaluation Date, which is a
 date within 90 days before the filing of this annual report, and they have concluded
 that, as of the Evaluation Date, our disclosure controls and procedures were effective.

Changes in internal controls

There were
 no significant changes in our internal controls, or to our knowledge, in other factors
 that could significantly affect our disclosure controls and procedures subsequent
 to the Evaluation Date.

46



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##### Table of Contents






PART IV




Item 15. 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                                                                      |  |     
|    |  | Consolidated
 Balance Sheets as of September 30, 2002 and 2001                                                                      |  |     
|    |  | Consolidated
 Statements of Operations for the Fiscal Years Ended September 30, 2002, 2001 and 2000                                 |  |     
|    |  | Consolidated
 Statements of Changes in Shareholders Equity (Deficit) for the Fiscal Years
 Ended September 30, 2002, 2001 and 2000 |  |     
|    |  | Consolidated
 Statements of Cash Flows for the Fiscal Years Ended September 30, 2002, 2001 and 2000                                 |  |     
|    |  | Notes to
 Consolidated Financial Statements                                                                                         |  |     
|(2) |  | Financial Statement Schedule                                                                                                        |  |     
|    |  | Valuation
 and qualifying accounts and reserves                                                                                     |  |     

b. Reports
 on Form 8-K

The Company
 filed a current report on Form 8-K on June 3, 2002 regarding the adoption of a shareholder
 rights plan and a current report on Form 8-K on September 18, 2002 regarding its
 announcement of its restructuring.

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 |                                                                                                                                                                                               
|        |     |                                                                                                                                                                                               
|3.2     |     | Amended Bylaws of
 the registrant. (Exhibit 3.2)(6)                                                                                                                                           
|        |     |                                                                                                                                                                                               
|4.1     |     | Form of common
 stock certificate. (Exhibit 4.1)(1)                                                                                                                                           
|        |     |                                                                                                                                                                                               
|4.2     |     | Rights Agreement
 dated May 24, 2002 between Mellon Investor Services LLC, as Rights Agent and the
 registrant. (Exhibit 4.2)(9)                                                              
|        |     |                                                                                                                                                                                               
|10.1    |     | Union Bank of California
 Center Office Lease dated March 12, 1999, between Walton Seattle Investors I, L.L.C. and
 the registrant. (Exhibit 10.3)(1)                                         
|        |     |                                                                                                                                                                                               
|10.2    |     | 1997 Stock Option
 Plan, as amended. (Exhibit 10.5)(1)                                                                                                                                        
|        |     |                                                                                                                                                                                               
|10.3    |     | 1999 Stock Option
 Plan. (Exhibit 10.6)(1)                                                                                                                                                    
|        |     |                                                                                                                                                                                               
|10.4    |     | 1999 Nonemployee
 Director Stock Option Plan. (Exhibit 10.7)(1)                                                                                                                               
|        |     |                                                                                                                                                                                               
|10.5    |     | Registration Rights
 Agreement effective as of December 31, 1998. (Exhibit 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. (Exhibit 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. (Exhibit 10.2)(2)
|        |     |                                                                                                                                                                                               
|10.8    |     | Employment Agreement
 of Farzeen Mohazzabfar, dated November 5, 1999. (Exhibit 10.22)(3)                                                                                                      
|        |     |                                                                                                                                                                                               
|10.9    |     | Nonqualified Stock
 Option Agreement for Farzeen Mohazzabfar, dated November 5, 1999. (Exhibit 10.23)(3)                                                                                      
|        |     |                                                                                                                                                                                               
|10.10   |     | 2000 Stock Option
 Plan. (Exhibit 10.29)(3)                                                                                                                                                   
|        |     |                                                                                                                                                                                               
|10.11   |     | Letter of Employment
 dated November 14, 2000 between J. Paul Quinn, Vice President, Chief Financial
 Officer, Secretary and Treasurer, and the registrant. (Exhibit 10.30)(3)                
|        |     |                                                                                                                                                                                               
|10.12   |     | Letter of
 Employment/Promotion dated February 15, 2001 between Craig Blessing, Vice President
 of Sales, and the registrant. (Exhibit 10.2)(4)                                               
|        |     |                                                                                                                                                                                               
|10.13   |     | Stock Option Agreement
 dated May 18, 2001 between Philip Welt, President and Chief Executive Officer, and the
 registrant. (Exhibit 10.2)(5)                                                 

