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# UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549

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# FORM 20-F

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

Or

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

| | For
the fiscal year ended December 31, 2005
| | -------------------------------------------

Or

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

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

| | Date
of event requiring this shell company report.............
| | --------------------------------------------------------------

| | For
the transition period from              to
| | ----------------------------------------------

# Commission File number: 000-23288

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# SILICOM LTD.(Exact name of
Registrant as specified in its charter)

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|                             |                               
|---------------------------- | ------------------------------
|
|
|
|
|N/A                          | ISRAEL                        
|(Translation of Registrant's | (Jurisdiction of incorporation
|name into English)           | or organization)              

# 8 Hanagar Street,

# Kfar Sava 44000, Israel(Address of principal executive offices)

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

|None                | None                                     
|------------------- | -----------------------------------------
|                    |                                          
|Title of each class | Name of each exchange on which registered

Securities registered or to be registered pursuant to Section 12(g) of the Act:
Ordinary Shares, NIS 0.01 nominal value per share
(Title of Class)



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Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:
None
(Title of Class)

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

4,351,050

Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of
the Securities Act.

Yes  o    No   x

If
this report is an annual or transition report, indicate by check mark if the registrant is
not required to file reports pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.

Yes  o    No  x

NoteChecking
the box above will not relieve any registrant required to file reports pursuant to
Section 13 or 15(d) of the Securities Exchange Act of 1934 from their obligations
under those Sections.

Indicate
by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12
months (or for such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.

Yes  x    No  o

Indicate
by check mark whether the registrant is a large accelerated filer, an accelerated filer,
or a non-accelerated filer. See definition of accelerated filer and large
accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  o   Accelerated filer  o   Non-accelerated filer  x

Indicate
by check mark which financial statement item the registrant has elected to follow.

Item 17  o    Item 18  x

If
this is an annual report, indicate by check mark whether the registrant is a shell company
(as defined in Rule 12b-2 of the Exchange Act).

Yes  o    No  x

2

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This annual report on Form 20-F
includes certain forward-looking statements within the meaning of Section 21E
of the Securities Exchange Act of 1934. The use of the words projects,
expects, may, plans or intends, or words
of similar import, identifies a statement as forward-looking. There can be no
assurance, however, that actual results will not differ materially from our expectations
or projections. Factors that could cause actual results to differ from our expectations or
projections include the risks and uncertainties relating to our business described in this
report at Item 3 titled Risk Factors.

As used herein or any in any document
incorporated by reference hereto, the Company, Silicom Ltd.,
Silicom, Registrant, we, us, or
our refers to Silicom Ltd. and its subsidiary.

We have prepared our consolidated
financial statements in United States dollars and in accordance with accounting principles
generally accepted in the United States. All references herein to dollars or
$ are to United States dollars, and all references to Shekels or
NIS are to New Israeli Shekels.

|Item 1. |  | IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS
|------- |  | -----------------------------------------------------

Not Applicable.

|Item 2. |  | OFFER STATISTICS AND EXPECTED TIMETABLE
|------- |  | ---------------------------------------

Not Applicable

|Item 3. |  | KEY INFORMATION
|------- |  | ---------------

# Selected Financial Data

| | The
selected data presented below under the captions Consolidated Statements of
Operations Data and Consolidated Balance Sheets Data for and as of the
end of each of the years in the five-year period ended December 31, 2005, are derived
from our consolidated financial statements, which have been audited by Somekh Chaikin,
Certified Public Accountants (Isr.), a member of KPMG International independent
registered public accounting firm. The consolidated financial statements as of December
31, 2005, and for each of the years in the three-year period ended December 31, 2005, and
the report thereon, are included elsewhere in this annual report. We have derived the
selected consolidated balance sheet data as of December 31, 2001, 2002, and 2003 and the
selected consolidated operating data for the years ended December 31, 2001 and 2002 from
our audited consolidated financial statements not included in this annual report. The
financial data set forth below should be read in conjunction with our consolidated
financial statements and the notes thereto, which are set forth in Item 18 Financial
Statements and the other financial information appearing elsewhere in this annual
report.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

3

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CONSOLIDATED STATEMENTS OF OPERATIONS DATA:

Year Ended December 31
In US$ Thousands

|                                 | 2005 | 2004 | 2003 | 2002   | 2001
|-------------------------------- | ---- | ---- | ---- | ------ | ----
|
|
|
|
|Sales                            |      |      | $    | 10,876 |     
|                                 |      |     
|Cost of sales                    |      |      |      | 6,507  |     
|                                 |      |      |      |        |     
|                                 |      |      |      |        |     
|Gross profit                     |      |      |      | 4,369  |     
|                                 |      |      |      |        |     
|                                 |      |      |      |        |     
|R&D costs, gross                 |      |      |      | 1,561  |     
|                                 |      |      |      |        |     
|(Less) government                |      |     
|royalty-bearing participations   |      |      |      | (98    | )   
|                                 |      |      |      |        |     
|                                 |      |      |      |        |     
|R&D costs, net                   |      |      |      | 1,463  |     
|                                 |      |      |      |        |     
|Selling, marketing, general      |      |     
|and administrative expenses      |      |      |      | 1,598  |     
|                                 |      |      |      |        |     
|Total operating expenses         |      |      |      | 3,061  |     
|                                 |      |      |      |        |     
|Operating income (loss)          |      |      |      | 1,308  |     
|Other expenses                   |      |      |      | -      |     
|Financial income (expenses), net |      |      |      | 14     |     
|                                 |      |      |      |        |     
|Income (loss) before taxes on    |      |     
|income                           |      |      |      | 1,322  |     
|Taxes on income                  |      |      |      | -      |     
|                                 |      |      |      |        |     
|Net income (loss)(1)             |      |      |      | 1,322  |     
|                                 |      |      |      |        |     
|Earnings (loss) per share        |      |     
|Basic earnings (loss) per        |      |     
|ordinary share                   |      |      | $    | 0.31   |     
|                                 |      |      |      |        |     
|Weighted average number of       |      |     
|ordinary shares used to          |      |     
|compute basic earnings (loss)    |      |     
|per share (in thousands)         |      |      |      | 4,256  |     
|                                 |      |      |      |        |     
|Diluted earnings (loss) per      |      |     
|ordinary share                   |      |      | $    | 0.30   |     
|                                 |      |      |      |        |     
|Weighted average number of       |      |     
|ordinary shares used to          |      |     
|compute diluted earnings         |      |     
|(loss) per share (in             |      |     
|thousands)                       |      |      |      | 4,364  |     
|                                 |      |      |      |        |     

(1) Net income is after  deduction
 of taxes on income,  which have been  reduced by virtue of tax  benefits to which the
Company is entitled in its  capacity as an "Approved  Enterprise"  under  Israeli  law.
As such,  the Company was not  required to pay full income tax for a period of up to
seven years  ending in 1997 and also for ten years ending in 2006.  See Note 10B to the
Financial  Statements  and "Item 10" - Additional  Information - Taxation."

4

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|                                  | 2005 | 2004 | 2003 | 2002      | 2001
|--------------------------------- | ---- | ---- | ---- | --------- | ----
|
|
|
|
|Consolidated Balance Sheets Data: |      |      |      |           |     
|Working capital                   |      |      | $    | 4,776     |     
|Total assets                      |      |      | $    | 9,045     |     
|Short-term debt                   |      |      | $    | 3,342     |     
|Long-term debt                    |      |      | $    | 1,031     |     
|Shareholders' equity              |      |      | $    | 4,672     |     
|Number of shares                  |      |     
|outstanding                       |      |      |      | 4,351,050 |     
|                                  |      |      |      |           |     

# Risk Factors

This annual report and statements
that we may make from time to time may contain forward-looking information. There can be
no assurance that actual results will not differ materially from our expectations,
statements or projections. Factors that could cause actual results to differ from our
expectations, statements or projections include the risks and uncertainties relating to
our business described below.

We depend on one line of
products for most of our revenues.

Our current business is based almost
in its entirety on our Multi Port Gigabit-Ethernet Server Adapter product line and the
majority of our revenue is generated from such product line. We expect that in the
foreseeable future we will continue to be dependent on this line of products for most of
our revenue due the nature of our business. We also sell legacy products, however, the
volume of sales of legacy products and the revenues generated from such sales is very low
and is diminishing. Although we sold legacy products throughout 2005 and in the first
months of 2006, we believe that the contribution of such products to our revenues in the
foreseeable future will be negligible. We cannot assure you that revenue generated from
our Mulit Port Gigabit-Ethernet Server Adapters will reach or exceed historical levels in
any future period. A decrease in the price of, or demand for, any of these products, or a
significant increase in our costs of manufacturing them could have a material adverse
affect on our business, results of operations and financial condition.

Increased demand for
products with characteristics similar to our products may cause manufacturers to integrate
such characteristics into server motherboards, eliminating the need for our add-on
products.

Our main products are add-on adapters
that are added to existing Servers in order to improve their functionality. If demand for
such improved functionality increases significantly, server manufacturers may begin
incorporating such functionality as a part of the basic design of their servers, whereby
eliminating the need to achieve such functionality through add-on adapters. In the past we
suffered from a similar trend with respect to our legacy products. We cannot assure you
that a similar trend will not occur in connection with our add-on adapters. Such trend
would have a material adverse effect on our business, results of operations and financial
condition.

5

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Our Multi Port Gigabit
Ethernet Server Networking Adapters including our Bypass Adapters which are sold mainly to OEMs, are
characterized by long sales cycles.

We sell our Multi Port Gigabit
Ethernet Server Networking Adapters (including our Bypass Adapters) mainly to original
equipment manufacturers, or OEMs. The decision making process of our OEM customers
includes several time consuming processes, resulting from the critical importance of our
products in their systems: They need to define the required configuration of their server
system/appliance, derive the need and type of adapters, evaluate adapters, intensively
test and qualify adapters and then (or in parallel) negotiate the terms for a purchase. It
may therefore take 12 months or more from the time we first contact a prospective customer
before such customer implements our cards in its system constituting what is known as a
Design Win. Additionally, once a Design Win is secured, our sales of these products
typically involve significant capital investment decisions by prospective end customers,
as well as a significant amount of time to educate such end customers as to the benefits
of systems and appliances that include our products. As a result, before purchasing
systems and appliances which include our products (and consequently facilitating sales of
our products), companies spend a substantial amount of time performing internal reviews
and obtaining capital expenditure approvals, consequently lengthening the period of time
required for a Design Win to mature into consistent sales. These long sales cycles make it
difficult to predict when and to what extent discussions with potential customers will
materialize into sales and could cause our revenue and operating results to fluctuate
widely from period to period. In addition, our allocation of significant resources to
potential sales opportunities that do not materialize into sales could have a material
adverse affect on our business, results of operations and financial condition.

The short lead time of
customer orders combined with the long lead time of our suppliers when ordering certain
components for our products could result in either a surplus or lack of sufficient
supplies, and impact negatively on our finances.

While we are generally required to
fill orders for our products within one or two weeks following the receipt of a firm
purchase order, we must place orders of certain components for our products between
sixteen and twenty weeks prior to delivery. As a result, we must have a significant amount
of components in our inventory to be able to meet our best forecasts of projected purchase
orders as opposed to on the basis of firm purchase orders. In the event that firm purchase
orders are significantly lower than such forecasts, a significant part of our inventory
will not be used and we may be unable to adjust costs in a timely manner to compensate for
revenue shortfalls and in the event that firm purchase orders exceed such forecasts, we
will not be able to fill such purchase orders which may lead to the loss of business from
a customer.

6

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Our visibility of future
sales is severely limited due to the short lead time of customer orders.

As a result of the short lead time
for firm purchase orders, we are unable to accurately forecast future revenues from
product sales. As a result, even dramatic fluctuation in revenue (whether increase or
decrease) might not be detected until the very end of a financial quarter, which may not
enable us to adjust costs in a timely manner to compensate for such fluctuation.

The loss or
ineffectiveness of our original equipment manufacturers or a reduction of purchase orders
or sales efforts by such original equipment manufacturers may have a material adverse
effect on our operations and financial results.

Our sales and marketing strategy is
to develop and maintain strategic relationships with leading OEMs in the Servers industry
and Server based systems industry, which integrate our products into their systems. These
OEMs are not within our control, are not obligated to purchase our products, and may
select other products that may compete with our lines of products. A reduction in their
sales efforts or discontinuance of sales of our products by our OEMs could lead to reduced
sales and could materially adversely affect our operating results. Use of OEMs also
entails the risk that they will build up inventories in anticipation of a growth in sales.
If such growth does not occur as anticipated, such OEMs may substantially decrease the
amount of products ordered in subsequent quarters, discontinue product orders or even
attempt to return unsold products (although our standard agreements do not allow return of
products). The termination or loss of one of our key OEMs or several OEMs at approximately
the same time, without being able to compensate this loss with sales to other new OEM
customers might have a material adverse effect.

The markets for our
products change rapidly and demand for new products is difficult to predict.

The markets for our products are
characterized by rapidly changing technology and evolving industry standards. For example,
The European Unions directive regarding Restriction Of Hazardous Substances (ROHS)
which requires products to be ROHS compliant and the migration from the PCI-X server bus
to the PCI-Express (PCI-E) server bus, cause our OEMs to demand such new products and
technologies. In the event that our OEMs decide to begin using such new technologies, we
may not be able to develop products for the new technology in a timely manner. Our OEMs
may also select competing products despite our ability to develop products incorporating
new technologies. Consequently, we may suffer from reduced sales to such OEMs and
accumulate unusable inventory which can be used only with older technologies. We intend to
continue investing in product and technology development. Although we have recorded
growing sales of our newest lines of products (to which the majority of our revenues are
attributable), there can be no assurance that we will continue to be successful in the
marketing of our current products and in developing, manufacturing and marketing enhanced
and new products in a timely manner.

7

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We may experience
difficulty in developing new, commercially successful products at acceptable release
times.

Since we commenced operations, we
have conducted extensive research, development and engineering activities. Our efforts
emphasize the development of new products, cost reduction of current products, and the
enhancement of existing products, generally in response to rapidly changing customer
preferences, technologies and industry standards. Although throughout 2004, 2005 and the
first months of 2006 we recorded growing sales of our latest lines of products, Multi Port
Gigabit-Ethernet Server Networking Adapters and Bypass Adapters, we cannot guarantee the
continued success of these products, that they will be widely accepted by the marketplace
or that any of our development efforts will result in commercially successful products,
that such products will be released in a timely manner or that we will be able to respond
effectively to technological changes or new product announcements by others.

Loss of our sources for
certain key components could harm our operations.

Although we generally use standard
parts and components for our products, certain key components used in our products are
currently available from only one source, and others are available from a limited number
of sources. We believe that we maintain a sufficient inventory of these components to
protect against delays in deliveries. However, we cannot guarantee that we will not
experience delays in the supply of critical components in the future or that we will have
a sufficient inventory of critical components at such time to produce products at full
capacity. In the event that we are not able to purchase key components of our products
from our limited sources, we may need to redesign certain products. We cannot guarantee
that we will have adequate resources for such a redesign or that such a redesign will be
successful. Such inability to obtain alternative resources or to successfully redesign our
products could have a material adverse effect on our business, results of operations and
financial condition.

Inability to receive
information from our key component manufacturers could affect our ability to develop new products
required by our OEMs and by the industry in which we operate.

Our products are based on networking
controllers which are manufactured by either Broadcom or Intel. In order to design our
products we need to receive information that enables us to design products with the use of
such controllers. There can be no assurance that we will continue to receive all the
information required for designing products with the use of new controllers continuously
released by both Intel and Broadcom. Intel and Broadcom may also compete with our
products. Such competition may also affect their decisions regarding the sharing of
information with us. The inability to obtain such information may adversely affect our
ability to design new products and may have an adverse effect.

8

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The market for our
products is highly competitive and some of our competitors may be better positioned than we
are.

The market for our products is highly
competitive. We face competition from numerous companies, some of which are more
established, benefit from greater market recognition and have greater financial,
production and marketing resources than we do. For example, in the server networking
industry for which we have developed our multi-port Gigabit-Ethernet Server Networking
cards, our main competitor is Intel. We cannot guarantee that our present or contemplated
products will continue to be distinguishable from those of our competitors or that the
marketplace will find our products preferable to those of our competitors. Furthermore,
there can be no assurance that competitive pressures will not result in price reductions
that could materially adversely affect our business and financial condition and the
results of our operations.

We may not be able to
prevent others from claiming that we have infringed their proprietary rights.

We cannot guarantee that one or more
parties will not assert infringement claims against us. The cost of responding to claims
could be significant, regardless of whether the claims have merit.Significant and
protracted litigation may be necessary to determine the scope of the proprietary rights of
others or to defend against claims of infringement, regardless of whether the claims have
merit. Although we believe that all our products use only our intellectual property, or
intellectual property which is properly licensed to us, in the event that any infringement
claim is brought against us and infringement is proven, we could be required to
discontinue the use of the relevant technology, to cease the manufacture, use and sale of
infringing products, to incur significant litigation damages, costs and expenses, to
develop non-infringing technology or to obtain licenses to the alleged infringing
technology and to pay royalties to use such licenses. There can be no assurance that we
would be able to develop any such alternative technologies or obtain any such licenses on
terms commercially acceptable to us. Although in the past we have resolved a claim of
infringement through a license agreement, the terms of which did not have a material
effect on our business, any infringement claim or other litigation against us could
seriously harm our business, operating results and financial condition. While there are no
lawsuits or other claims currently pending against us regarding the infringement of
patents or intellectual property rights of others, we have been a party to such claims in
the past and may be party to such claims in the future.

We are dependent on key
personnel.

Our success has been, and will be,
dependent to a large degree on our ability to retain the services of key personnel and to
attract additional qualified personnel in the future. Competition for such personnel is
intense. There can be no assurance that we will be able to attract, assimilate or retain
key personnel in the future and our failure to do so would have a material adverse affect
on our business, financial condition and results of operations.

9

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Exchange rate
fluctuations and international risks could increase the cost of our operations.

Substantially all of our
international sales are denominated in U.S. dollars and may be subject to government
controls and other risks, including, in some cases, export licenses, federal restrictions
on export, currency fluctuations, political instability, trade restrictions, and changes
in tariffs and freight rates. We believe that the rate of inflation in Israel and exchange
rate fluctuations between the New Israeli Shekel (NIS) and the U.S. dollar have had a
minor effect on our business to date. However, our dollar costs in Israel will increase if
inflation in Israel exceeds the devaluation of the NIS against the dollar, if the timing
of such devaluation lags behind inflation in Israel or if the dollar devaluates against
the NIS. See Item 5. Operating and Financial Review and Prospects  Impact of
Inflation and Devaluation on Results of Operations, Liabilities and Assets.

If we are characterized
as a passive foreign investment company for U.S. federal income tax purposes, our U.S. shareholders
may suffer adverse tax consequences.

We will be a passive foreign
investment company, or PFIC, if 75% or more of our gross income in a taxable year,
including our pro rata share of the gross income of any company, U.S. or foreign, in which
we are considered to own, directly or indirectly, 25% or more of the shares by value, is
passive income. Alternatively, we will be considered to be a PFIC if at least 50% of our
assets in a taxable year, averaged over the year and ordinarily determined based on fair
market value and including our pro rata share of the assets of any company in which we are
considered to own, directly or indirectly, 25% or more of the shares by value, are held
for the production of, or produce, passive income. If we were to be a PFIC, and a U.S.
Holder does not make an election to treat us as a qualified electing fund, or
QEF, or a mark to market election, excess distributions to a U.S.
Holder, and any gain recognized by a U.S. Holder on a disposition or our ordinary shares,
would be taxed in an unfavorable way. Among other consequences, our dividends, to the
extent that they constituted excess distributions, would be taxed at the regular rates
applicable to ordinary income, rather than the 15% maximum rate applicable to certain
dividends received by an individual from a qualified foreign corporation, and certain
interest charges may apply. In addition, gains on the sale of our shares would
be treated in the same way as excess distributions. The tests for determining
PFIC status are applied annually and it is difficult to make accurate predictions of
future income and assets, which are relevant to the determination of PFIC status. In
addition, under the applicable statutory and regulatory provisions, it is unclear whether
we would be permitted to use a gross loss from sales (sales less cost of goods sold) to
offset our passive income in the calculation of gross income. In light of the
uncertainties described above, no assurance can be given that we will not be a PFIC in any
year. If we determine that we have become a PFIC, we will then notify our U.S. Holders and
provide them with the information necessary to comply with the QEF rules. A U.S. Holder
who makes a QEF election is taxed currently on such holders proportionate share of
our earnings. If the IRS determines that we are a PFIC for a year with respect to which we
have determined that we were not a PFIC, however, it might be too late for a U.S. Holder
to make a timely QEF election, unless the U.S. Holder qualifies under the applicable
Treasury regulations to make a retroactive (late) election. U.S. Holders who hold ordinary
shares during a period when we are a PFIC will be subject to the foregoing rules, even if
we cease to be a PFIC, subject to exceptions for U.S. Holders who made a timely QEF or
mark-to-market election, or certain other elections.

10

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The trading volume of our
shares has been low in the past and may be low in the future, resulting in lower than expected
market prices for our shares.

Our shares have been traded at low
volumes in the past and may be traded at low volumes in the future for reasons related or
unrelated to our performance. This low trading volume may result in lower than expected
market prices for our ordinary shares and our shareholders may not be able to resell their
shares for more than they paid for them.

Israeli courts might not
enforce judgments rendered outside of Israel.

We are incorporated in Israel. All of
our executive officers and all of our directors are non-residents of the United States,
and a substantial portion of our assets and the assets of these persons are located
outside the United States. Therefore, it may be difficult to enforce a judgment obtained
in the United States against us or any such persons. It may also be difficult to enforce
civil liabilities under U.S. federal securities laws in original actions instituted in
Israel. However, subject to certain time limitations, Israeli courts may enforce United
States final executory judgments for liquidated amounts in civil matters obtained after
due trial before a court of competent jurisdiction (according to the rules of private
international law currently prevailing in Israel) which enforces similar Israeli
judgments, provided that the requisite procedural and legal requirements are adhered to.
If a foreign judgment is enforced by an Israeli court, it generally will be payable in New
Israeli Shekels, which can then be converted into foreign currency at the rate of exchange
of such foreign currency on the date of payment. Pending collection, the amount of the
judgment of an Israeli court stated in New Israeli Shekels (without any linkage to a
foreign currency) ordinarily will be linked to the Israeli consumer price index plus
interest at the annual statutory rate prevailing at such time. Judgment creditors bear the
risk of unfavorable exchange rates.

11

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The political environment
and hostilities in Israel could harm our business.

Since the establishment of the State
of Israel in 1948, a state of hostility has existed between Israel and the Arab countries
in the region. This state of hostility has varied in degree and intensity over time. A
significant increase in violence began in September 2000 and has continued with varying
levels of severity into 2006 and negotiations between Israel and Palestinian
representatives ceased for some time. Beginning in late September 2000 and until the first
months of 2005, there was a significant increase in hostilities and unrest between
Israel, the Palestinian Authority and certain terrorist groups operating within the
Palestinian Authority. During the first months of 2005, negotiations between Israel and
the Palestinian Authority were renewed and hostilities diminished to a certain extent,
however, hostile acts resumed during the course of 2005. While previous hostilities did
not have a material adverse impact on our business, we cannot guarantee that hostilities
will not be renewed and have such an effect in the future. In addition, the election of
representatives of the Hamas militant group in January 2006 to a majority of seats in the
Palestinian Legislative Council may create additional unrest and uncertainty in the
region. The political and security situation in Israel may result in parties with whom we
have contracts claiming that they are not obligated to perform their commitments under
those agreements pursuant to force majeure provisions. Any hostilities involving Israel or
the interruption or curtailment of trade between Israel and its present trading partners
could adversely affect our operations and could make it more difficult for us to raise
capital. Furthermore, many of our facilities are located in Israel. Since we do not have a
detailed disaster recovery plan that would allow us to quickly resume business activity,
we could experience serious disruptions if acts associated with this conflict result in
any serious damage to our facilities. Our business interruption insurance may not
adequately compensate us for losses that may occur and any losses or damages incurred by
us could have a material adverse effect on our business. Any future armed conflicts or
political instability in the region would likely negatively affect business conditions and
harm our results of operations.

Many of our employees in
Israel are required to perform military reserve duty.

All non-exempt male adult permanent
residents of Israel under the age of 40 are obligated to perform military reserve duty and
may be called to active duty under emergency circumstances. In recent years, there have
been significant call-ups of military reservists, and it is possible that there will be
additional call-ups in the future. While we have operated effectively despite these
conditions in the past, we cannot assess what impact these conditions may have in the
future, particularly if emergency circumstances arise. Our operations could be disrupted
by the absence for a significant period of one or more of our executive officers or key
employees or a significant number of our other employees due to military service. Any
disruption in our operations would harm our business.

We are affected by
volatility in the securities markets.

The securities markets in general
have experienced volatility which has particularly affected the securities of many
high-technology companies and particularly those in the fields of communications, software
and Internet, including companies that have a significant presence in Israel. This
volatility has often been unrelated to the operating performance of these companies and
may cause difficulties in raising additional financing required to effectively operate and
grow their businesses. Such difficulties and the volatility of the securities markets in
general may affect our financial results.

12

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We are affected by
worldwide downturns in industries based on technology.

The volatility in the securities
markets discussed above and its effect on high-technology companies may have a ripple
effect on our performance. In the last downturn which the markets experienced beginning in
2001, technology companies dealing in communications and computers were severely affected
and some were forced to cease operations. We felt the effects of this downturn in 2001
through 2003. We can give no assurance that our results will not be affected on a going
forward basis by any future downturns.

|Item 4. |  | INFORMATION ON THE COMPANY.
|------- |  | ---------------------------

# History and Development
of the Company

Our legal and commercial name is
Silicom Ltd. We were incorporated under the laws of Israel in 1987, and we operate under
Israeli law and legislation. Our registered and principal executive offices are located in
Israel at 8 Hanagar Street, Kfar Sava, Israel 44000, and our telephone number is
011-972-9-764-4555. Our website is http://www.silicom.co.il. We do not intend for any
information contained on our internet website to be considered part of this annual report.

We are currently engaged in the
design, manufacture, marketing and support of connectivity solutions for a broad range of
servers and server based systems. Our first products were integrated circuits for
information technology, or IT, manufacturers. In the early 1990s, we began focusing our
strategy on designing, manufacturing, marketing and supporting a range of connectivity
solutions for mobile and personal computers, or PC, users. In subsequent years we
developed several Broadband Internet related products.

In 2002 we leveraged our expertise
and know-how in networking and operating systems to develop a line of high-end multi-port
server networking cards, which have contributed to our recent sales growth and which we
expect to continue being the principal engine of our sales growth in the coming years. In
November and December of 2003 we secured our first design wins for these new products.
Since that time we have identified the server-based network appliances market and
specifically the server-based security appliances within such market as demonstrating a
strong demand for our products. We have added to our product lines networking products
which include special functionalities called Bypass Adapters for the server based
appliances and have received significant orders for both our Bypass Adapters and our
non-Bypass adapters. We secured additional design wins throughout 2004 and 2005. Several
of these design wins were from leading companies engaged in a number of industries.

On December 20, 2005 we obtained the
approval of the Tel Aviv Stock Exchange, or TASE, for the listing of our shares on TASE.
Trading of our shares on TASE commenced on December 27, 2005. Our shares are included in
the Tel-Tech index. Our shares continue to be listed on the NASDAQ Capital Market
(previously known as the NASDAQ Small-Cap) under the ticker symbol SILC
(previously SILCF) See Item 9. The Offer and Listing -Markets and Share
Price History.

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In January 2006, we completed an
offering and sale of 10,000 units in Israel, composed of 800,000 of our ordinary shares
and 400,000 warrants, pursuant to a prospectus filed with the Israeli Securities Authority
and TASE. Each warrant sold in the offering is exercisable into one of our ordinary shares
until January 31, 2008 at an exercise price in NIS equivalent to $8.64 calculated on the
date of exercise of such warrant. The sale of units resulted in net proceeds of
approximately $5.7 million. Any exercise of warrants in the future would contribute
additional proceeds of up to approximately $3,500,000. The offering and sale of the units
pursuant to the January 2006 prospectus was made only in Israel and was not intended for
the public in the United States or any other country. All purchasers of securities
pursuant to the January 2006 prospectus were deemed to have stated that they are not
U.S. Persons as defined in Regulation S under the Securities Act of 1933, or
the Securities Act, that they did not purchase securities for the benefit of any U.S.
Person and that they were not present in the United States at the time the request for
purchase of the securities was submitted. A similar statement will be required from anyone
requesting to exercise warrants purchased in the offering. The January 2006 prospectus and
the securities offered thereunder are subject to Israeli law. The January 2006 prospectus
was not filed with the Securities Exchange Commission and the securities offered
thereunder are not registered in accordance with the Securities Act. We have not assumed
any obligation to register any of the securities offered under the January 2006
prospectus, in accordance with the Securities Act.

# Business Overview

We are currently active in the
following product lines, each of which is described in greater detail below:

| |  | High-end
Server networking cards with and without bypass (Server Adapters): these are the
products for which we are leveraging our expertise in networking and operating systems
and facilitating improved connectivity for servers by increasing the number of ports on
the Server Adapters and by adding bypass and other special functionality for security
appliances and other network appliances.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Legacy
products, including connectivity solutions for portable PCs and Broadband Internet accessproducts: this is our previous area of expertise, in which demand for our
products has significantly declined and in which we expect to fully phase out over time.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Server Adapters

In an effort to leverage our
strengths, in late 2002 we began exploring a new direction which we feel has become and
will continue to be our primary growth driver in the future: high-end server networking
cards. Our core expertise has always been our broad range of Ethernet and connectivity
products, which provided personal computer users with solutions to their connectivity
problems. In late 2002 we decided to employ our core know-how in the realm of server-based
systems. Doing so takes advantage of our competitive edge by using the expertise we have
developed in connectivity solutions for personal computers in industries which require
broader connectivity solutions with very high-performance environments. These industries
include security, load balancing, acceleration and other network appliances, data storage,
video on demand, internet content delivery, high-performance computing, web servers, etc.

14

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We have developed a line of products
for the server networking industry which facilitates interaction between servers, allowing
them to communicate with each other through a larger number of ports and with higher
performance than their original capabilities. These are powerful products that allow
server-based systems to fully exploit the high speed potential of Gigabit Ethernet. The
products have either one, two, four or six ports, which plug into the servers between
which interaction is facilitated. Our main competitor in this area, Intel, has developed
cards which do not cover the full scope of features that our products do. For instance,
Intels products do not offer six ports, nor do they offer Multi Port Fiber LX
interfaces. We believe that our expanded feature set coupled with the fact that our
products are based on two different industry leader chip sets (Intel and Broadcom), which
makes them more compatible with our potential customers needs, gives us a
competitive edge. To the best of our knowledge we are currently the only company offering
such a comprehensive range of server networking products.

Following demands from customers and
potential customers, we developed some of these same products with a bypass feature.
Intended for mission-critical environments, the Silicom Gigabit Ethernet Bypass Networking
Cards feature innovative bypass circuitry to maintain continuity of network connectivity
in the event of a gateway failure. Upon the occurrence of a gateway failure, the
cards bypass mechanism automatically reroutes traffic to bypass faulty components,
enabling customers to have reliable and always available network accessibility. As with
all of Silicoms Multiport Gigabit Ethernet Networking Cards, the Bypass Cards also
improve server throughput and performance during normal operations by introducing more
ports and better throughput while reducing network congestion, simplifying network
management, and minimizing CPU utilization. The addition of the innovative bypass
capability makes Silicom Gigabit Ethernet Bypass Networking Cards an appropriate
connectivity solution for security appliances, as well as for appliances
targeted at other high-potential, growing markets such as network monitoring,
load balancing, network event management, network optimization, LAN policy enforcement,
intrusion detection, virus protection, e-mail content filtering, and more. To the best of
our knowledge we are currently the only company offering such a comprehensive line of
bypass products, which offers dual port and quad port cards, copper and fiber interfaces
and dual chip set (Intel and Broadcom). Although the situation may change in the future,
we believe that our competition in the bypass card market is less significant than in the
non-bypass card market.

The products are divided into two
groups: One group of products is based on Broadcoms chipset and the other group is
based on Intels chipset.

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Examples of products based on
Broadcoms chipset are: PXG6, PXG4, PXG2, PXG2F, PEG1, PEG1F, PXG2BP, PXG4BP,
PXG2-ROHS. The number in each product name represents the number of Gigabit-Ethernet ports
that the product has. The F (in the fourth and sixth products) represents a Fiber-optic
Ethernet interface, rather than a copper Ethernet interface as in the other products. The
X represents PCI-X based products, while E represents PCI-Express based products,
indicating products that are based on the newest PCI-Express bus. The BP represents a card
that carries the bypass functionality. The ROHS represents a card that is ROHS compliant.
Products based on the Intel chipset carry the same name with an addition of I
at the end to indicate the Intel chipset. Examples of the Intel based products are: PXG6i,
PXG4i, PXG2i, PXG2Fi, PXG4Fi, PXG2BPi, PXG4BPi, PXG4BPi-ROHS, PXG2BPFi and PXG4BPFi.
Except for the difference in the type of chipset, type of bus, bypass functionality,
number of ports and type of Ethernet interface, all of the principal applications are
similar:

Principal Applications, all of which
demand high performance multi port connectivity:

| |  | Security
appliances
| | - | -------------------

| |  | WAN
acceleration appliances
| | - | ---------------------------

| |  | Load
balancing and traffic management appliances
| | - | ------------------------------------------------

| |  | Network-attached
storage (NAS)
| | - | ------------------------------

| |  | Video
on Demand servers
| | - | -----------------------

| |  | Content
Delivery servers
| | - | ------------------------

| |  | Internet
Service Providers / Web Hosting
| | - | ----------------------------------------

| |  | High
end computing
| | - | ------------------

It would be difficult to design such
high-end products without a high level of cross-disciplinary knowledge. The products we
have developed use our Ethernet and operating systems expertise. The products in this line
include more than forty multi-port Gigabit-Ethernet Server Networking cards (bypass and
non-bypass).

Our business model for our server
adapter line of products is called the Design Win Model. The following are the main
aspects of this model:

| |  | We
approach a potential customer or are approached by such customer.
| | - | --------------------------------------------------------------------

| |  | If
the customer shows interest in the products and we believe that achievement of a business
relationship with the customer is possible, we ship products for such customers
evaluation.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | During
the evaluation process the customer receives a few of our Server Networking Cards for
initial basic testing. If the evaluation process is successful, we ship products for
qualification.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | During
the qualification process the customer receives a larger amount of our Server Networking
Cards for more specific testing, which may include certain customization of our products
to its specific needs.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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| |  | If
the qualification process is successful, we enter into negotiations regarding the terms
of a business relationship.
| | - | ----------------------------------------------------------------------------------------------------------------------

| |  | In
some cases, typically with the larger customers, the evaluation and qualification process
may take 12 months or more.
| | - | ------------------------------------------------------------------------------------------------------------------------

| |  | Once
all phases mentioned above are concluded, the customer will purchase products from us, in
order to incorporate them within its server based systems and sell such systems with our
cards embedded in them. The sale of our products within such systems is the objective of
our Design Win Model. In most cases once we secure a design win our customer will
continue to buy our cards for as long as it continues to sell its server based system.
Yet, in some cases, we may only be a second source from which a customer purchases, in
which case the customer may not necessarily make continuous orders, even though it
continues to sell its systems.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We believe that the high-end server
networking cards (with and without bypass) will continue to be a key driver of our growth
in the coming years. A distinct advantage of these products is that the demand in the
server based industry has been almost continuously growing. Certain fields within this
industry, such as the security appliances market, other network appliances market, the
storage market and several additional markets have demonstrated strong growth. This
industry continues to require innovative solutions that must become faster and must
provide additional functionalities each time they are implemented. However, the process of
achieving design wins and obtaining new customers is time consuming as a result of the
fact that the sales cycles for products in this industry are long. Nevertheless, each
design win we achieve, may represent an opportunity for sustained, long-term revenues.

Legacy Products

Traditional Connectivity
Solutions for Portable PCs.

Since the early 1990s, the growth in
the use of portable computers has corresponded with an increased dependence on
network-based communication systems, resulting from the need to effectively and
efficiently use resources and communicate information in todays competitive business
environment. In the field of portable computers, our core strength has been our broad
range of single and multi-function connectivity products that incorporate various Silicom
and third party technologies to provide portable computer users with a comprehensive
solution to their connectivity problems.

While all the above is still true,
the trend in the data communications industry has been to incorporate modems as built-in
elements of portable PCs, and to incorporate Ethernet and Fast Ethernet as built-in
elements of portable PCs. Both these trends have obviated much of the need for our Modem
and Ethernet/Fast Ethernet PC Card products. Our Modem PC Cards have therefore been
completely phased out and we believe that Ethernet/Fast Ethernet PC Cards will also be
phased out completely over time. See Item 5  Operating and Financial Review
and Prospects  Trend Information.

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Broadband Internet Access

One of the former technological
challenges in delivering high-speed internet services to subscribers was to easily connect
a broadband modem to a subscribers PC. In late 2000 and early 2001, we developed
products and technologies which helped in overcoming this challenge. However, as products
in this area quickly become commodities, we stopped investing in this area and currently,
we have virtually no sales in this market.

# Principal Markets

The principal markets in which we
compete are set forth more particularly in, and are incorporated by reference to Note
12(A) to the consolidated financial statements set forth in Item 18 of this annual report
(the financial statements). In 2003, 2004 and 2005, approximately 9%, 6% and 5%,
respectively, of our sales were in Europe, 86%, 84% and 77% respectively, were in the
United States and Canada, and 5%, 10% and 18%, respectively, were in other countries.Our main business is not seasonal, and we believe that there are sufficient sources
and raw materials available to sustain it.

# Sales and Marketing

Over the last few years, our sales
and marketing has been carried out through a network of strategic relationships with
leading original equipment manufacturers which sell our products, generally as a part of
their systems and sometimes under their own private labels. Our current original equipment
manufacturer customers are mostly active in the security appliances market, other network
appliances markets (such as load balancing, traffic management and WAN acceleration),
storage market, general servers market and other server based applications. They are
referred to in this report as OEMs, or OEM customers. Our strategy of carrying out
strategic relationships with OEM customers continues to be the strategy under which we
operate. We believe that these relationships enable us to take advantage of the superior
financial resources and market presence of these companies to increase our sales and
establish, maintain and strengthen our position and reputation in the market. In addition,
we believe that relationships with OEMs improve access to new technologies developed by
such OEMs, thereby ensuring smooth integration of our products and technology with those
of the OEMs. In furtherance of this strategy, in 2005 we entered into additional strategic
arrangements with additional OEMs and continued recording design wins from OEMs who
purchase our products. Revenues from sales of our products to OEM customers in 2005
constituted approximately 95% of our revenues. We expect the percentage of our revenues
that is derived from sales of connectivity products to OEM customers to continue being
approximately 95% or even increase slightly as we continue to focus our efforts on our
server adapter products, which are sold mostly to OEMs.As such, the loss of some
of our OEM customers may have a material adverse effect on our operations and financial
results and we cannot assure you that we will be able to enter into strategic
relationships with OEMs in the future. Our other non-OEM products are marketed directly,
through our U.S.-based subsidiary and through a network of independent distributors.
Normal payment terms of our OEM customers are up to 90 days net.Substantially all
of our international sales are denominated in U.S. dollars and may be subject to
government controls and other risks, including, in some cases, export licenses, federal
restrictions on export, currency fluctuations, political instability, trade restrictions
and changes in tariffs and freight rates. We have experienced no material difficulties to
date as a result of these factors.