47



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##### Table of Contents





|Exhibit |       |                                                                                                                                                                   
|------- | ----- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Number  |       | Description of Document                                                                                                                                           
|        |       |                                                                                                                                                                   
|        | 10.14 |                                                                                                                                                                   
|        |       |                                                                                                                                                                   
|10.15   |       | Sublease Agreement
 dated October 22, 2001 between Widevine Technologies, Inc. and the registrant. (10.26)(6)                                                     
|        |       |                                                                                                                                                                   
|10.16   |       | First Amendment, dated
 November 8, 2001, to Sublease Agreement dated October 22, 2001 between Widevine
 Technologies, Inc. and the registrant. (Exhibit 10.27)(6)
|        |       |                                                                                                                                                                   
|10.17   |       | Severance Agreement
 and Release dated April 17, 2002 between Elizabeth Hall, Vice President  U.S. Sales, and
 the registrant. (Exhibit 10.1)(7)                 
|        |       |                                                                                                                                                                   
|10.18   |       | Employment Agreement
 effective May 18, 2002 between Howard P. Welt, President and Chief Executive Officer, and
 the registrant. (Exhibit 10.1)(8)                
|        |       |                                                                                                                                                                   
|10.19   |       | Stock Option Agreement
 dated August 2, 2002 between Howard P. Welt, President and Chief Executive Officer, and the
 registrant. (Exhibit 10.2)(8)                
|        |       |                                                                                                                                                                   
|10.20   |       | Employee Stock Purchase
 Plan (Exhibit 10.2)(10)                                                                                                                  
|        |       |                                                                                                                                                                   
|10.21   |       | 2002 Stock Award Plan
 (Exhibit 10.2)(11)                                                                                                                         
|        |       |                                                                                                                                                                   
|10.22   |       | Separation Agreement
 and General Release dated September 9, 2002 between Cher Paige, Vice
 President  Marketing, and the registrant. (filed herewith)           
|        |       |                                                                                                                                                                   
|23.1    |       | Consent of Independent
 Auditors dated December 18, 2002 (filed herewith)                                                                                         
|        |       |                                                                                                                                                                   
|99.1    |       | Certification of
 Principle Executive and Financial Officers pursuant to 18 U.S.C. Section 1350 (filed herewith)                                                  



---



|(1)  | Incorporated
 by reference to the designated exhibit to the registrants Registration Statement
 on Form S-1 (File No. 333-78495).                          
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------
|     |                                                                                                                                                             
|(2)  | Incorporated by
 reference to the designated exhibit to the registrants Form 10-Q for the quarter
 ended June 30, 1999 (File No. 0-26825).                 
|     |                                                                                                                                                             
|(3)  | Incorporated
 by reference to the designated exhibit to the registrants Form 10-K for the year
 ended September 30, 2000 (File No. 0-26825).               
|     |                                                                                                                                                             
|(4)  | Incorporated by
 reference to the designated exhibit to the registrants Form 10-Q for the quarter
 ended March 31, 2001 (File No. 0-26825).                
|     |                                                                                                                                                             
|(5)  | Incorporated by
 reference to the designated exhibit to the registrants Form 10-Q for the quarter
 ended June 30, 2001 (File No. 0-26825).                 
|     |                                                                                                                                                             
|(6)  | Incorporated by
 reference to the designated exhibit to the registrants Form 10-K for the year ended
 September 30, 2001 (File No. 0-26825).               
|     |                                                                                                                                                             
|(7)  | Incorporated by
 reference to the designated exhibit to the registrants Form 10-Q for the quarter ended
 March 31, 2002 (File No. 0-26825).                
|     |                                                                                                                                                             
|(8)  | Incorporated by
 reference to the designated exhibit to the registrants Form 10-Q for the quarter ended
 June 30, 2002 (File No. 0-26825).                 
|     |                                                                                                                                                             
|(9)  | Incorporated by
 reference to the designated exhibit to the registrants Registration Statement on
 Form 8-A filed on June 3, 2002 (File No. 0-26825).      
|     |                                                                                                                                                             
|(10) | Incorporated by
 reference to the designated exhibit to the registrants Registration Statement on
 Form S-8 filed on April 4, 2000 (File No. 333-85482).   
|     |                                                                                                                                                             
|(11) | Incorporated by
 reference to the designated exhibit to the registrants Registration Statement on
 Form S-8 filed on October 3, 2002 (File No. 333-100291).

48



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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
 18, 2002.



| | N2H2, Inc.
| | ----------
|
| | By:       
| |           
| |           
| |           

POWER OF ATTORNEY

Each person
 whose individual signature appears below hereby authorizes and appoints Howard Philip
 Welt and J. Paul Quinn, and each of them, with full power of substitution and resubstitution
 and full power to act without the other, as his or her true and lawful attorney-in-fact
 and agent to act in his or her name, place and stead and to execute in the name
 and on behalf of each person, individually and in each capacity stated below, and
 to file, any and all amendments to this report, and to file the same, with all exhibits
 thereto, and other documents in connection therewith, with the Securities and Exchange
 Commission, granting unto said attorneys- in-fact and agents, and each of them,
 full power and authority to do and perform each and every act and thing, ratifying
 and confirming all that said attorneys-in-fact and agents or any of them or their
 or his or her substitute or substitutes may lawfully do or cause to be done by virtue
 thereof.