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Our arrangements with OEMs (and
distributors and resellers when applicable) are generally non-exclusive. We have generally
experienced good relations with our customers and are not aware of any pending
terminations other than with respect to products that newer technologies have eliminated
the need for.

Our OEMs, distributors and resellers
are not within our control. They are not obligated to purchase products from us and may
represent other lines of products. A reduction in sales effort or discontinuance of sales
of our products by our OEMs could lead to reduced sales and could materially adversely
affect our operating results. Use of OEMs also entails the risk that OEMs will build up
inventories in anticipation of a growth in sales. If such growth does not occur as
anticipated, these OEMs may substantially decrease the amount of products ordered in
subsequent quarters, discontinue product orders or even attempt to return unsold products.
The loss or ineffectiveness of several of our OEMs at approximately the same time might
have a material adverse effect on us.

# Research and Product
Development

Since we commenced operations, we
have conducted extensive research, development and engineering activities. Our efforts
emphasize the development of new products, cost reduction of current products, and the
enhancement of existing products, generally in response to rapidly changing customer
preferences, technologies and industry standards. During 2003, 2004 and 2005 we fully
matured our multi port line of Server Adapter products and further invested in the
development of other products including development of cards incorporating bypass
functionality, addition of a full line of PCI-Express cards based on both chip-sets we
used for the PCI-X based cards, supplementing a line of PCI-Express bypass cards and
adding a line of ROHS compliant cards for PCI-X cards (as PCI-Express cards were
originally designed to be ROHS compliant). We cannot assure you that any of our
development efforts will result in commercially successful products, that such products
will be released in a timely manner or that we will be able to respond effectively to
technological changes or new product announcements by others.

The markets for our products are characterized by rapidly changing technology and evolving industry standards. We
believe that success will depend upon our ability to successfully market new networking and connectivity concepts and,
to a lesser extent, upon our ability to enhance our existing products and to continue to introduce new products on a
timely basis. Accordingly, we intend to make substantial investments in technology development. Notwithstanding these
efforts, we cannot assure you that we will be successful in selecting, developing, manufacturing and marketing our
technology or our enhanced and new products in a timely manner.

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# Manufacturing and
Suppliers

Our manufacturing operations consist
primarily of producing finished goods from components and sub-assemblies purchased from
third parties. In addition, we perform testing and quality assurance procedures with
respect to the components and sub-assemblies which are incorporated into our final
products and the final products themselves.

We seek to monitor quality with
respect to each stage of the production process including, but not limited to, the
selection of component suppliers, warehouse procedures and final testing, packaging and
shipping. We have been certified as complying with ISO 9001:2000", which is a
quality control standard used in our industry. We believe that our quality assurance
procedures have been instrumental in achieving a high degree of reliability for our
products. We intend to continue to maintain and improve the efficiency of such procedures.

Although we generally use standard
parts and components for our products, certain key components used in our products are
currently available from only one source, and others are available from a limited number
of sources. Components currently available from one source include proprietary Gigabit
Ethernet chipsets and other components, including other semiconductor devices and
transformers, as well as plastic and metal product housings. We believe that we maintain a
sufficient inventory of these components to protect against delays in deliveries. There
can be no assurance that we will not experience delays in the supply of critical
components in the future or that we will have a sufficient inventory of critical
components at such time to produce products at full capacity. If we do experience such
delays and there is an insufficient inventory of critical components at that time, our
operations and financial results would be adversely affected.

We are generally required to fill
orders for our products within one or two weeks after receipt of a firm purchase order.
Consequently, we need to maintain inventory at levels that are in accordance with our
forecasts and those of our customers. There can be no assurance that such forecasts will
indeed materialize into firm purchase orders and consequently we cannot guarantee that the
full volume of such inventory will be delivered against firm purchase orders and not
remain unused.

# Competition

The data server adapters industry is
highly competitive. We face competition from numerous companies, some of which are more
established, benefit from greater market recognition and have greater financial,
production and marketing resources than we do. We cannot guarantee that our present or
contemplated products will continue to be distinguishable from those of our competitors or
that the marketplace will find our products preferable to those of our competitors.
Furthermore, there can be no assurance that competitive pressures will not result in price
reductions that could materially adversely affect our business and financial condition and
the results of our operations.

20

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In the server networking industry for
which we have developed our multi-port Gigabit-Ethernet Server Networking cards, our main
competitor is Intel. In the bypass cards industry, our competition is not as significant.
To the best of our knowledge, our only significant competitors in this industry are
Interface Masters and Portwell. There also may exist other local solutions which may
compete with our products, including solutions which are not an embedded card but rather
an external box.

# Intellectual Property
Rights and Software Protection

Our success and ability to compete
are dependent to a significant degree on our technology. We currently rely on a
combination of non-disclosure agreements and technical measures, to establish and protect
the technology we use in our products. These measures afford only limited protection, and
accordingly, there can be no assurance that the steps we take will be adequate to prevent
misappropriation of our technology or the independent development of similar technologies
by others. Despite our efforts to protect our technology, unauthorized parties may attempt
to copy aspects of our products and develop similar hardware or software or to obtain and
use information that we regard as proprietary. In addition, there can be no assurance that
one or more parties will not assert infringement claims against us. The cost of responding
to claims could be significant, regardless of whether the claims are valid.

In April 2002 we reached an agreement
with a company that claimed that certain of our legacy connectivity products infringe its
patents. We agreed to pay the amount of $150,000 to this company in exchange for the right
to a license for our past and future products which use this alleged infringing
technology. In reaching agreement we avoided incurring additional costs and expenses. See
Note 7 to the consolidated financial statements.

# Governmental Regulation
Affecting the Company

We are affected by the terms of
research and development grants we have received from the Office of the Chief Scientist of
Israel (OCS). Under the terms of Israeli Government participation, a royalty
of 3% or up to 5% of the net sales of products developed from a project funded by the OCS
must be paid, beginning with the commencement of sales of products developed with grant
funds and ending when 100% or 150% of the grant is repaid. For projects approved after
January 1, 1999, the amount of royalties payable is up to a dollar-linked amount equal to
100% of such grants plus interest at LIBOR. The terms of Israeli Government participation
also impose significant restrictions on manufacturing outside Israel of products developed
with government grants and the transfer to third parties of technologies developed through
such projects is subject to approval of the OCS. There can be no assurance that such
approval, if requested, will be granted on reasonable commercial terms.

21

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In addition, we receive certain tax
benefits and reduced tax rates from the Israeli government due to our being granted
Approved Enterprise status under the Law for the Encouragement of Capital
Investments-1959, as amended. See Item 10. Additional Information 
Taxation. The entitlement to these benefits is conditional upon our fulfillment of
the conditions stipulated by the law, regulations promulgated thereunder and the
instruments of approval for the specific investments. In the event of failure to comply
with these conditions, the benefits could be canceled and we would be required to refund
the amount of the benefits, in whole or in part, with the addition of linkage differences
and interest.

# Organizational Structure

We are a member of the Rad
Group of companies, which is an affiliated group of high-technology companies in
Israel. We have one wholly owned subsidiary which is incorporated in the United States
under the name Silicom Connectivity Solutions, Inc. Two of our founders, Messrs. Yehuda
and Zohar Zisapel, are also founders, directors and principal shareholders of several
other corporations within the Rad Group. See Item 7. Major Shareholders and Related
Party Transactions.

# Property, Plants and
Equipment

We do not own any real property, but
we lease property at three locations. Our executive offices and research and development
facilities are located in Kfar Sava, Israel. The original term of our lease with respect
to such space expired on October 31, 1998 and was renewed for additional one-year periods
through October 31, 2006. The facility is 600 square meters in size and we currently pay a
monthly rent of approximately $5,000.

We conduct our manufacturing from a
facility of approximately 610 square meters in Yokneam, Israel. The monthly rent payments
for this facility are approximately $5,000. The lease was originally for a 4 year period,
ending on August 15, 2004 and included an option to renew the lease for an additional
period of one year. We exercised the renewal option for our manufacturing facility, and
further extended the lease agreement until August 15, 2006.

Commencing in February 2004, we began
to sub-lease space in Paramus, New Jersey, from an affiliate. This sub-lease was in effect
until January 31, 2006 and has been extended until January 31, 2007. Currently, the
monthly rent payments for this space are approximately $500. See Item 7  Major
Shareholders and Related Party Transactions.

We believe that our facilities in
Israel and in the United States are suitable and adequate for our operations as currently
conducted. In the event that additional facilities are required or we need to seek
alternative rental properties, we believe that we could obtain such additional or
alternative facilities at commercially reasonable prices.

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|Item 4A. |  | UNRESOLVED STAFF COMMENTS
|-------- |  | -------------------------

Not Applicable.

|Item 5. |  | OPERATING AND FINANCIAL REVIEW AND PROSPECTS
|------- |  | --------------------------------------------

# General

Silicom was incorporated in Israel
and commenced operations in 1987. We have traditionally been engaged in the design,
manufacture, marketing and support of connectivity solutions for computers. In the years
2000 and 2001, we leveraged the IP developed in this area for use in the broadband
internet access market. In late 2002 we leveraged our expertise and know-how in networking
and operating systems to develop a line of high-end server networking cards. We made
initial sales of these products to a number of customers during 2003 and recorded growing
sales of these products throughout 2004, and 2005. We primarily sell our products through
original equipment manufacturers and, to a lesser extent, through independent distributors
(on a non exclusive basis).

# Critical Accounting
Policies

The discussion and analysis of our
financial condition and results of operations are based upon our consolidated financial
statements, which have been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amount of assets and liabilities,
revenues and expenses, and related disclosure of contingent assets and liabilities at the
date of our financial statements. Actual results may differ from these estimates under
different assumptions or conditions.

Critical accounting policies are
defined as those that are reflective of significant judgments and uncertainties, and could
potentially result in materially different results under different assumptions and
conditions. We believe that our critical accounting policies are limited to those
described below.

 Inventories 
Inventories are stated at the lower of cost or market. Cost is determined using the
average-cost method for raw materials. The cost of the work in process and
finished goods of the Companys Traditional Products is determined based on the
allocation of labor and overhead, which are allocated on the basis of raw materials
consumption. The cost of the work in process and finished goods of the Companys
Server Networking Products is determined based on a specific allocation of overhead to
each product. We carefully examine our obsolete or slow inventory situation and establish
allowances for obsolete or slow moving inventory to record at the lower of cost or market.
The examination of obsolete or slow moving inventory includes our estimates of the
likelihood of using or selling each of the material inventory parts.

 Allowance for doubtful
accounts  Trade receivables are recorded less the related allowance for doubtful
accounts receivable. We consider accounts receivable to be doubtful when it is probable
that we will be unable to collect all amounts, taking into account current information and
events regarding our customers ability to repay their obligations. The balance sheet
allowance for doubtful debts is determined as a specific amount for those accounts the
collection of which is uncertain. We perform our estimates regarding potential doubtful
debts based on payment history and correspondence with our customers, and based on new
information we receive about customers financial situation. As of December 31, 2005,
the allowance for doubtful debts was $20,000.

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 Deferred Taxes  We
account for income taxes under SFAS 109 Accounting for Income taxes. Under
SFAS 109, deferred tax assets or liabilities are recognized in respect of temporary
differences between the tax bases of assets and liabilities and their financial reporting
amounts as well as in respect of tax losses and other deductions which may be deductible
for tax purposes in future years, based on tax rates applicable to the periods in which
such deferred taxes will be realized. Deferred tax assets for future tax benefits from
realization are included when their realization is more likely than not. Valuation
allowances are established when necessary to reduce deferred taxes assets to the amount
expected to be realized. Valuation allowances in respect of deferred taxes were recorded
in respect of the following matters:

| | n
Carry forward tax losses  As of December 31, 2005, we had carry forward tax losses
in Israel of approximately $3,639,000 and our subsidiary had federal carry forward tax
losses of approximately $569,000 to be realized until 2018 to 2024 and New Jersey state
carry forward tax losses of approximately $445,000 to be realized until 2010 to 2012.
There is no assurance that these carry forwards will be realized.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | n
Taxes, which may apply upon the realization of investments in consolidated subsidiaries
and affiliated companies  currently there is no intention to realize such
investments.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Recently Enacted
Accounting Pronouncements

In November 2004, the FASB issued FASB
Statement No. 151, Inventory Costs, an amendment to ARB 43, Chapter 4 (SFAS 151). The
amendments made by SFAS 151 clarify that abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage) should be recognized as
current-period charges, and also require the allocation of fixed production overhead to
inventory based on the normal capacity of the production facilities. The guidance is
effective for inventory costs incurred during fiscal years beginning after June 15, 2005.
Earlier application is permitted for inventory costs incurred during fiscal years
beginning after November 23, 2004. The provision of SFAS 151 should be applied
prospectively. Adoption of this statement is not expected to have a material impact on the
Companys financial statements.

24

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In December 2004, the FASB issued
SFAS No. 123 (Revision 2004), Share-Based Payment, (SFAS 123R), that addresses
the accounting for share-based payment transactions in which employee services are
received in exchange for either equity instruments of the Company, liabilities that are
based on the fair value of the Companys equity instruments or that may be settled by
the issuance of such equity instruments. SFAS 123R eliminates the ability to account for
share-based compensation transactions using the intrinsic value method as prescribed in
APB Opinion No. 25, Accounting for Stock Issued to Employees. Instead, SFAS
123R requires that such transactions be accounted for using a fair-value-based method and
that compensation expense be recognized in the statement of operations rather than
disclosing the pro forma impact of the stock based compensation as the Company currently
discloses in Note 9. SFAS 123R provides two alternative adoption methods. The first method
is a modified prospective transition method whereby a company would recognize share-based
employee costs from the beginning of the fiscal period in which the recognition provisions
are first applied as if the fair-value-based accounting method had been used to account
for all employee awards granted, modified, or settled after the effective date and to any
awards that were not fully vested as of the effective date. Measurement and attribution of
compensation cost for awards that are unvested as of the effective date of SFAS 123R would
be based on the same estimate of the grant-date fair value and the same attribution method
used previously under SFAS No. 123, Accounting for Stock-Based Compensation
(SFAS 123). The second adoption method is a modified retrospective transition
method whereby a company would recognize employee compensation cost for periods presented
prior to the adoption of SFAS 123R in accordance with the original provisions of SFAS 123;
that is, an entity would recognize employee compensation costs in the amounts reported in
the pro forma disclosures provided in accordance with SFAS 123. A company would not be
permitted to make any changes to those amounts upon adoption of SFAS 123R unless those
changes represent a correction of an error. The provisions of SFAS 123R are effective for
annual periods beginning after June 15, 2005. This Standard will be effective for the
Company as of January 1, 2006. The Company adopted the first method mentioned above and
expects the adoption of this Standard will reduce 2006 and 2007 net income by
approximately $143 thousand and $52 thousand respectively. This estimate is based on the
number of options currently outstanding and exercisable and could change based on the
number of options granted or forfeited in fiscal 2006.

In December 2004, the FASB issued
SFAS No. 153, Exchanges of Nonmonetary Assets  an amendment to APB No.
29. This Statement amends Opinion No. 29 to eliminate the exception for nonmonetary
exchanges of similar productive assets and replaces it with a general exception for
exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary
exchange has commercial substance if the future cash flows of the entity expected to
change significantly as a result of the exchange. SFAS 153 is effective for fiscal periods
beginning after June 15, 2005 and shall be applied prospectively. Adoption of this
statement is not expected to have a material impact on the consolidated financial
statements of the Company.

# Operating Results

The following table sets forth, for
the periods indicated, the relationship (in percentages) of items from our Consolidated
Statement of Operations Data to our total sales:

25

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# Year Ended December 31,

|                                                        | 2005 | 2004 | 2003
|------------------------------------------------------- | ---- | ---- | ----
|
|
|
|
|Sales                                                   |      |      |     
|Cost of sales                                           |      |      |     
|Gross profit                                            |      |      |     
|R&D costs, gross                                        |      |      |     
|(Less) government royalty bearing participation         |      |      |     
|R&D costs, net                                          |      |      |     
|Selling, marketing, general and administrative expenses |      |      |     
|Operating Income (Loss)                                 |      |      |     
|Financial income (expenses), net                        |      |      |     
|Net Income (Loss) for the year                          |      |      |     
|                                                        |      |      |     

Sales in 2005 increased to
$10,876,000 compared to $4,559,000 in 2004, mainly due to design wins which matured during
2005 and due to additional design wins which were secured during 2005, all of which were
related to our Server Adapters and Server Bypass Adapters. Approximately 78% of our sales
in 2005 were attributable to our line of Server Adapters and 22% were attributed to our
legacy products.

Sales in 2004 increased to $4,559,000
compared to $3,725,000 in 2003, mainly due to the growing sales of our server networking
cards. Approximately 48% of our sales in 2004 were attributable to our line of multi-port
Gigabit Ethernet networking cards and 52% were attributable to our legacy products.

Gross profit in 2005 was $4,369,000
compared to $1,560,000 in 2004. Gross profit as percentage of sales in 2005 was 40.2%,
compared to 34.2% in 2004. The Gross profit percentage was higher in 2005 than in 2004
mainly due to sales of products with higher profit margins in 2005 and due to the fact
that as sales increase, the impact of fixed costs of sales on the gross profit is lower.

Gross profit in 2004 was $1,560,000
compared to $1,565,000 in 2003. Gross profit as percentage of sales in 2004 was 34.2%,
compared to 42.0% in 2003. The Gross profit percentage was lower in 2004 than in 2003
mainly due to 2004 being a transitional period between sales of legacy products and new
products. In such transitional period, the manufacturing quantities, which represented
only initial quantities for the new design wins, were translated into high manufacturing
costs, significantly impacting our profitability.

26

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Gross research and development
expenses for 2005 decreased insignificantly by 2.2% to $1,561,000 compared to $1,596,000
during 2004. Because the markets for our products are characterized by rapidly changing
technology and evolving industry standards, our success will depend upon our ability to
select, develop, manufacture and market new and enhanced products in a timely manner to
meet changing market needs. We expect to continue to invest resources in new product
development, enhancements to existing products, and the development of new networking and
connectivity technologies.

Gross research and development
expenses for 2004 decreased insignificantly by 3.1% to $1,596,000 compared to $1,647,000
during 2003.

Selling and marketing expenses for
2005 increased by 25.8% to $903,000 compared to $718,000 during 2004, mainly due to the
fact that we continued investing resources in promoting the sales and marketing of our
server networking products.

Selling and marketing expenses for
2004 decreased by 28.6% to $718,000, compared to $1,006,000 during 2003, mainly due to the
fact that we ceased most of our sales and marketing activities for our traditional
products and focused mainly in promoting the sales and marketing of our server networking
products.

General and administrative expenses
for 2005 increased by 13.2% to $695,000 compared to $614,000 during 2004, mainly due to
the significant growth in our activity as demonstrated by the considerable increase in our
revenues which amounted to 139%.

General and administrative expenses
for 2004 increased insignificantly by 2.7% to $614,000 compared to $598,000 during 2003.

Net income for 2005 was $1,322,000
compared to a net loss of $1,240,000 in 2004, mainly due to our higher sales and higher
gross profit in 2005.

Net loss for 2004 was $1,240,000
compared to a net loss of $1,509,000 in 2003, mainly due to the decrease in selling and
marketing expenses.

# Impact of Inflation and
Devaluation on Results of Operations, Liabilities and Assets

Since the institution by the Israeli
government of an economic recovery program for the halting of high inflation rates in
1985, inflation, while continuing, has been significantly reduced and the rate of
devaluation has been substantially diminished. Since the majority of our revenues are
denominated and paid in U.S. dollars, we believe that inflation and fluctuations in the
U.S. dollar exchange rate have no material effect on our revenue. Inflation in Israel and
the Israeli currency as well as U.S. dollar exchange rate fluctuations, do however, have
some effect on our expenses and, as a result, on our net income/loss. The cost of our
Israeli operations, as expressed in U.S. dollars, is influenced by the extent to which any
increase in the rate of inflation in Israel is not offset (or is offset on a lagging
basis) by a devaluation of the NIS in relation to the U.S. dollar.

We do not presently engage in any
hedging or other transactions intended to manage the risks relating to foreign currency
exchange rate or interest rate fluctuations. However, we may in the future undertake such
transactions, if management determines that it is necessary to offset such risks.

27

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# Liquidity and Capital
Resources

At December 31, 2005, we had working
capital of $4,776,000 and our current ratio (current assets to current liabilities) was
2.43. Since inception, our operations have been funded through capital contributions,
research and development grants and cash flow from operations.Cash and cash
equivalents as of December 31, 2005 increased by $1,190,000 to $2,276,000 compared with
$1,086,000 as at December 31, 2004. Short-term investments decreased by $519,000 and short
term bank credits increased by $500,000. The net increase of $171,000 in these three
balance sheet items in 2005 was mainly due to the net cash provided by operating
activities.

Short term trade receivables
increased to $2,395,000 at December 31, 2005 from $741,000 on December 31, 2004, mainly
due to the significant increase in sales in the fourth quarter of 2005, as compared to
sales in the fourth quarter of 2004. Other receivables increased from $337,000 to
$453,000.

Cash provided by operating activities
in 2005 amounted to $41,000 compared to cash used in operating activities in the amount of
$1,536,000 in 2004. The cash provided by operating activities in 2005 was the result of
our positive operating income. The figure is lower than the actual operating income due to
the fact that as sales grow, we are required to devote more resources to inventories and
manufacturing activities, before collection of payments from customers.

Inventories increased from $1,994,000
at the end of 2004 to $2,994,000 at the end of 2005, mainly due to the fact that as our
sales grow and customers demand receipt of products within a number of weeks following the
issuance of purchase orders, we are required to be ready to deliver our products in
accordance with our customers expectations.

Capital expenditures on property and
equipment in 2005 increased by $108,000 compared with 2004, mainly due to the fact that in
2005 we increased investment in development and testing tools for our new product lines of
server networking cards.

On October 31, 2005 we obtained a credit
line in the amount of up to $1 million from Bank Hapoalim B.M., or Bank Hapoalim. In
consideration for the credit line extended to us by Bank Hapoalim we registered a floating
charge on all of our assets in favor of Bank Hapoalim and a fixed charge in favor of Bank
Hapoalim on all of our share capital not yet issued. Any amounts drawn on account of the
credit line bore annual interest at a rate of LIBOR plus 1.6% compounded on a monthly
basis. As of December 31, 2005 we drew an aggregate of $500,000 under the credit line. In
February 2006 we requested cancellation of the credit line and repaid all amounts drawn in
connection with such credit line. Following repayment of such amounts Bank Hapoalim agreed
to removal of all the charges we registered in its favor in connection with obtainment of
the credit line and released us from all our undertakings in connection with such credit
line.

28

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In January 2006, we completed an
offering and sale of 10,000 units in Israel, composed of 800,000 of our ordinary shares
and 400,000 warrants, pursuant to a prospectus filed with the Israeli Securities Authority
and TASE. The sale of units resulted in net proceeds of approximately $6 million. Any
exercise of warrants in the future would contribute additional proceeds of up to
approximately $3,500,000. See Item 4. Information on the Company  History and
Development of the Company.

We have cash and cash equivalents
that we believe are sufficient for our present requirements.

Other Assets: Our subsidiary, Silicom
Connectivity Solutions, Inc., entered into a Non-Exclusive Limited Patent License
Agreement in April 2002 as part of an agreement with a company that suggested that
certain of our legacy connectivity products infringe its patents. The agreement included a
payment of a one-time license fee of $150,000 from our subsidiary to the other company
which represented a licensing fee for both past and future Silicom sales of certain
connectors and PC cards under patents of the licensor. Our subsidiary classified this
$150,000 payment as an intangible asset. . The remainder of the license fee to be
amortized as of December 31, 2005 was approximately $57,000. The amount of approximately
$9,000 is presented in Current Assets in the financial statements, while the amount of
$48,000 is presented as Other Assets in the financial statements.

Trade payables increased from
$1,008,000 at the end of 2004 to $2,020,000 at the end of 2005, mainly due to the growing
sales resulting in growing operating expenses. Other payables and accrued liabilities
increased from $522,000 at the end of 2004 to $822,000 at the end of 2005.

# Research and
development, patents and licenses, etc.

Because the market for our products
is characterized by rapidly changing technology and evolving industry standards, our
success depends upon our ability to select, develop, manufacture and market new and
enhanced products in a timely manner to meet changing market needs. As such, we invest
significant resources in research and new product development, enhancements to existing
products, and the development of new networking and connectivity technologies, and we
expect to continue to do so.

29

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The Government of Israel encourages
research and development projects oriented towards products for export or projects which
will otherwise create surplus yield for the Israeli economy. As indicated below, in each
of the three fiscal years from 1999 to 2001, we received grants from the Office of the
Chief Scientist (OCS) for the development of systems and products. We have
received from the OCS approximately 30% of certain research and development expenditures
for particular projects. Under the terms of Israeli Government participation, a royalty of
3% or up to 5% of the net sales of products developed from a project funded by the OCS
must be paid, beginning with the commencement of sales of products developed with grant
funds and ending when 100% or 150% of the grant is repaid. For projects approved after
January 1, 1999, the amount of royalties payable is up to a dollar-linked amount equal to
100% of such grants plus interest at LIBOR. The terms of Israeli Government participation
also place restrictions on the location of the manufacturing of products developed with
government grants, which, in general, must be performed in Israel, and on the transfer to
third parties of technologies developed through projects in which the government
participates. See Item 10. Additional Information  Taxation. Due to the
decreasing budget of the OCS, we did not receive any grants for our projects in 2002, and
we received approximately 20% of certain research and development expenditures for a
particular project in 2003 and approximately 30% of a particular project in 2004. We did
not receive any grants from the OCS for our projects in 2005. In August 2005 we received
approval for a $54 thousand dollar grant from the Korea-Israel Industrial Research and
Development Foundation, or Koril-RDF, in connection with the joint development of a
certain product with a Korean company. Under the terms of this grant we are required to
repay the amounts received at a rate of 2.5% per year of our gross sales of the product
developed with the grant in each such year, until 100% of the grant (and any other sums
received from Koril-RDF) are repaid. The annual payment for every year following the first
sale of the product will not exceed certain percentages of the amounts received from
Koril-RDF. We cannot guarantee that any encouragement programs will be continued, or that
we will continue to participate in them to the extent they are continued.

The following table shows, for the
periods indicated, our gross research and development expenditures, the portion of such
expenditures which was funded by OCS and the net cost to us of our research and
development activities:

|                                                                              | 1999 | 2000 | 2001 | 2002  | 2003 | 2004 | 2005 
|----------------------------------------------------------------------------- | ---- | ---- | ---- | ----- | ---- | ---- | -----
|
|
|
|
|Gross research and development expenses                                       |      |      | $    | 1,078 |      | $    | 1,418
|                                                                              |      |      |      |       |      |      |      
|Portion funded by Chief Scientist                                             |      |      | $    | 417   |      | $    | 410  
|                                                                              |      |      |      |       |      |      |      
|Portion funded by Korea-Israel Industrial Research and Development Foundation |      |      |      | -     |      |      | -    
|Net research and development expenses                                         |      |      | $    | 661   |      | $    | 1,008

* This amount reflects final
adjustments for projects supported in previous years.

We expect that we will continue to
commit resources to research and development in the future. As of March 31, 2006, the
Company employed 21 persons in research and development. Our gross research and
development expenses constituted approximately 14%, 35% and 44% of our sales, and our net
research and development expenses constituted approximately 13%, 32% and 40% of such
sales, in the respective years ended December 31, 2005, 2004 and 2003. For additional
information concerning commitments to pay royalties on sales of products developed from
projects funded by the Office of the Chief Scientist, see Note 8A to our financial
statements included elsewhere in this annual report and see Item 10. Additional
Information  Taxation.

30

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# Trend Information

The trend in the mobile computing
industry has been to incorporate modems and Ethernet/Fast Ethernet as built-in elements of
portable PCs. This trend has obviated much of the need for our legacy Ethernet/Fast
Ethernet PC Card products. Although one of our OEM customers continued purchasing our
legacy Ethernet/Fast Ethernet products in 2005, we believe that this trend will continue,
and that during 2006 our legacy Ethernet/Fast Ethernet PC Cards will be phased out
completely.

Having anticipated the above trend,
we began a number of years ago to position ourselves to compete in the broadband internet
access industry. In 1999, 2000 and 2001, we invested most of our research and development
efforts in this industry. In 2003, 2004 and 2005 sales to the broadband internet access
and multi tenant unit, or MTU, industries constituted 14%, 7% and 1% of our total sales,
respectively. An additional trend which affected our sales of these products was the
worldwide slowdown in technology-based companies, which worsened throughout 2002 and part
of 2003, and had a ripple effect on our performance, especially in the broadband internet
access and MTU industries. Since then, products for this industry have become
commodities, mostly manufactured by companies from the Far East. We have therefore ceased
our investments in this industry.

In late 2002, we leveraged our
expertise and know-how in networking and operating systems to develop a line of high-end
server networking cards (Server Adapters). In todays network-based environment,
there is a growing demand for server-based systems. The markets for such systems were less
affected by the worldwide slowdown described above and are almost continuously growing.
Furthermore, the security market, which is also growing due to an increase in demand for
security appliances, most of which are server based, is an additional market in which our
server adapters provide added value. We began investing in marketing and sales of this
line to potential markets and customers during 2003 and received initial purchase orders
from a number of sources. We continued to invest in the marketing of these products during
the course of 2004 and 2005 and the number of purchase orders for these products increased
significantly. The sales cycles in these markets are long, but once we establish a
customer base, each such customer will represent an opportunity for sustained, long-term
revenues. We expect that this product line will continue to be our principal growth driver in
the coming years, specifically with respect to the higher port density cards, bypass
cards, PCI-Express cards and ROHS compliant cards, however, there is no assurance that we
will continue to succeed in having significant sales in this area.

31

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# Off-Balance Sheet
Arrangements

On July 22, 2002, our Audit Committee
and the Board of Directors approved an Indemnification Agreement with our directors and
officers. Our shareholders approved the terms of this agreement in a General and
Extraordinary Meeting held on January 7, 2004. The Agreement provides that the directors
and officers will be exempt from liability in certain circumstances. The Agreement also
provides that the expenses of these directors and officers for obligations that are
connected to an act performed in their capacity as an officer of the Company will be paid
by us. This right to indemnification is limited, and does not cover breaches of an
officers duty of loyalty or care, or reckless disregard for the consequences of such
breach. The right to indemnification also does not cover acts that are taken intentionally
to realize personal gain. The maximum amount of our liability under the Indemnification
Agreement is currently $3,000,000.

# Tabular disclosure of
contractual obligations

The following table shows our
outstanding contractual obligations by category and by payments due as of December 31,
2005:

|                     | Payments due by period
|-------------------- | ----------------------
|
|
|
|
|Operating Leases     |                       
|Purchase Obligations |                       
|Total                |                       

The Companys total outstanding
contingencies in respect of royalty-bearing participations received or accrued from the
OCS, net of royalties paid or accrued to the OCS, amounted to approximately $3,084
thousand as of December 31, 2005 ($3,142 thousand as of December 31, 2004), of which
$2,408 thousand are attributable to sales of our legacy products and $676 thousand are
attributable to sales of our new line of products.

|Item 6. |  | DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES
|------- |  | ------------------------------------------

# Directors and Senior
Management

The following table and notes thereto
set forth information regarding our officers, directors and senior managers as of May 31,
2006.

|Name             | Age | Position with Company                  
|---------------- | --- | ---------------------------------------
|Avi Eizenman     | 49  | Active Chairman of the Board           
|Shaike Orbach    | 55  | Chief Executive Officer, Director      
|Yehuda Zisapel   | 63  | Director                               
|Einat Domb-Har   | 39  | Outside Director                       
|Ilan Kalmanovich | 40  | Outside Director                       
|David Hendel     | 45  | Vice President Research and Development
|Eran Gilad       | 39  | Chief Financial Officer                

32

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Avi Eizenman
co-founded the Company in 1987 and has served as its President and as a Director, since
its inception. Mr. Eizenman also served as Chief Executive Officer from our inception
until April 1, 2001, and on such date, he resigned from his position as Chief Executive
Officer and was appointed Active Chairman of the Board. Mr. Eizenman served as head of the
ASIC department at Scitex Ltd. in 1986. From 1979 until 1985, Mr. Eizenman held various
positions, including project manager, ASIC specialist and engineer, with the Electronic
Research & Development Department of the Israeli Ministry of Defense. Mr. Eizenman
holds a B.Sc. degree, with honors, in Electrical Engineering from the Technion, and an
M.B.A. from Tel Aviv University.

Shaike Orbachhas been President and Chief Executive Officer of the Company since April
2001. In December 2001, Mr. Orbach was named a Director, replacing Zohar Zisapel, who
resigned from the Board of Directors. Prior to that, for a period of four and a half
years, Mr. Orbach was President and CEO of Opgal Ltd., a high-tech subsidiary of
Israels Rafael and El-Op corporations. Previously, he was General Manager of
Edusoft, an Israeli company the shares of which were traded on the NASDAQ National Market,
and Managing Director of Tecsys Ltd. He holds a B.Sc degree in Mechanical Engineering from
the Technion.

Yehuda Zisapel
is a co-founder of the Company. He has served as a Director since its inception and served
as Chairman of the Board from 1999 until March 2001. Mr. Zisapel is also a founder and a
director of Rad Data Communications Ltd. (Rad), Bynet Data Communications Ltd.
(Bynet) and its subsidiaries and other companies in the Rad Group. We have
certain dealings with members of the Rad Group. See Item 7. Major Shareholders and
Related Party Transactions. In 1966 and 1968, Mr. Zisapel received a B.Sc. and an
M.Sc. degree, respectively, in Electrical Engineering from the Technion. In 1975, Mr.
Zisapel received an M.B.A. from Tel Aviv University.

Einat Domb-Har
has served as the CFO of Stage One Venture Capital, which focuses on seed investment in
the telecom industry, since April 2004. From 2000 to 2004 Ms. Domb-Har served as a
controller of Pitango Venture Capital, Israels largest pool of four venture capital funds.
From 1994 to 1999 Ms. Domb-Har served as a senior manager at Kost, Forer and
Gabbay, CPA, a member of Ernst & Young International. Ms. Domb-Har is an Israeli
Certified Public Accountant and holds a BA in Economics and Accounting from Tel Aviv
University. She also holds an MBA from the Israeli extension of Bradford University.

33

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Ilan Kalmanovich
has acted as an independent consultant since 2003 and as Vice President of Fahn Kaneh
Consulting since 2004. From 2001 to 2002, Mr. Kalmanovich served as the vice president of
Igud Hashkaot Veyizum (A.S.I.) Ltd. of the Igud Bank Group. From 1996 to 2000 he
served as a senior consultant at BDO Ziv Haft Consulting and Management Ltd. From 2003 to
May 2004 Mr. Kalmanovich served as a director on the board of Satcom Systems Ltd. and
previously served as a director on the board of Cukierman & Co. Investment House Ltd.,
and as an alternate director at Catalyst Investments L.P., the general partner of the
Catalyst Fund L.P. venture capital fund. Mr. Kalmanovich holds a B.Sc degree (with honors)
in Industrial Engineering from Ben-Gurion University and an MBA from Tel Aviv University.
He also serves as a court-certified mediator and holds a license for investment consulting
from the Israeli Securities Authority.

David Hendelhas
been Vice President, Research and Development of the Company since 1995. From 1991 to
1995, he served as a Senior Hardware Engineer of the Company. Mr. Hendel previously served
as an engineer in the Intelligence Corps of the Israeli Defense Forces. He holds a B.Sc.
degree in Electrical Engineering from Ben-Gurion University.

Eran Gilad has
been the Chief Financial Officer of the Company since May 2005. From 2002 to 2004 Mr.
Gilad served as VP of Finance & Operation at Frontline PCB Solutions Ltd. From 2000
until 2002 Mr. Gilad held senior financial and operational positions at -Lynx Photonic
Networks Inc. From 1996 until 2000 Mr. Gilad held senior financial positions at
Technomatix Technologies Ltd. He is a Certified Public Accountant in Israel and holds an
M.A in Economics from Tel-Aviv University and a B.A in Accounting and Economics from
Tel-Aviv University.

# Compensation

The aggregate direct remuneration
paid to all persons as a group who served in the capacity of director or executive officer
during the year ended December 31, 2005 was $624,000. We do not pay cash compensation to
Yehuda Zisapel for serving on our board of directors. We do pay cash compensation to Avi
Eizenman who is an active Chairman of the Board, to Shaike Orbach, who is the President
and Chief Executive Officer, and to Ms. Einat Domb-Har and Mr. Ilan Kalmanovich who are
outside directors and receive compensation in accordance with the regulations promulgated
under the Israeli Companies Law-1999. All our officers work full time for us. Certain of
the compensation previously paid to our directors was paid in the form of options under
the Silicom Directors Share Incentive Plan (1994) and certain of such compensation is paid
in the form of options under the Share Option Plan (2004) described below. The Directors
Share Incentive Plan (1994) was adopted by the board of directors in August 1994 in order
to grant options to members of the board of directors who served on the board of directors
for at least three fiscal quarters. The Director Share Incentive Plan was administered by
the board of directors, which designated the optionees, dates of grant and the exercise
price of options. Under the Director Share Incentive Plan, 500,000 of our ordinary shares
were reserved for issuance. The options granted under the Director Share Incentive Plan
expire at the end of ten years from their date of grant and are non-assignable except by
the laws of descent. The grantee is responsible for all personal tax consequences of the
grant and the exercise thereof. We believe that we will bear no tax consequences in
connection with such grant or exercise. The Director Share Incentive Plan was cancelled in
July 2004 with respect to any share capital previously reserved and not yet allocated as
well as any share capital that becomes unallocated from time to time as outstanding
options expire or are forfeited. As of May 31, 2006, 170,000 options are outstanding under
the Director Share Incentive Plan (1994), of which, 110,000 options (at an average
exercise price of $5.61 and at termination dates that range from April 2010 to August
2010) were granted to Mr. Avi Eizenman and 60,000 options (at an average exercise price of
$4.70 and a termination date that ranges from December 2006 to April 2010) were granted to
Mr. Yehuda Zisapel. See Note 9 to the financial statements.