Pursuant to
 the requirements of the Securities Exchange Act of 1934, this report has been signed
 below by the following persons on behalf of the registrant and in the capacities
 and on the date indicated.



|Signature               | Title                                                                                                        
|----------------------- | -------------------------------------------------------------------------------------------------------------
|                        |                                                                                                              
|/s/ HOWARD
 PHILIP WELT | President, Chief
 Executive Officerand Director (principal executive officer)                                
|                        |                                                                                                              
|/s/ J. PAUL
 QUINN      | Vice
President  Chief Financial Officer,Secretary
 and Treasurer (principal financialand 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/ DAWN
TRUDEAU        | Director                                                                                                     
|                        |                                                                                                              
|/s/ MICHAEL
T. LENNON   | Director                                                                                                     

49



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##### Table of Contents






CERTIFICATIONS

I, Howard Philip Welt, certify that:

1.    I have reviewed this
 annual report on Form 10-K of N2H2, Inc. (N2H2);

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

3.    Based
 on my knowledge, the financial
 statements, and other financial information included in this annual report, fairly
 present in all material respects the financial condition, results of operations
 and cash flows of N2H2 as of, and for, the periods presented in this annual report;

4.    N2H2s
 other certifying officer
 and I are responsible for establishing and maintaining disclosure controls and procedures
 (as defined in Exchange Act Rules 13a-14 and 15d-14) for N2H2 and we have:



| | a) | designed such
 disclosure controls and procedures to ensure that material information relating
 to N2H2, including its consolidated subsidiaries, is made known to us by others
 within those entities, particularly during the period in which this annual report
 is being prepared;
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) | evaluated
 the effectiveness of N2H2s disclosure controls and procedures as of a date
 within 90 days prior to the filing date of this annual report (the Evaluation Date);
 and                                                                                                   
|
| | c) | presented
 in this annual report our conclusions about the effectiveness of the disclosure
 controls and procedures based on our evaluation as of the Evaluation Date;                                                                                                                

5.    N2H2s
 other certifying officer
 and I have disclosed, based on our most recent evaluation, to N2H2s auditors
 and the audit committee of N2H2s board of directors (or persons performing
 the equivalent function):



| | a) | all significant
 deficiencies in the design or operation of internal controls which could adversely
 affect N2H2s ability to record, process, summarize and report financial data
 and have identified for N2H2s auditors any material weaknesses in internal
 controls; and
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) | any fraud,
 whether or not material, that involves management or other employees who have a
 significant role in N2H2s internal controls; and                                                                                                                                

6.    N2H2s
 other certifying officer
 and I have indicated in this annual report whether or not there were significant
 changes in internal controls or in other factors that could significantly affect
 internal controls subsequent to the date of our most recent evaluation, including
 any corrective actions with regard to significant deficiencies and material weaknesses.

Date: December 18, 2002

/s/ HOWARD PHILIP WELT
Howard Philip
 WeltPresident and Chief Executive Officer(Principal Executive Officer)

50



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##### Table of Contents



I, J. Paul Quinn, certify that:

1.    I
 have reviewed this annual report on
 Form 10-K of N2H2, Inc. (N2H2);

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

3.    Based
 on my knowledge, the financial
 statements, and other financial information included in this annual report, fairly
 present in all material respects the financial condition, results of operations
 and cash flows of N2H2 as of, and for, the periods presented in this annual report;

4.    N2H2s
 other certifying officer
 and I are responsible for establishing and maintaining disclosure controls and procedures
 (as defined in Exchange Act Rules 13a-14 and 15d-14) for N2H2 and we have:



| | a) | designed such
 disclosure controls and procedures to ensure that material information relating
 to N2H2, including its consolidated subsidiaries, is made known to us by others
 within those entities, particularly during the period in which this annual report
 is being prepared;
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) | evaluated
 the effectiveness of N2H2s disclosure controls and procedures as of a date
 within 90 days prior to the filing date of this annual report (the Evaluation Date);
 and                                                                                                   
|
| | c) | presented
 in this annual report our conclusions about the effectiveness of the disclosure
 controls and procedures based on our evaluation as of the Evaluation Date;                                                                                                                

5.    N2H2s
 other certifying officer
 and I have disclosed, based on our most recent evaluation, to N2H2s auditors
 and the audit committee of registrants board of directors (or persons performing
 the equivalent function):



| | a) | all significant
 deficiencies in the design or operation of internal controls which could adversely
 affect N2H2s ability to record, process, summarize and report financial data
 and have identified for N2H2s auditors any material weaknesses in internal
 controls; and
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) | any fraud,
 whether or not material, that involves management or other employees who have a
 significant role in N2H2s internal controls; and                                                                                                                                

6.    N2H2s
 other certifying officer
 and I have indicated in this annual report whether or not there were significant
 changes in internal controls or in other factors that could significantly affect
 internal controls subsequent to the date of our most recent evaluation, including
 any corrective actions with regard to significant deficiencies and material weaknesses.

Date: December 18, 2002

/s/ J. PAUL QUINN
J. Paul QuinnVice
 President, Chief Financial Officer, Secretary and Treasurer(Principal Financial Officer)

51