34

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On October 24, 2000, the board of
directors adopted the Silicom Ltd. US Share Option Plan (2000). This Plan is intended to
constitute a means of providing additional incentive to officers, consultants and certain
other present and future employees and directors of the Company and its subsidiaries.
Pursuant to the Plan, the Company may grant both Incentive Stock Options (as such term is
defined in Section 422 of the Internal Revenue Code of 1986, as amended; ISOs)
and Nonqualified Stock Options (NSOs), provided, however, that only our
employees or employees of our subsidiaries can receive ISOs. The Plan is administered by
the board of directors, which has full authority to grant options under the Plan. Under
the terms of the Plan, up to a maximum of 200,000 of our ordinary shares are reserved for
issuance, subject to certain adjustments. The exercise price of the options granted under
the Plan shall be not less than the higher of 100 percent (or, in the case of a grant of
ISOs to a holder of more than 10% of the Companys outstanding shares, 110
percent) of the Fair Market Value (as defined in the Plan) of the ordinary shares subject
to the option on the date the option is granted. The vesting period of the options is
subject to the discretion of the Board. The term of ISOs shall not exceed 10 years from
the date on which they are granted (or 5 years, in the case of optionees who hold more
than 10% of our outstanding shares). In total, as of May 31, 2006, we have granted 17,600
options pursuant to the US Share Option Plan (2000) to employees of our US subsidiary
 Silicom Connectivity Solutions, Inc., 11,300 of which were returned to the Company
due to certain employees who left their positions not exercising their options.

On December 30, 2004, our
shareholders adopted our Share Option Plan (2004). Under the terms of the Share Option
Plan (2004) up to a maximum of 282,750 of our ordinary shares are reserved for issuance,
subject to certain adjustments, upon the exercise of options granted to employees,
directors, officers, consultants and service providers. The Share Option Plan (2004) is
administered by the board of directors, which designates the optionees, dates of grant,
vesting periods and the exercise price of options. The options are non-assignable except
by the laws of descent. Certain tax advantages apply to certain of our directors, officers
and employees with respect to options granted to them under the Share Option Plan (2004).
As of May 31, 2006, we have granted a total of 258,500 options under the Share Option Plan
(2004), of which 30,000 options (at an exercise price of $2.53 and at a termination date
of December 30, 2014) were granted to Mr. Avi Eizenman, 30,000 options (at an exercise
price of $2.53 and at a termination date of December 30, 2014) were granted to Mr. Yehuda
Zisapel, 30,000 options (at an exercise price of $2.53 and at a termination date of
December 30, 2014) were granted to Mr. Shaike Orbach, 30,000 options (at an exercise price
of $2.53 and at a termination date of December 30, 2014) were granted to Ms. Einat
Domb-Har and 30,000 options (at an exercise price of $2.53 and at a termination date of
December 30, 2014) were granted to Mr. Ilan Kalmanovich. 15,500 of the options granted
under the Share Option Plan (2004) were returned to the company due to certain employees
who left their positions not exercising their options.

35

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In addition to the Plans described
above, the oldest of the Companys share option plans was adopted in December 1993,
and amended in 1997. Pursuant to this plan, 300,000 ordinary shares were reserved for
issuance upon the exercise of options granted to employees and consultants of the Company.
This reserve was increased by the board of directors to 500,000. The Share Option Plan was
administered by the board of directors, which designated the optionees, dates of grant,
vesting periods and the exercise price of options. The options granted under this plan
expire after 10 years from their date of grant and are non-assignable except by the laws
of descent. The grantee is responsible for all personal tax consequences of the grant and
the exercise thereof. The 1993 share option plan was cancelled in July 2004 with respect
to any share capital previously reserved and not yet allocated as well as any share
capital that becomes unallocated from time to time as outstanding options expire or are
forfeited. In total, as of May 31, 2006, 37,000 options which were granted to our various
executive officers and employees pursuant to the Share Option Plan remain outstanding.

# Board Practices

Each of Yehuda Zisapel, Avi Eizenman,
Shaike Orbach and our outside directors Ms. Einat Domb-Har and Mr. Ilan Kalmanovich, was
elected to the board of directors most recently on October 6, 2005 to serve until the next
Annual Shareholders Meeting. Messrs. Yehuda Zisapel and Avi Eizenman are both
Founders of the Company, and have served as Directors since our inception in 1987. None of
the members of the board of directors is entitled to receive any severance or similar
benefits upon termination of his or her service with the board of directors, except for
Avi Eizenman, who also functions as the active Chairman of the board.

36

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# Board of Directors

Our Articles of Association provide
for a board of directors of not less than two nor more than eight members. Each director
is elected to serve until the next annual general meeting of shareholders and until his or
her successor has been elected. Officers serve at the discretion of the board of
directors. Under the Israeli Companies Law 1999 which entered into effect on February 1,
2000 and was amended most recently in March 2006, a public companys board of
directors must determine the minimum number of directors who are required to have
expertise in finance and accounting (with the same meaning described below in
connection with outside directors) taking into account the type of company, its size, the
extent of its activities and the complexity of the companys operations. The
Companies Law states that at least one non-external director must have expertise in
finance and accounting. Following determination by the board of directors of the minimum
number of directors required to have expertise in finance and accounting, when the board
of directors evaluates whether a non-external director has such expertise in order to meet
the minimum requirement, such director must also submit an affidavit with the statements
described below. The Israeli Companies Law- require the board of directors of a public
company to determine the number of directors who shall possess expertise in finance and
accounting. These regulations are described below. The Articles of Association of the
Company provide that any director may, by written notice to the Company, appoint another
person to serve as a substitute director and may cancel such appointment. Under the
Israeli Companies Law-1999, a person who is already serving as a director will not be
permitted to act as a substitute director. Additionally, the Israeli Companies Law-1999
prohibits a person from serving as a substitute director for more than one director.
Appointment of a substitute director for a member of a board committee is only permitted
if the substitute is a member of the board of directors and does not regularly serve as a
member of such committee. If the committee member being substituted is an outside
director, the substitute may only be another outside director who possesses the same
expertise as the outside director being substituted and may not be a regular member of
such committee. The term of appointment of a substitute director may be for one meeting of
the board of directors or for a specified period or until notice is given of the
cancellation of the appointment. To our knowledge, no director currently intends to
appoint any other person as a substitute director, except if the director is unable to
attend a meeting of the board of directors.

# Outside Directors; Audit
Committee

Under the Israeli Companies Law-1999,
companies registered under the laws of Israel the shares of which have been offered to the
public in or outside of Israel are required to appoint no less than two outside directors.
No person may be appointed as an outside director if such person or the persons
relative, partner, employer or any entity under the persons control, has or had, on
or within the two years preceding the date of the persons appointment to serve as
outside director, any affiliation with the company or any entity controlling, controlled
by or under common control with the company. The term affiliation includes:

| |  | an
employment relationship;
| | - | ---------------------------

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

| |  | control;
and
| | - | ------------

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

| | A
person shall be qualified to serve as an outside director only if he or she possesses
accounting and financial expertise or professional qualifications. At least one outside
director must posses accounting and financial expertise.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

37

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Regulations have been recently
promulgated under the Israeli Companies Law mandating that when appointing an external
director in the future to the board of directors of a public company, in addition to the
already existing requirements for such external director, at least one of the external
directors must have expertise in finance and accounting while the other
external director must be professionally qualified.

A director can satisfy the
requirements of having expertise in finance and accounting if due to his or
her education, experience and qualifications he or she has acquired expertise and
understanding in business and accounting matters and financial statements, in a manner
that allows him or her to understand, in depth, the companys financial statements
and to spur a discussion regarding the manner in which the financial data is presented.

A public companys board of
directors must evaluate the proposed external directors expertise in finance and
accounting, by considering, among other things, such candidates education,
experience and knowledge in the following: (i) accounting and auditing issues typical to
the field in which the company operates and to companies of a size and complexity similar
to such company; (ii) the companys independent public accountants duties and
obligations; (iii) preparation of the companys financial statements and their
approval in accordance with the Companies Law and the Israeli Securities Law  1961.

A director is deemed to be
professionally qualified if he or she meets any of the following criteria: (i)
has an academic degree in any of the following professions: economics, business
administration, accounting, law or public administration; (ii) has a different academic
degree or has completed higher education in a field that is the companys main field
of operations, or a field relevant to his or her position; or (iii) has at least five
years experience in any two of the following: (A) a senior position in the business
management of a corporation with a significant extent of business, (B) a senior public
position or a senior position in public service, or (C) a senior position in the
companys main field of operations. As with a candidates expertise in finance
and accounting, the board of directors here too must evaluate the proposed external
directors professional qualification in accordance with the criteria set
forth above.

The affidavit required by law to be
signed by a candidate to serve as an external director must include a statement by such
candidate concerning his or her education and experience, if relevant, in order that the
board of directors may properly evaluate whether such candidate meets the requirements of
having expertise in finance and accounting or being professionally
qualified as set forth in the regulations. Additionally, the candidate should submit
documents and certificates that support the statements set forth in the affidavit.

No person may serve as an outside
director if the persons position or other business activities create, or may create,
a conflict of interest with the persons responsibilities as an outside director or
may otherwise interfere with the persons ability to serve as an outside director.
If, at the time outside directors are to be appointed, all current members of the board of
directors are of the same gender, then at least one outside director must be of the other
gender.

38

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Outside directors are to be elected
by a majority vote at a shareholders meeting, provided that either:

| |  | the
majority of shares voted at the meeting, including at least one-third of the shares held
by non-controlling shareholders voted at the meeting, vote in favor of election of the
director; or
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | the
total number of shares held by non-controlling shareholders voted against the election of
the director does not exceed one percent of the aggregate voting rights in the company.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The initial term of an outside
director is three years and may be extended for one additional term of three years.
Outside directors may be removed only by the same percentage of shareholders as is
required for their election, or by a court, and then only if the outside directors cease
to meet the statutory qualifications for their appointment, violate their duty of loyalty
to the company or are found by a court to be unable to perform their duties on a full time
basis. Outside directors may also be removed by an Israeli court if they are found guilty
of bribery, fraud, administrative offenses in a company or use of inside information. Each
committee of a companys board of directors must include at least one outside
director.

An outside director is entitled to
compensation as provided in regulations adopted under the Israeli Companies Law-1999 and
is otherwise prohibited from receiving any other compensation, directly or indirectly, in
connection with service provided as an outside director. Ms. Einat Domb-Har and Mr. Ilan
Kalmanovich were elected to the board of directors as outside directors on June 30, 2004.

# Audit Committee

The Israeli Companies Law-1999
requires public companies to appoint an audit committee. The responsibilities of the audit
committee include identifying irregularities in the management of our business and
approving related party transactions as required by law. An audit committee must consist
of at least three directors, including all the outside directors of the company. The
chairman of the board of directors, any director employed by or otherwise providing
services to the company, and a controlling shareholder or any relative of a controlling
shareholder, may not be a member of the audit committee. Currently, Ms. Einat Domb-Har,
Mr. Ilan Kalmanovich and Mr. Yehuda Zisapel serve as members of our audit committee.

# Internal Auditor

Under the Israeli Companies Law-1999,
the board of directors must appoint an internal auditor, nominated by the audit committee.
The role of the internal auditor is to examine, among other matters, whether our actions
comply with the law and orderly business procedure. Under the Israeli Companies Law-1999,
the internal auditor may be an employee of the company but not an office holder (as
defined in Item 10 below), or an affiliate, or a relative of an office holder or
affiliate, and he or she may not be our independent accountant or its representative. Our
board of directors appointed Fahn Kaneh Control Management to be our internal auditor on
April 26, 2005, according to the recommendation of the audit committee.

39

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# Employees

The number of employees over the last
three financial years is set forth in the table below.

|As at December 31                       | 2003 | 2004 | 2005
|--------------------------------------- | ---- | ---- | ----
|
|
|
|
|Total Employees                         | 42   | 38   | 47  
|Marketing, Sales, Customer Services     | 6    | 3    | 4   
|Research & Development                  | 19   | 17   | 19  
|Manufacturing                           | 12   | 13   | 18  
|Corporate Operations and Administration | 5    | 5    | 6   

At May 31, 2006, we had 52 employees,
including 6 in marketing, sales and customer services, 21 in research and development, 19
in manufacturing, and 6 in corporate operations and administration. All such employees,
except for 1 employee in the United States, are based in Israel. We consider our relations
with our employees excellent and have never experienced a labor dispute, strike or work
stoppage. None of our employees is represented by a labor union. We do not employ a
significant number of temporary employees, but we do use temporary employees from time to
time, as necessary

Certain provisions of the collective
bargaining agreements between the Histadrut (General Federation of Labor in Israel) and
the Coordination Bureau of Economic Organizations including the Industrialists
Associations are applicable to our Israeli employees by order of the Israeli Ministry of
Labor. The laws principally concern the length of the work day, minimum daily wages for
professional workers, contributions to a pension fund, insurance for work-related
accidents, procedures for dismissing employees, determination of severance pay and other
conditions of employment. We generally provide our employees with benefits and working
conditions beyond the required minimums. See Note 6 of Notes to our Consolidated Financial
Statements.

Israeli law generally requires
severance pay, which may be funded by Managers Insurance described below, upon the
retirement or death of an employee or termination of employment without cause (as defined
in the law). The payments thereto amount to approximately 8.33% of wages. Furthermore,
Israeli employees and employers are required to pay predetermined sums to the National
Insurance Institute, which is similar to the United States Social Security Administration.
Such amounts also include payments for national health insurance. The payments to the
National Insurance Institute are equal to approximately 16% of the wages, of which the
employee contributes approximately 62.5% and the employer contributes approximately 37.5%.
In the past, National Insurance payments were made on salaries up to a specified ceiling,
but this ceiling was cancelled for the period between June 2002 and July 2003.

40

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A general practice followed by the
Company, although not legally required, is the contribution of funds on behalf of most of
its employees to a fund known as Managers Insurance. This fund provides
a combination of savings plan, insurance and severance pay benefits to the employee,
giving the employee a lump sum payment upon retirement and securing the severance pay, if
legally entitled, upon termination of employment. The Company decides whether each
employee is entitled to participate in the plan; each employee who agrees to participate
contributes an amount equal to 5% of his salary, and the employer contributes between
13.3% and 15.8% of the employees salary.

# Share Ownership

The following table sets forth, as of
May 31, 2006, the number of Shares owned by officers, directors and senior management of
the Company:

|Name and Address                      | Number of Sharesand Options Owned1 | Percent ofOutstanding Shares
|------------------------------------- | ---------------------------------- | ----------------------------
|
|
|
|
|Yehuda Zisapel                        |                                    |                             
|Avi Eizenmann                         |                                    |                             
|Shaike Orbach                         |                                    |                             
|Einat Domb Har                        |                                    |                             
|Ilan Kalmanovich                      |                                    |                             
|David Hendel                          |                                    |                             
|Eran Gilad                            |                                    |                             
|All directors and officers as a group |                                    |                             

* Denotes ownership of less than 1%
of the outstanding shares.

---

1            The table
above includes the number of shares and underlying options that are           exercisable
within 60 days of May 31, 2006. Ordinary shares subject to these           options are
deemed beneficially owned for the purpose of computing the ownership           percentage
of the person or group holding these options, but are not deemed           outstanding
for purposes of computing the ownership percentage of any other           person. To our
knowledge, the persons and entities named in the table have sole           voting and
dispositive power with respect to all shares shown as beneficially           owned by
them.

41

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The terms of the options granted to each
of the shareholders in the above table who hold more than 1% of the Companys shares
are described above. See Item 6. Directors and Senior Management 
Compensation.

|Item 7. |  | MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
|------- |  | -------------------------------------------------

# Major Shareholders

The shareholders of the Company who
own over 5% or more of each class of shares, as well as the number of shares owned and the
percentage of outstanding shares owned by each, and additional information, is set forth
below. The voting rights of our major shareholders do not differ from the voting rights of
other holders of our ordinary shares.

|Name of Shareholder | Number ofShares andOptions Owned2 | Percentage ofOutstanding Shares | Any SignificantChange in Past 3Years
|------------------- | --------------------------------- | ------------------------------- | ------------------------------------
|
|
|
|
|Yehuda Zisapel      |                                   |                                 |                                     
|Zohar Zisapel       |                                   |                                 |                                     
|Robert Mark Sussman |                                   |                                 |                                     

As of May 31, 2006, there were
approximately 16 record holders of ordinary shares, including approximately 10 record
holders in the United States. Collectively, these record holders held approximately 28% of
the outstanding ordinary shares.

# Related Party
Transactions

Messrs.
          Yehuda and Zohar Zisapel are brothers and are our founders. Mr. Yehuda Zisapel
          currently serves as a Director on our board of directors. Messrs. Yehuda and
          Zohar Zisapel are also founders, directors and principal shareholders of several
          other corporations within the Rad Group, as described above. The
          other members of the Rad Group are actively engaged in designing, manufacturing,
          marketing and supporting data communications products, none of which are
          currently the same as our products. Certain products of members of the Rad Group
          are complementary to, and may be used in connection with, our products. We and
          other members of the Rad Group also market certain of our products through the
          same distribution channels. Such products may, to a limited extent, compete with
          one another for the distributors time and efforts. Commencing in February
          2004, we began to sub-lease space in Paramus, New Jersey, from Radcom Equipmet,
          Inc., an affiliated company. This sub-lease was in effect until January 31, 2006
          and has been extended until January 31, 2007. Currently, the monthly rent
          payments for this space are approximately $500.

---

2            The table
above includes the number of shares and underlying options that are           exercisable
within 60 days of May 31, 2006. Ordinary shares subject to these           options are
deemed beneficially owned for the purpose of computing the ownership           percentage
of the person or group holding these options, but are not deemed           outstanding
for purposes of computing the ownership percentage of any other           person. To our
knowledge, the persons and entities named in the table have sole           voting and
dispositive power with respect to all shares shown as beneficially           owned by
them.

42

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Finally, the Rad Group provides us
with certain personnel and other services, and is reimbursed by us for the costs of
providing such services. We believe that the terms of the transactions in which we have
engaged and are currently engaged with other members of the Rad Group are generally no
less favorable to us than terms which might be available to us from unaffiliated third
parties. Our board of directors recently approved a resolution under which sales to, or
purchases from any members of the Rad Group must meet certain criteria or be specifically
approved by the audit committee, board of directors and shareholders, as applicable in
accordance with Israeli law. These criteria include a stipulation that the transactions
between us and members of the RAD Group relate to standard equipment, services and
products purchased or sold by us and the Rad Group, as applicable and that such
transactions occur within our ordinary course of business. The resolution of our Board of
Directors also states that transactions with members of the Rad Group must be entered into
at least on market terms and at a value lower than 0.5% of our annual turnover per
transaction and not more than 1% of our annual turnover in the aggregate for all such
transactions in a financial year. All future related party transactions and arrangements
(or modifications of existing ones) with members of the Rad Group, transactions in which
office holders of the Company have a personal interest, or transactions which raise issues
of such office holders fiduciary duties, may require audit committee, board of
directors and shareholder approval under the Israeli Companies Law-1999.

In addition to being a founder,
director and principal shareholder of each member of the Rad Group, Yehuda Zisapel is the
founder and principal shareholder of Bynet and its subsidiaries. Bynet acts as a
distributor in Israel for us and for other members of the Rad Group and also acts as a
distributor in Israel for numerous unaffiliated manufacturers of data communications and
other equipment. We believe that the terms of our relationship with Bynet are generally no
less favorable to us than terms which might be available to us from unaffiliated third
parties.

Except as indicated above, we do not
currently compete with other members of the Rad Group and do not currently contemplate
engaging in competition with any other member of the Rad Group in the future. However,
opportunities to develop, manufacture or sell new products (or otherwise enter new fields)
may arise in the future, which opportunities might be pursued by us or by one or more
other members of the Rad Group to the exclusion of (or in competition with) other members
of the Rad Group (including us). In the event that any such opportunity arises, the
directors then in office will determine whether or not we should seek to pursue it. Any
such determination will be based upon such factors as the directors then deem relevant.
However, in making any such determination, the directors will be bound by their fiduciary
duties to the Company (and to any other corporation or other person to whom they then owe
a fiduciary duty).

43

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On July 22, 2002, our audit committee
and the Board of Directors approved an Indemnification Agreement with our directors and
officers. Our shareholders approved the terms of this agreement in a General and
Extraordinary Meeting held on January 7, 2004. The Agreement provides that our directors
and officers will be exempt from liability in certain circumstances. The Agreement also
provides that the expenses of these directors and officers for obligations that are
connected to an act performed in their capacity as an officer of the Company will be paid
by us. This right to indemnification is limited, and does not cover breaches of an
officers duty of loyalty or care, or reckless disregard for the consequences of such
breach. The right to indemnification also does not cover acts that are taken intentionally
to realize personal gain. The maximum amount of our liability under the Indemnification
Agreement is currently $3,000,000. On January 7, 2004 our shareholders also approved the
procurement of a 12 month discovery period relating to our directors and officers
insurance policy, which expired on April 30, 2003. We procured such discovery period,
which was in effect until April 30, 2004. The discovery period provided coverage for
incidents or actions that were originally covered by the insurance policy that expired on
April 30, 2003, in the event that claims arising from such incidents or actions were
initiated between April 30, 2003 and April 30, 2004. On December 30, 2004 our shareholders
approved the procurement of a new insurance policy for our directors and officers to
provide for coverage of up to $4,000,000, effective from February 1 2004 until January 31,
2005. This policy was renewed for the period of February 1, 2005 until February 1, 2006,
following approval by our audit committee and board of directors. Under Israeli law, we
are also required to obtain the approval of our shareholders for such renewal and we
received the approval of our shareholders at the annual and extraordinary meeting of our
shareholders held on October 6, 2005. On January 30, 2006, our audit committee and board
of directors approved, subject to the approval of our shareholders, an additional renewal
of our directors and officers insurance policy for the period of one year. All of our
directors are parties to our Indemnification Agreement and are covered by our directors
and officers insurance policy.

|Item 8. |  | FINANCIAL INFORMATION
|------- |  | ---------------------

Our
consolidated financial statements and other financial information are incorporated herein
by reference to pages F-1 through F-34.

# Legal Proceedings

We are not a party to any material
litigation and we are not aware of any pending or threatened litigation that would have a
material adverse effect on us or our business.

44

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|Item 9. |  | THE OFFER AND LISTING
|------- |  | ---------------------

# Markets and Share Price
History

The primary trading market for our
ordinary shares is the NASDAQ Capital Market (previously NASDAQ Small-Cap Market), where
our shares are listed and traded under the symbol SILC (previously SILCF). The table below
sets forth the high and low bid prices in dollars of our ordinary shares, as reported by
NASDAQ during the indicated periods:

|PERIOD                                       | HIGH  | LOW 
|-------------------------------------------- | ----- | ----
|
|
|
|
|LAST 6 CALENDAR MONTHS                       |       |     
|May, 2006                                    | 9.26  | 6.50
|April, 2006                                  | 10.79 | 7.80
|March, 2006                                  | 12.46 | 9.62
|February, 2006                               | 11.99 | 7.26
|January, 2006                                | 8.75  | 6.58
|December, 2005                               | 9.39  | 6.07
|FINANCIAL QUARTERS DURING THE PAST TWO YEARS
|First Quarter, 2006                          | 12.46 | 6.58
|Fourth Quarter, 2005                         | 9.39  | 3.31
|Third Quarter, 2005                          | 5.09  | 2.75
|Second Quarter, 2005                         | 4.89  | 2.59
|First Quarter, 2005                          | 3.46  | 2.34
|Fourth Quarter, 2004                         | 2.84  | 1.72
|Third Quarter, 2004                          | 2.44  | 1.76
|Second Quarter, 2004                         | 3.00  | 1.70
|FIVE MOST RECENT FULL FINANCIAL YEARS       
|2005                                         | 9.39  | 2.34
|2004                                         | 3.21  | 1.67
|2003                                         | 1.97  | 0.28
|2002                                         | 1.01  | 0.30
|2001                                         | 5.44  | 0.56

On December 27, 2005, our shares
commenced trading on the Tel Aviv Stock Exchange in Israel under the symbol
SILC (in Hebrew letters). The following table sets forth, for the periods
indicated, the high and low reported sales prices, in NIS, of the ordinary shares on the
Tel Aviv Stock Exchange:

45

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|PERIOD         | HIGH  | LOW  
|-------------- | ----- | -----
|
|
|
|
|May, 2006      | 42.20 | 30.00
|April, 2006    | 49.50 | 37.60
|March, 2006    | 56.59 | 46.02
|February, 2006 | 50.00 | 33.63
|January, 2006  | 40.50 | 30.25
|December, 2005 | 42.19 | 38.00

|Item 10. |  | ADDITIONAL INFORMATION
|-------- |  | ----------------------

# Memorandum and Articles
of Association

Articles of Association

Our shareholders last approved the
amendment of our Articles of Association (Articles) on January 7, 2004. The
objective stated in the Articles is to engage in any business permitted under the law.

We have currently outstanding only
one class of securities, our Ordinary Shares, having a nominal value of NIS 0.01 per
share. Holders of Ordinary Shares have one vote per share, and are entitled to participate
equally in the payment of dividends and share distributions and, in the event of a
liquidation of the Company, in the distribution of assets after satisfaction of
liabilities to creditors. No preferred shares are currently authorized.

Our Articles require that we hold our
annual general meeting of shareholders each year no later than 15 months from the last
annual meeting, at a time and place determined by the board of directors, upon at least 7
days prior notice to our shareholders or, if a special resolution is to be proposed
at an extraordinary general meeting, upon at least 21 days prior notice to our
shareholders. No business may be commenced at a general meeting until a quorum of two or
more shareholders is present in person or by proxy. No business may be commenced at an
extraordinary general meeting, which is anything other than an annual general meeting,
until a quorum of two or more shareholders holding at least 51% of the voting rights is
present in person or by proxy. Shareholders may vote in person or by proxy.

The Israeli Companies Law-1999,
provides that a simple majority is required to amend the articles of association of a
company unless such articles provide otherwise. According to our Articles, as amended, any
amendment of the Articles, any modification of the shareholders rights, and any increase
or reduction of our authorized share capital and alterations of our share capital, must be
decided upon in a special resolution, by a majority of 75% of the shareholders who vote at
the general meeting, without taking abstaining votes into account.

46

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Pursuant to the Israeli Companies
Law-1999, resolutions regarding the following matters must be passed at a general meeting
of shareholders:

| |  | appointment
or termination of our auditors;
| | - | -------------------------------------------

| |  | appointment
and dismissal of directors;
| | - | ---------------------------------------

| |  | approval
of interested party acts and transactions requiring general meeting approval as provided
in sections 255 and 268 to 275 of the Israeli Companies Law-1999;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
merger as provided in section 320(a) of the Israeli Companies Law-1999;
| | - | -------------------------------------------------------------------------

| |  | the
exercise of the powers of the board of directors, if the board of directors is unable to
exercise its powers and the exercise of any of its powers is vital for our proper
management, as provided in section 52(a) of the Israeli Companies Law-1999.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

An extraordinary general meeting may
be convened by demand of two directors or by written request of one or more shareholders
holding at least 5% of our issued share capital and 1% of the voting rights or one or more
shareholders holding at least 5% of the voting rights. Shareholders requesting a special
meeting must submit their proposed resolution with their request. Within 21 days of
receipt of the request, the board of directors must convene a special meeting and send out
notices setting forth the date, time and place of such meeting.

The Israeli Companies
Law-1999

We are subject to the provisions of
the Israeli Companies Law-1999, which became effective on February 1, 2000 and was amended
most recently in March 2006. The Israeli Companies Law-1999 codifies the fiduciary duties
that office holders, including directors and executive officers, owe to a
company. An office holder, as defined in the Israeli Companies Law-1999, is a director,
general manager, chief business manager, deputy general manager, vice general manager,
executive vice president, vice president, another manager directly subordinate to the
managing director or any other person assuming the responsibilities of any of the
foregoing positions without regard to such persons title. Each person listed in the
table in Item 6. Directors, Senior Management and Employees above is an office
holder.

The Israeli Companies Law-1999
requires that an office holder of a company promptly disclose, no later than the first
board meeting in which such transaction is discussed, any personal interest that he or she
may have and all related material information known to him or her, in connection with any
existing or proposed transaction by the company. In addition, if the transaction is an
extraordinary transaction, the office holder must also disclose any personal interest held
by the office holders relative, or by any corporation in which the office holder is
a 5% or greater shareholder, holder of 5% or more of the voting power, director or general
manager or in which he or she has the right to appoint at least one director or the
general manager. An extraordinary transaction is defined as a transaction not in the
ordinary course of business, not on market terms, or that is likely to have a material
impact on the companys profitability, assets or liabilities.

47

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In the case of a transaction that is
not an extraordinary transaction, after the office holder complies with the above
disclosure requirement, only board approval is required unless the articles of association
of the company provide otherwise. The transaction must not be adverse to the
companys interests. If the transaction is an extraordinary transaction, then, in
addition to any approval required by the articles of association, it must also be approved
by the audit committee and by the board of directors, and, under specified circumstances,
by a meeting of the shareholders, as well.

Subject to certain exceptions
provided for in the regulations to the Israeli Companies Law-1999, agreements regarding
directors terms of compensation require the approval of the audit committee, board
of directors and the shareholders of the company. In all matters in which a director has a
personal interest, including matters of his or her terms of compensation, he or she shall
not be permitted to vote on the matter or be present in the meeting in which the matter is
considered. However, if a majority of the audit committee or of the board of directors has
a personal interest in the matter then:

| |  | all
of the directors are permitted to vote on the matter and attend the meeting           in
which the matter is considered; and
| | - | --------------------------------------------------------------------------------------------------------------------------------

| |  | the
matter requires approval of the shareholders at a general meeting.
| | - | ----------------------------------------------------------------------

According to the Israeli Companies
Law-1999, the disclosure requirements discussed above also apply to a controlling
shareholder of a public company. Such requirements also apply to certain shareholders of a
public company, with respect to private placements that will increase their relative
holdings in the company. The term controlling shareholder is defined as a
shareholder who has the ability to direct the activities of a company, other than if this
power derives solely from the shareholders position on the board of directors or any
other position with the company, and the definition for these purposes also includes
shareholders that hold 25% or more of the voting rights if no other shareholder owns more
than 50% of the voting rights in the company. In general, extraordinary transactions with
a controlling shareholder or in which a controlling shareholder has a personal interest,
and agreements relating to employment and compensation terms of a controlling shareholder,
require the approval of the audit committee, the board of directors and the shareholders
of the company. The shareholder approval must either include at least one-third of the
shares held by disinterested shareholders who actively participate in the voting process
(without taking abstaining votes into account), or, alternatively, the total shareholdings
of the disinterested shareholders who vote against the transaction must not represent more
than one percent of the voting rights in the company.

Private placements in a public
company require approval by a companys board of directors and shareholders in the
following cases:

| |  | A
private placement that meets all of the following conditions:
| | - | ---------------------------------------------------------------

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| |  | The
private placement will increase the relative holdings of a shareholder that
               holds five percent or more of the companys outstanding share
capital,                assuming the exercise of all of the securities convertible into
shares held by                that person, or that will cause any person to become, as a
result of the                issuance, a holder of more than five percent of the companys
outstanding                share capital.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 20
percent or more of the voting rights in the company prior to such issuance
               are being offered.
| | - | ---------------------------------------------------------------------------------------------------------------

| |  | All
or part of the consideration for the offering is not cash or registered
               securities, or the private placement is not being offered at market terms.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | A
private placement which results in anyone becoming a controlling shareholder of the
public company.
| | - | -----------------------------------------------------------------------------------------------------

In addition, under the Companies Law
 1999, certain transactions or a series of transactions are considered to be one
private placement.

Any placement of securities that does
not fit the above description may be issued at the discretion of the board of directors.

Under the Israeli Companies Law-1999,
a shareholder has a duty to act in good faith towards the company and other shareholders
when exercising his or her rights and refrain from abusing his power in the company,
including, among other things, voting in the general meeting of shareholders on the
following matters:

| |  | any
amendment to the articles of association;
| | - | ---------------------------------------------

| |  | an
increase of the company's authorized share capital;
| | - | ------------------------------------------------------

| |  | a
merger; or
| | - | ------------

| |  | approval
of interested party acts and transactions that require general meeting approval as
provided in sections 255 and 268 to 275 of the Israeli Companies Law-1999.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

In addition, any controlling
shareholder, any shareholder who knows that it possesses power to determine the outcome of
a shareholder vote and any shareholder who has the power to appoint or prevent the
appointment of an office holder in the company is under a duty to act with fairness
towards the company. The breach of such duty is governed by Israeli contract laws. The
Israeli Companies Law-1999 does not describe the substance of this duty. The Israeli
Companies Law-1999 requires that specified types of transactions, actions and arrangements
be approved as provided for in a companys articles of association and in some
circumstances by the audit committee, by the board of directors and by the general meeting
of the shareholders. In general, the vote required by the audit committee and the board of
directors for approval of these matters, in each case, is a majority of the disinterested
directors participating in a duly convened meeting.

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# NASD Marketplace Rules
and Home Country Practices

In accordance with Israeli law and
practice and subject to the exemption set forth in Rule 4350(a)(1) of the NASD Marketplace
Rules, we follow the provisions of the Israeli Companies Law  1999, rather than the
requirements of Rule 4350 of the Market Place Rules with respect to the following
requirements:

| |  | Distribution
of annual and quarterly reports to shareholders   Under Israeli law we
are not required to distribute annual and quarterly reports directly to shareholders and
the generally accepted business practice in Israel is not to distribute such reports to
shareholders. We do however make our audited financial statements available to our
shareholders prior to our annual general meeting and file our quarterly and annual
financial results with the Securities Exchange Commission on Form 6-K.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Independence,
Nomination and Compensation of Directors  A majority of our board of
directors is not comprised of independent directors as defined in Rule 4200 of the NASD
Marketplace Rules. Our board of directors contains two outside directors in accordance
with the provisions contained in Sections 239-249 of the Israeli Companies Law  1999.
Israeli law does not require, nor do our outside directors conduct, regularly scheduled
meetings at which only they are present. In addition, with the exception of our outside
directors, our directors are elected for terms of one year or until the following annual
meeting, by a general meeting of our shareholders. The nominations for director which are
presented to our shareholders are generally made by our directors. Israeli law does not
require the adoption of and our board has not adopted a formal written charter or board
resolution addressing the nomination process and related matters. Compensation of our
directors and other officers is determined in accordance with Israeli law.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Audit
Committee   Our audit committee does not meet with all the
requirements of Rules 4350(d)(2)(A)(i), 4350(d)(2)(A)(iii) and 4350(d)(2)(A)(iv) of the
NASD Marketplace Rules. We are of the opinion that the members of our audit committee
comply with the requirements of Rule 10A-3(b) of the general rules and regulations
promulgated under the Securities Act of 1933 and all requirements under Israeli law. Our
audit committee has not adopted a formal written audit committee charter specifying the
items enumerated in Rule 4350(d)(1) of the NASD Marketplace Rules.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Quorum  Under
Israeli law a company is entitled to determine in its articles of association the number
of shareholders and percentage of holdings required for a quorum at a shareholders
meeting. Our Articles of Association provide that a quorum of two or more shareholders is
required for commencement of business at a general meeting. However, the quorum set forth
in our Articles of Association with respect to an extraordinary general meeting, which is
anything other than an annual general meeting, consists of two or more shareholders
holding at least 51% of the voting rights in person or by proxy.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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| |  | Approval
of Related Party Transactions  All related party transactions are
approved in accordance with the requirements and procedures for approval of interested
party acts and transactions, set forth in sections 268 to 275 of the Israeli Companies
Law-1999.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Shareholder
Approval  We seek shareholder approval for all corporate action
requiring such approval, in accordance with the requirements of the Israeli Companies Law
 1999.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Material Contracts

All of our contracts over the past
two years have been entered into in the ordinary course of business, except for our real
property leases, described in Item 4. Information on the Company  Property,
Plants and Equipment.

# Exchange Controls

Under current Israeli regulations,
any dividends or other distributions paid in respect of our ordinary shares purchased by
nonresidents of Israel with certain non-Israeli currencies (including dollars) and any
amounts payable upon the dissolution, liquidation or winding up of our affairs, as well as
the proceeds of any sale in Israel of our securities to an Israeli resident, will be
freely repatriable in such non-Israeli currencies at the rate of exchange prevailing at
the time of conversion pursuant to the general permit issued under the Israeli Currency
Law, 1978, provided that Israeli income tax has been paid on (or withheld from) such
payments. Because exchange rates between the NIS and the U.S. dollar fluctuate
continuously, U.S. shareholders will be subject to any such currency fluctuation during
the period from when such dividend is declared through the date payment is made in U.S.
dollars.

Investments outside Israel by the
Company no longer require specific approval from the Controller of Foreign Currency at the
Bank of Israel.

# Taxation

The following is a summary of some of
the current tax law applicable to companies in Israel, with special reference to its
effect on us. The following also contains a discussion of specified Israeli tax
consequences to our shareholders and government programs from which we benefit. To the
extent that the discussion is based on tax legislation (including the legislation passed
as part of the recent tax reform in Israel) that has not been subject to judicial or
administrative interpretation, there can be no assurance that the views expressed in the
discussion will be accepted by the tax authorities in question.

The discussion is not intended, and
should not be construed, as legal or professional tax advice and is not exhaustive of all
possible tax considerations.

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Holders of our ordinary shares
should consult their own tax advisors as to the United States, Israeli or other tax
consequences of the purchase, ownership and disposition of ordinary shares, including, in
particular, the effect of any foreign, state or local taxes.

General Corporate Tax
Structure

Israeli companies are subject to
corporate tax at the rate of 34% of taxable income in the 2005 tax year, 31% in the 2006
tax year, 29% in the 2007 tax year, 27% in the 2008 tax year, 26% in the 2009 tax year and
25% in the 2010 tax year. However, the effective tax rate payable by a company which
derives income from an Approved Enterprise (as further discussed below) may be
considerably less.

Law for the Encouragement
of Capital Investments, 1959

Certain of our facilities have been
granted Approved Enterprise status under the Law for the Encouragement of
Capital Investments, 1959, as amended (the Investment Law). The Investment Law
provides that a capital investment in eligible facilities may, upon application to the
Israel Investment Center of the Ministry of Industry and Trade of the State of Israel
(referred to as the Investment Center), be designated as an Approved Enterprise. Each
certificate of approval for an Approved Enterprise relates to a specific investment
program delineated both by its financial scope, including its capital sources and its
physical characteristics, for example, the equipment to be purchased and utilized pursuant
to the program. The tax benefits derived from any such certificate of approval relate only
to taxable income attributable to the specific Approved Enterprise.

A recent amendment to the Investment
Law which came into effect as of April 1, 2005 (the Amendment) has
significantly changed the provisions of the Investment Law. The Amendment limits the scope
of enterprises which may be approved by the Investment Center by determining criteria for
the approval of a facility as an Approved Enterprise, such as provisions generally
requiring that at least 25% of the income of an Approved Enterprise will be derived from
export. Additionally, as explained below, the Amendment sets forth major changes in the
manner in which tax benefits are awarded under the Investment Law whereby companies no
longer require Investment Center approval (and Approved Enterprise status) in order to
qualify for tax benefits. However, the Investment Law provides that terms and benefits
included in any certificate of approval already granted will remain subject to the
provisions of the Investment Law as in effect on the date of such approval. Therefore the
tax benefits granted to our Approved Enterprises under the Investment Law will generally
not be subject to the provisions of the Amendment.

# Tax Benefits Prior to
the Amendment

In general, taxable income of a
company derived from an Approved Enterprise was subject to corporate tax at the maximum
rate of 25% rather than the rates stated above (this will also apply to Approved
Enterprises approved after the Amendment, as explained below). The 25% corporate tax rate
applies for a period of time termed the benefit period. The benefit period is
a period of seven years commencing with the year in which the Approved Enterprise first
generates taxable income. In any event, the benefit period is limited to 12 years from the
commencement of production or 14 years from the year in which the approval was received,
whichever is earlier. Under certain circumstances (as further detailed below), the benefit
period may extend to a maximum of ten years from the commencement of the benefit period.
In the event that a company is operating under more than one approval or that only part of
its capital investments are approved (a Mixed Enterprise), its effective
Company Tax rate is the result of a weighted combination of the various applicable rates.

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A company which qualifies as a
Foreign Investors Company is entitled to an extended benefit period and
to further reductions in the tax rate normally applicable to Approved Enterprises. Subject
to certain conditions, a Foreign Investors Company is a company which
has more than 25% of its combined shareholders investment in share capital (in terms
of rights to profits, voting and the appointment of directors) and in long term
shareholders loans, as defined in the Investment Law, made by persons who are not
residents of Israel. The percentage owned by nonresidents of Israel for any tax year will
be determined by the lowest percentage in any of the above rights held by nonresidents
during that year. Foreign Investors Company will pay Company Tax at reduced rates
for an extended ten-year (rather than the otherwise applicable seven-year) period as
detailed below:

|Level of Foreign Investment   | Company Tax Rate | Benefit period (years)
|----------------------------- | ---------------- | ----------------------
|
|
|
|
|Over 0% but less than 25%     |                  |                       
|Over 25% but less than 49%    |                  |                       
|49% or more but less than 74% |                  |                       
|74% or more but less than 90% |                  |                       
|90% or more                   |                  |                       

There can be no assurance that the
above-mentioned shareholding proportion will be reached for each subsequent year.

Prior to the Amendment, a company
owning an Approved Enterprise approved after April 1, 1986 (or prior thereto provided no
government grants or loans had previously been granted regarding such enterprise) was
entitled to elect (as we have) to forego certain Government grants extended to Approved
Enterprises in return for an alternative route of tax benefits (the
Alternative Route). Under the Alternative Route, a companys
undistributed income derived from an Approved Enterprise is exempt from corporate tax for
a period of between two and ten years from the first year of taxable income, depending on
the geographic location of the Approved Enterprise within Israel, and such company is
eligible for the reduced tax rates under the Investment Law for the remainder of the
benefit period as mentioned above.

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Our production facilities have been
granted Approved Enterprise status under the Alternative Route according to
the Investment Law. The initial Approved Enterprise status was granted in 1988
(Initial Approved Enterprise). An extension program was granted Approved
Enterprise status in 1995 (the Extended Approved Enterprise). Income derived
from our Approved Enterprises is tax exempt during six years of the seven year tax benefit
period and is subject to a reduced tax rate of 25% in the seventh year. The seven year
period of benefits commences in the year the Approved Enterprise first earns taxable
income but is limited to twelve years from commencement of production or fourteen years
from date of approval, whichever is earlier. The period of tax benefits, relating to our
Initial Approved Enterprise, commenced in 1991 and expired in 1997. The period of tax
benefits relating to our Extended Approved Enterprise commenced in 1997 and will expire in
2006, as explained below.

In June 1995, we reached an agreement
with the tax authorities regarding our entitlement to benefits under the Investment Law.
The agreement, effective from tax year 1994 and thereafter, relates to the method of
determination of taxable income from our research and development activities. Pursuant to
the agreement, for the purpose of determining our tax liability, our income will be
allocated to our manufacturing plant and to our research and development center, according
to a formula based on the net costs plus royalties of the research and development center
and our profitability. Income allocated to the expansion of the manufacturing plant will
benefit from a ten-year tax exemption, while income allocated to the research and
development center will benefit from a two-year exemption, and for a five-year period
immediately following will be taxed at a 25% rate.

Our income to be attributed to our
Extended Approved Enterprise in any year will be computed as a ratio of the increase in
our sales turnover, if any, in that year to our turnover in the year before the Extended
Approved Enterprise commenced its tax benefits entitlement. The tax authorities have
reserved their right to reconsider our claim to such tax benefits in future years.

The entitlement to the above benefits
is conditional upon our fulfillment of the conditions stipulated by the law, regulations
published thereunder and the instruments of approval for the specific investments in the
Approved Enterprise. In the event of failure to comply with these conditions, the benefits
may be canceled and we may be required to refund the amount of the benefits, in whole or
in part, with the addition of linkage differences, interest and penalties.

Should we derive income from sources
other than the Approved Enterprise during the relevant periods of benefits, such income
will be taxable at regular corporate tax rates stated above.

A company that elected the
Alternative Route prior to the Amendment and that subsequently pays a dividend out of
income derived from the Approved Enterprise(s) during the tax exemption period will be
subject to Company Tax in the year the dividend is distributed in respect of the amount
distributed (including the corporate tax thereon), at the rate that would have been
applicable had the company not elected the Alternative Route (10%-25%, depending on the
level of foreign investment in the company, as explained above). In addition, the dividend
recipient is taxed at the reduced rate applicable to dividends from Approved Enterprises
(15%), if the dividend is distributed during the tax exemption period or within a
specified period thereafter. (In the event, however, that the company qualifies as a
Foreign Investors Company, there is no such time limitation). This tax must be
withheld by the company at source, regardless of whether the dividend is converted into
foreign currency.

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Subject to certain provisions
concerning income subject to the Alternative Route, all dividends are considered to be
attributable to the entire enterprise and the effective tax rate is the result of a
weighted combination of the various applicable tax rates.

The Investment Law also provides that
an Approved Enterprise is entitled to accelerated depreciation on its property and
equipment that are included in an approved investment program. We have not utilized this
benefit.

Grants and certain other incentives
received by a company in accordance with the Investment Law remain subject to final
ratification by the Israel Investment Center and final determination by the Israel Tax
Authority. Such ratification and determination are conditional upon fulfillment of all of
the terms of the approved program.

# Tax Benefits under the
Amendment

As a result of the Amendment, a
company is no longer required to acquire Approved Enterprise status in order to receive
the tax benefits previously available under the Alternative Route and therefore such
companies need not apply to the Investment Center for this purpose. However, the
Investment Center will continue to grant Approved Enterprise status to companies seeking
Governmental grants. A company may claim the tax benefits offered by the Investment Law
directly in its tax returns, provided that its facilities meet the criteria for tax
benefits set forth in the Amendment (a Benefited Enterprise). Companies are
also entitled to approach the Israeli Tax Authority for a pre-ruling regarding their
eligibility for benefits under the Amendment. The Amendment includes provisions intended
to ensure that a company will not enjoy both government grants and tax benefits for the
same investment program.

Tax benefits are available under the
Amendment to production facilities and other eligible facilities, which are generally
required to derive more than 25% of their business income from export. In order to receive
the tax benefits, the Amendment states that the company must make an investment in the
Benefited Enterprise exceeding a minimum amount specified in the Investment Law. Such
investment may be made over a period of no more than three years, such period concluding
at the end of the year in which the company requests to have the tax benefits apply to its
Benefited Enterprise (the Year of Election). Where the company requests to
have the tax benefits apply to an expansion of existing facilities, only the expansion
will be considered a Benefited Enterprise and the companys effective tax rate will
be the result of a weighted combination of the applicable rates. In the case of an
expansion of existing facilities, the minimum investment required in order to qualify as a
Benefited Enterprise is determined as a certain percentage of the companys
production assets before the expansion.

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The tax benefits available under the
Amendment to qualifying income of a Benefited Enterprise are determined by the geographic
location of the Benefited Enterprise in Israel. The Investment Law divides the country
into three zones  A, B and C, so that a Benefited Enterprise operating in Zone A
(which generally includes areas remote from the center of Israel) will receive the
greatest benefits and Benefited Enterprises in Zone C will receive the least benefits.

The Amendment provides that a company
producing income from a Benefited Enterprise in Zone A may elect either that (i) the
undistributed income derived from the Benefited Enterprise will be fully tax exempt for
the entire benefit period described below (tax exemption), in which case the
ordinary provisions described below concerning the taxation of the company and shareholder
for distribution of dividends will apply; or (ii) that the income from its Benefited
Enterprise will be subject to corporate tax at a rate of a 11.5%, in which case dividends
paid out of such income to a foreign resident will be taxed at a rate of 4% and the
company will not be subject to additional tax upon dividend distribution. Further benefits
are available in the event of certain large investments by multinational companies.
Benefited Enterprises located in Zones B and C will be exempt from tax for six and two
years, respectively, and subject to tax at a rate of 10%-25% for the remainder of the
benefit period, depending on the extent of foreign investment in the Company, as described
above.

Dividends paid out of income derived
by a Benefited Enterprise, or out of dividends received from a company whose income is
derived from a Benefited Enterprise, are generally subject to withholding tax at the rate
of 15%, such tax being deductible at source. The reduced withholding tax rate of 15% is
limited to dividends and distributions out of income derived during the benefit period and
actually paid at any time up to 12 years thereafter. A company qualifying for tax benefits
under the Amendment which pays a dividend out of income derived by its Benefited
Enterprise during the tax exemption period will be subject to corporate tax in respect of
the gross amount of the dividend. The rate of such corporate tax will be 25%, which is the
rate to which a Benefited Enterprise is generally subject. Such tax rate is lower in the
case of a qualified Foreign Investors Company. The dividend recipient is
subject to tax at the rate of 15% on the amount received which tax is deductible at
source.

The period for which tax benefits are
available under the Amendment is also determined by the geographical location of the
Benefited Enterprise in Israel. The benefit period for Benefited Enterprises in Zone A
will end on the earlier of (i) a period of ten years from the tax year in which the
company first derived taxable income from the Benefited Enterprise (the Commencement
Year); or (ii) twelve years (or in certain cases fourteen years) from the first day
of the Year of Election. The benefit period for Benefited Enterprises in Zones B and C
will extend until the earlier of (i) seven years from the Commencement Year or (ii) 12
years from the first day of the Year of Election. This period may be extended for
Benefited Enterprises owned by a Foreign Investors Company during all or
part of the benefit period.

Additionally, the Amendment sets
forth a minimal amount of foreign investment required for a company to be regarded a
Foreign Investors Company.

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We have selected the 2004 tax year as
our Year of Election, from which the period of benefits under the Investment Law are to
commence, by submitting a request to the Israeli Tax Authority as required under the
Investment Law.

There can be no assurance that we
will attain approval for additional tax benefits under the Amendment, or receive approval
for Approved Enterprises in the future.

Law for the Encouragement
of Industrial Research and Development, 1984

Under the Law for the Encouragement
of Industrial Research and Development (the Research Law), research and
development programs approved by the Research Committee (the Research
Committee) of the Office of the Chief Scientist (OCS) are eligible for
grants or loans if they meet certain criteria, in return for the payment of royalties from
the sale of the product developed in accordance with the program and subject to other
restrictions. Once a project is approved, the OCS will award grants of up to 50% of the
projects expenditures in return for royalties, usually at the rate of 3% to 5% of
sales of products developed with such grants, up to a dollar-linked amount equal to 100%
or 150% of such grants. For projects approved after January 1, 1999, the amount of
royalties payable is up to a dollar-linked amount equal to 100% of such grants plus
interest at LIBOR. There is no further liability for payment.

The terms of these grants prohibit
the manufacture outside of Israel without the prior consent of the Research Committee of
the OCS. Such approval, if granted, is generally subject to an increase in the total
amount to be repaid to the OCS to between 120% and 300% of the amount granted, depending
on the extent of the manufacturing to be conducted outside of Israel.

The Research Law also provides that
know-how from the research and development, which is used to produce the product, may not
be transferred to Israeli third parties without the approval of the Research Committee.
Until recently, the Research Law stated that such know-how may not be transferred to
non-Israeli third parties at all. A recent amendment to the Research Law has set forth
certain exceptions to this rule, however, the practical implications of such exceptions
are quite limited. The Research Law has stressed, that it is not just transfer of know-how
that is prohibited, but also transfer of any rights in such know-how. Such restriction
does not apply to exports from Israel of final products developed with such technologies.
Approval of the transfer may be granted only if the transferee undertakes to abide by all
of the provisions of the Research Law and regulations promulgated thereunder, including
the restrictions on the transfer of know-how and the obligation to pay royalties. There
can be no assurance that such consent, if requested, will be granted or, if granted, that
such consent will be on reasonable commercial terms.

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Tax Benefits and Grants
for Research and Development

Israeli tax law allows, under certain
conditions, a tax deduction in the year incurred for expenditures (including capital
expenditures) in scientific research and development projects, if the expenditures are
approved by the relevant Israeli Government Ministry (determined by the field of research)
and the research and development is for the promotion of the enterprise and is carried out
by or on behalf of the company seeking such deduction. Such expenditures not so approved
are deductible over a three-year period.

Law for the Encouragement
of Industry (Taxes), 1969

Under the Law for the Encouragement
of Industry (Taxes), 1969 (the Industry Encouragement Law), Industrial
Companies (as defined below) are entitled to the following tax benefits:

(a)       
          Amortization of purchases of know-how and patents over eight years for tax
          purposes.

(b)       
          The right to elect, under specified conditions, to file a consolidated tax
          return with other related Israeli Industrial Companies.

(c)       
          Amortization of expenses incurred in connection with certain public securities
          issuances over a three-year period.

(d)       
          Accelerated depreciation rates on equipment and buildings.

Eligibility for benefits under the
Industry Encouragement Law is not subject to receipt of prior approval from any
governmental authority. Under the Industry Encouragement Law, an Industrial
Company is defined as a company resident in Israel, at least 90% of the income of
which, in any tax year, determined in Israeli currency, exclusive of income from
government loans, capital gains, interest and dividends, is derived from an
Industrial Enterprise owned by it. An Industrial Enterprise is
defined as an enterprise whose major activity in a given tax year is industrial production
activity.

We believe that we currently qualify
as an Industrial Company within the definition of the Industry Encouragement Law. No
assurance can be given that we will continue to qualify as an Industrial Company or that
the benefits described above will be available in the future.

Calculation of Results
for Tax Purposes

The Israeli Income Tax Regulations
(Rules for Maintaining Accounting Records of Foreign Investors Companies and Certain
Partnerships and Determining Their Taxable Income)  1986 provide that as a Foreign
Investors Company (as defined in the Investment Law described above), if we elect to
follow such regulations, our taxable income or loss is to be calculated in dollars. Our
management has elected to apply these regulations and accordingly our taxable income or
loss is calculated in dollars in the manner set forth in such regulations.

58

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Capital Gains Tax on
Sales of Our Ordinary Shares

Until the end of the year 2002 and
provided we maintained our status as an industrial corporation, capital gains from the
sale of our securities were generally exempt from Israeli Capital Gains Tax. This
exemption did not apply to a shareholder whose taxable income is determined pursuant to
the Israeli Income Tax Law (Inflationary Adjustments) 1985, or to a person whose gains
from selling or otherwise disposing of our securities were deemed to be business income.

On January 1, 2006 an amendment to
the Israeli tax regime, or the 2006 Tax Reform, became effective. The 2006 Tax Reform
significantly changed the tax rates applicable to income derived from shares.

According to the 2006 Tax Reform, an
individual is subject to a 20% tax rate on real capital gains derived from the sale of
shares, as long as the individual is not a substantial shareholder (generally
a shareholder with 10% or more of the right to profits, right to nominate a director and
voting rights) in the company issuing the shares. The tax rate for gains from publicly
traded shares realized before January 1, 2006 is 15%.

A substantial shareholder will be
subject to tax at a rate of 25% in respect of real capital gains derived from the sale of
shares issued by a company in which he or she is a substantial shareholder. The
determination of whether the individual is a substantial shareholder will be made on the
date on which the securities are sold. In addition, the individual will be deemed to be a
substantial shareholder if at any time during the 12 months preceding the date of sale, he
or she was a substantial shareholder.

Non-Israeli residents are exempt from
Israeli capital gains tax on any gains derived from the sale of shares in an Israeli
corporation publicly traded on TASE and/or on a foreign stock exchange, provided such
gains do not derive from a permanent establishment of such shareholders in Israel and that
such shareholders did not acquire their shares prior to the issuers initial public
offering. However, non-Israeli corporations will not be entitled to such exemption if an
Israeli resident has a controlling interest of 25% or more in such non-Israeli
corporation, or is the beneficiary of, or is entitled to, 25% or more of the revenues or
profits of such non-Israeli corporation, whether directly or indirectly.

In some instances where our
shareholders may be liable for Israeli tax on the sale of their ordinary shares, the
payment of the consideration may be subject to the withholding of Israeli tax at the
source.

Pursuant to the treaty between the
governments of the United States and Israel with respect to taxes on income, or the
U.S.-Israel tax treaty, the sale, exchange or disposition of our ordinary shares by a
person who qualifies as a resident of the United States under the treaty and who is
entitled to claim the benefits afforded by the treaty, will generally not be subject to
Israeli capital gains tax. This exemption does not apply to a person who held, directly or
indirectly, shares representing 10% or more of the voting power in our company during any
part of the 12 month period preceding the sale, exchange or disposition, subject to
certain conditions. A sale, exchange or disposition of our shares by a U.S. resident
qualified under the treaty, who held, directly or indirectly, shares representing 10% or
more of the voting power in our company at any time during the 12 month period preceding
such sale, exchange or disposition, would be subject to Israeli tax, to the extent
applicable; however, under the treaty, this U.S. resident would be permitted to claim a
credit for these taxes against the U.S. income tax with respect to the sale, exchange or
disposition, subject to the limitations in U.S. laws applicable to foreign tax credits.

59

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Taxation of Dividends

Non-residents of Israel are subject
to income tax on income accrued or derived from sources in Israel.  These sources of
income include passive income such as dividends, royalties and interest, as well as
non-passive income from services rendered in Israel. On distributions of dividends
(other than bonus shares or stock dividends) to Israeli individuals and foreign resident
individuals and corporations we would be required to withhold income tax at the rate of
20%.  If the income out of which the dividend is being paid is attributable to an
Approved Enterprise under the Investment Law, the rate is 15%.  A different rate may
be provided for in a treaty between Israel and the shareholders country of
residence.  Under the U.S.-Israel tax treaty, if the income out of which the dividend
is being paid is not attributable to an Approved Enterprise, then we are required to
withhold income tax at a rate of 12.5% with respect to shareholders that are U.S.
corporations and held at least 10% of our voting power in the 12 month period preceding
the distribution of such dividends.

Residents of the United States will
generally have taxes in Israel withheld at source. Such persons generally would be
entitled to a credit or deduction for United States Federal income tax purposes for the
amount of such taxes withheld, subject to limitations applicable to foreign tax credits.

Passive Foreign
Investment Company Status under U.S. Federal Income Tax Law

In general, a foreign corporation
will be classified for U.S. tax purposes as a passive foreign investment company
(hereafter also referred to as a PFIC) in any taxable year in which either (i)
75% or more of its gross income (including the pro rata gross income of any company (U.S.
or foreign) in which it is considered to own 25% or more of the ordinary shares by value)
for the taxable year is passive income, or (ii) at least 50% of the average value of all
of its gross assets (including the pro rata fair market value of the assets of any company
in which it is considered to own 25% or more of the ordinary shares by value) during the
taxable year, calculated quarterly by value, produce, or are held for the production of,
passive income. Passive income for these purposes includes items such as dividends,
interest, royalties, rents and gains from commodities and securities transactions.

60

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If we are classified as a passive
foreign investment company, highly complex rules will apply to our U.S. shareholders.
Accordingly, U.S. shareholders are urged to consult their tax advisors regarding the
application of such rules.

If a corporation is a passive foreign
investment company, a U.S. shareholder will be subject to one of three alternative taxing
regimes:

The simplest is the QEF
regime. If the shareholder elects to treat the PFIC as a qualified electing
fund (QEF), then each year the shareholder includes in its gross income
a proportionate share of the PFICs ordinary income and net capital gain. A second
regime may be elected if the PFIC stock is marketable. The U.S. shareholder
may elect to mark the stock to market each year. At the end of each taxable
year, the shareholder recognizes gain equal to the excess of the fair market value of the
PFIC stock over the shareholders tax basis in the stock. (Losses may also be
recognized to the extent of previously recognized gains.)

A U.S. shareholder making neither of
these elections is subject to the excess distribution regime. The tax is
triggered when the shareholder receives an excess distribution from the PFIC.
An excess distribution is either (1) a distribution with respect to stock that is greater
than 125% of the average of such distributions over the preceding three years, or (2) 100%
of the gain from the disposition of shares in the PFIC.

An excess distribution is subject to
special tax rules. In most cases, only a portion of it is included in the gross income of
the U.S. shareholder and taxed at normal rates. The remainder is never so included, but is
used as the basis for calculating a deferred tax amount, which is simply added
to the shareholders tax bill.

The deferred tax amount is computed
as follows. The excess distribution is first ratably allocated, share by share, to each
day of the shareholders holding period. Portions allocated to the current year, and
to any pre-PFIC years (that is, years before 1987, when there were no PFICs, or years
before the first year in which the company was a PFIC with respect to that shareholder),
are included in ordinary income for the current year. Portions allocated to prior PFIC
years are hypothetically taxed at the highest marginal rate in effect for those years
(without regard to the shareholders actual rate or to any deductions or credits for
those years). To this hypothetical tax is added the interest that the shareholder would
have paid if it were simply paying that tax late for that year. The sum of the tax and the
interest charge is the deferred tax amount, which cannot be offset or otherwise affected
by current net operating losses or other deductions.

A U.S. person who inherits shares in
a foreign corporation that was a PFIC in the hands of the decedent (who did not make
either of the elections described above), is denied the otherwise available step-up in the
tax basis of such shares to fair market value at the date of death. The U.S. person steps
into the shoes of the decedent and will be subject to the rules described above.

61

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Although a determination as to a
corporations PFIC status is made annually, an initial determination that a
corporation is a PFIC for any taxable year generally will cause the above-described
consequences to apply for all future years as to U.S. shareholders who held shares in the
corporation at any time during the PFIC taxable year and who made neither a valid QEF
election with respect to such shares nor a valid election to mark such shares to market.
This will be true even if the corporation loses its PFIC status in later years. However,
with respect to a PFIC that does not make any distributions or deemed distributions, the
above tax treatment would apply only to gains realized on the disposition of such shares
by a U.S. shareholder.

If we are classified as a PFIC,
complicated rules will apply to our U.S. shareholders. Our status in future years will
depend on our assets and activities in those years, although shareholders will be treated
as continuing to own an interest in a passive foreign investment company if we are a
passive foreign investment company in any year in which a shareholder owns our shares,
unless certain elections are made.

This discussion does not address all
aspects of U.S. federal income taxation that may be relevant to a U.S. shareholder in
light of his or her particular circumstances or to a U.S. shareholder subject to special
treatment under U.S. federal income tax law. U.S. shareholders are urged to consult their
tax advisors about the U.S. federal income taxation rules to which they will be subject,
as well as the PFIC rules, including the advisability, procedure and timing of making a
mark-to-market election, in connection with their holding of our shares, including
warrants or rights to acquire our shares.

Tax Assessment

Silicom Ltd. received final tax
assessments for all years up to and including the tax year ended December 31, 2000. Our
U.S. subsidiary, Silicom Connectivity Solutions, Inc., has not yet been assessed for tax
purposes since incorporation in 1993. In accordance with the provisions of the Income Tax
Ordinance, tax returns submitted up to and including the 2001 tax year can be regarded as
final.

# Documents on Display

We are required to file reports and
other information with the Securities and Exchange Commission (the SEC) under
the Securities Exchange Act of 1934 (the Exchange Act) and the regulations
thereunder applicable to foreign private issuers. Although as a foreign private issuer we
are not required to file periodic information as frequently or as promptly as United
States companies, we generally do publicly announce our quarterly and year-end results
promptly and file periodic information with the SEC under cover of Form 6-K. We are also
exempt from the rules under the Exchange Act prescribing the furnishing and content of
proxy statements and our officers, directors and principal shareholders are exempt from
the reporting and other provisions in Section 16 of the Exchange Act.

62

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You may review a copy of our filings
with the SEC, including any exhibits and schedules, at the SECs public reference
facilities in Room 1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549
and at the regional offices of the SEC located at the Northwestern Atrium Center, 500 West
Madison Street, Suite 1400, Chicago, Illinois 60661. You may also obtain copies of such
materials from the Public Reference Section of the SEC, Room 1024, Judiciary Plaza, 450
Fifth Street, N.W., Washington, D.C. 20549, at prescribed rates. You may call the SEC at
1-800-SEC-0330 for further information on the public reference rooms. In addition, such
information concerning our company can be inspected and copied at the offices of the
National Association of Securities Dealers, Inc., 9513 Key West Avenue, Rockville,
Maryland 20850 and at the offices of the Israel Securities Authority at 22 Kanfei Nesharim
St., Jerusalem, Israel. As a foreign private issuer, all documents which were filed after
November 4, 2002 on the SECs EDGAR system will be available for retrieval on the
SECs website at www.sec.gov. You may read and copy any reports, statements or other
information that we file with the SEC at the SEC facilities listed above. These SEC
filings are also available to the public from commercial document retrieval services. The
documents referred to in this document may be inspected at the Companys offices,
located at 8 Hanagar Street, Kfar Sava, Israel 44000.

Any statement in this annual report
about any of our contracts or other documents is not necessarily complete. If the contract
or document is filed as an exhibit to the annual report the contract or document is deemed
to modify the description contained in this annual report. We urge you to review the
exhibits themselves for a complete description of the contract or document.

|Item 11. |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|-------- |  | ----------------------------------------------------------

Market risk represents the risk of
changes in the value of a financial instrument caused by fluctuations in interest rates,
equity prices and foreign exchange rates.

# Interest Rate Risk

At December 31, 2005 we had a short
term loan in the amount of $500,000. This loan was obtained on December 14, 2005 bore
interest at a rate of LIBOR plus 1.6%. (See Item 4. Information on the Company
 History and Development of the Company.) This loan was repaid on February 28,
2006. Hence, between December 14, 2005 and February 28, 2006 there was minimal exposure to
interest rate risk in the event that LIBOR increased. As of March 1, there was no exposure
to interest rate risk.

# Equity Price Risk

At December 31, 2005 we did not have
any marketable securities which were recorded at a fair value, hence there was no exposure
to equity price risk.

63

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# Foreign Currency
Exchange Risk

At December 31, 2005 we had accounts
receivable in New Israeli Shekels (NIS) or in funds linked thereto in the amount of
$642,000. Market risk was estimated as the potential decrease in fair value resulting from
a hypothetical 10% increase in the year-end Dollar exchange rate. Assuming such increase
in the Dollar exchange rate, the fair value of our accounts receivable would decrease by
$58,000. At December 31, 2005 we had accounts payable in New Israeli Shekels (NIS) or in
funds linked thereto in the amount of $2,367,000. Market risk was estimated as the
potential increase in fair value resulting from a hypothetical 10% decrease in the
year-end Dollar exchange rate. Assuming such decrease in the Dollar exchange rate, the
fair value of our accounts payable would increase by $263,000.

In 2005 there was an increase of
6.85% in the Dollar exchange rate which resulted in an aggregate decrease in the fair
value of our assets of $73,000 and an aggregate decrease in the fair value of our
liabilities of $83,000.

As at December 31, 2005 we were not
engaged in any hedging transactions.

|Item 12. |  | DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES
|-------- |  | ------------------------------------------------------

Not applicable.

# PART II.

|Item 13. |  | DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES
|-------- |  | -----------------------------------------------

None.

|Item 14. |  | MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS
|-------- |  | ----------------------------------------------------------------------------

None.

|Item 15. |  | CONTROLS AND PROCEDURES
|-------- |  | -----------------------

Our
chief executive officer and chief financial officer, after evaluating the effectiveness of
our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as
of December 31, 2005, have concluded that, as of such date, our disclosure controls and
procedures were effective to ensure that the information required in the reports that we
file or submit under the Exchange Act is recorded, processed, summarized and reported,
within the time periods specified in the SECs rules and forms, and such information
is accumulated and communicated to our management, including our chief executive officer
and chief financial officer, as appropriate to allow timely decisions regarding required
disclosure.

|Item 16. |  | Reserved
|-------- |  | --------

64

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|Item 16A. |  | AUDIT COMMITTEE FINANCIAL EXPERT
|--------- |  | --------------------------------

Our board of directors has determined
that Ms. Einat Domb-Har is our audit committee financial expert.

|Item 16B. |  | CODE OF ETHICS
|--------- |  | --------------

Our company has adopted a code of
ethics, which applies to all of our employees, officers and directors, including our chief
executive officer, our chief financial officer and our principal accountant. A copy of the
code of ethics will provided to any person upon request.

|Item 16C. |  | PRINCIPAL ACCOUNTANT FEES AND SERVICES
|--------- |  | --------------------------------------

The following table presents fees for
professional audit services rendered by Somekh Chaikin for the audit of the Companys
consolidated annual financial statements for the years ended December 31, 2005 and
2004, and fees billed for other services rendered by Somekh Chaikin, a member firm of KPMG
International.

|                  | 2005 | 2004
|----------------- | ---- | ----
|
|
|
|
|Audit Fees(1)     |      |     
|                  |      |     
|Tax Fees(2)       |      |     
|                  |      |     
|Other services(3) |      |     

|(1) | Audit
fees consist of fees for professional services rendered for the audit of the Companys
consolidated financial statements and services normally provided by the independent
auditor in connection with statutory and regulatory filings or engagements.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Tax
services fees consist of compliance fees for the preparation of original and amended tax
returns and claims for refunds.
|--- | ----------------------------------------------------------------------------------------------------------------------------

|Item 16D. |  | EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES
|--------- |  | ----------------------------------------------------------

Not applicable.

|Item 16E. |  | PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS
|--------- |  | ----------------------------------------------------------------------

Not applicable.

65

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# PART III.

|Item 17. |  | FINANCIAL STATEMENTS
|-------- |  | --------------------

Not applicable

|Item 18. |  | FINANCIAL STATEMENTS
|-------- |  | --------------------

See pages F-1 to F-34.

66

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|Item 19. |  | EXHIBITS
|-------- |  | --------

|1.1 |  | Articles
of Association, adopted on February 1, 1994, filed by us as an Exhibit to our annual
             report on Form 20-F for the fiscal year ended December 31, 2000, as filed
with the Securities and              Exchange Commission on June 30, 2001, and
incorporated herein by reference (other than Article              122).
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|1.2 |  | Article
122 of our Articles of Association as amended on January 7, 2004, filed by us as an
             Exhibit to our annual report on Form 20-F for the fiscal year ended December
31, 2003, as filed              with the Securities and Exchange Commission on June 30,
2004, and incorporated herein by              reference.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.1. |  | Lease
between the Company and Yaakov Metzkin and Dov Segev, for premises in Kfar Sava, Israel,
             dated November 1, 1994, and amendment dated March 17, 2002, filed by us as
an Exhibit to our              annual report on Form 20-F for the fiscal year ended
December 31, 2001, as filed with the              Securities and Exchange Commission on
June 27, 2002, and incorporated herein by reference. As              this lease and the
amendment are written in Hebrew, a summary of each was included in the Exhibit.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.2 |  | Lease
between the Company and Ground A.S. Ltd., for manufacturing facility in Yokneam, Israel,
             dated June 27, 2000. As this lease is written in Hebrew, a summary was filed
by us as an Exhibit              to our annual report on Form 20-F for the fiscal year
ended December 31, 2000, as filed with the              Securities and Exchange
Commission on June 30, 2001. It is incorporated herein by reference.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.3 |  | Lease
between Silicom Connectivity Solutions, Inc. and RAD Data Communications Inc., for space
in              Mahwah, New Jersey, dated as of September 1, 1997, filed by us as an
Exhibit to our annual report              on Form 20-F for the fiscal year ended December
31, 2000, as filed with the Securities and              Exchange Commission on June 30,
2001, and incorporated herein by reference.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.4 |  | Sublease
Agreement between Silicom Connectivity Solutions, Inc. and Radcom Equipmet, Inc., for
space              in Paramus, New Jersey, dated as of February 1, 2004, filed by us as
an Exhibit to our annual              report on Form 20-F for the fiscal year ended
December 31, 2003, as filed with the Securities              and Exchange Commission on
June 30, 2004, and incorporated herein by reference.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.5 |  | Addendum
to Lease dated June 27, 2000, dated as of May 5, 2005, between the Company, Ground A.S.
             Ltd., Shaarei Haeer Investment Company Ltd. and Kanyon HaDrachim No. 1
Yokneam Ltd. filed by us              as an Exhibit to our annual report on Form 20-F for
the fiscal year ended December 31, 2004, as              filed with the Securities and
Exchange Commission on May 31, 2005, and incorporated herein by              reference.
As this addendum is written in Hebrew, a translation was included in the Exhibit.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

67

---

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|8. |  | List
of subsidiaries, filed by us as an Exhibit to our annual report on Form 20-F for the
fiscal              year ended December 31, 2000, as filed with the Securities and
Exchange Commission on June 30,              2001, and incorporated herein by reference.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|12.1 |  | Certification
by Chief Executive Officer pursuant to section 302 of the Sarbanes-Oxley Act of
             2002.
|---- |  | ----------------------------------------------------------------------------------------------------------------

|12.2 |  | Certification
by Chief Financial Officer pursuant to section 302 of the Sarbanes-Oxley Act of
             2002.
|---- |  | ----------------------------------------------------------------------------------------------------------------

|13.1 |  | Certification
by Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of
             2002.
|---- |  | ----------------------------------------------------------------------------------------------------------------

|13.2 |  | Certification
by Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of
             2002.
|---- |  | ----------------------------------------------------------------------------------------------------------------

|14.1 |  | Opinion
of McGladrey & Pullen, LLP, dated January 6, 2003, on the financial statements of Silicom
             Connectivity Solutions, Inc., for the two years ended December 31, 2001 and
2002, filed by us as              an Exhibit to our annual report on Form 20-F for the
fiscal year ended December 31, 2003, as              filed with the Securities and
Exchange Commission on June 30, 2004, and incorporated herein by              reference.
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|14.2 |  | Opinion
of McGladrey & Pullen, LLP, dated January 6, 2003, on the financial statements of Silicom
             Connectivity Solutions, Inc., for the year ended December 31, 2002 filed by
us as an Exhibit to              our annual report on Form 20-F for the fiscal year ended
December 31, 2004, as filed with the              Securities and Exchange Commission on
May 31, 2005, and incorporated herein by reference.
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

68

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# SIGNATURES

The Registrant hereby certifies that
it meets all of the requirements for filing on Form 20-F and that it has duly caused and
authorized the undersigned to sign this annual report on its behalf.

| |  | SILICOM LIMITEDBy: /s/ Shaike Orbach
Shaike OrbachChief Executive Officer
| |  | ---------------------------------------------------------------------------------------

June 13, 2006

69

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# Silicom Ltd.

# and its Consolidated
Subsidiary

# Financial Statements

# December 31, 2005

F - 1

---

---



|Silicom Ltd. and its Consolidated Subsidiary             
|---------------------------------------------------------
|                                                         
|Consolidated Financial Statements as of December 31, 2005
|                                                         
|                                                         

# Contents

|                                                           | Page
|---------------------------------------------------------- | ----
|
|
|
|
|Report of Independent Registered Public Accounting Firm    | F-3 
|                                                          
|                                                          
|Consolidated Financial Statements:                        
|                                                          
|Consolidated Balance Sheets                                | F-4 
|                                                          
|Consolidated Statements of Income                          | F-6 
|                                                          
|Consolidated Statements of Changes in Shareholders' Equity | F-7 
|                                                          
|Consolidated Statements of Cash Flows                      | F-8 
|                                                          
|Notes to Consolidated Financial Statements                 | F-9 

F - 2

---

---



# Report of Independent
Registered Public Accounting Firm

# To the Board of
Directors and Shareholders of Silicom Ltd. and its Subsidiary

We have audited the accompanying
consolidated balance sheets of Silicom Ltd. (Silicom) and its subsidiary as of
December 31, 2005 and 2004 and the related consolidated statements of income, changes in
shareholders equity and cash flows for each of the years in the three-year period
ended December 31, 2005. These consolidated financial statements are the responsibility of
Silicoms board of directors and management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance
with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance that
the financial statements are free of material misstatement. An audit includes examining,
on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by the board of directors and management, as well as evaluating
the overall financial statements presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, based upon our
audits, the aforementioned consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Silicom and its subsidiary as
of December 31, 2005 and 2004 and the consolidated results of their operations, changes in
stockholders equity, and their cash flows for each of the years in the three-year period
ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

Somekh Chaikin
Certified Public Accountants (Isr.)
Member Firm of KPMG International

Tel Aviv, Israel, April
24, 2006

F - 3

---

---



|Silicom Ltd. and its Consolidated Subsidiary
|--------------------------------------------
|                                            
|Consolidated Balance Sheets at December 31  
|                                            
|                                            

|                                   |  | 2005 | 2004
|---------------------------------- |  | ---- | ----
|
|
|
|
|Assets                             |  |      |     
|                                   |  |     
|Current assets                     |  |     
|Cash and cash equivalents          |  |      | 3   
|Investment securities              |  |      | 4   
|Receivables:                       |  |     
|Trade                              |  |      | 11A 
|Other                              |  |      | 11B 
|Inventories                        |  |      | 11C 
|                                   |  |      |     
|                                   |  |     
|Total current assets               |  |      |     
|                                   |  |      |     
|                                   |  |     
|                                   |  |     
|Assets held for severance benefits |  |      | 6   
|                                   |  |      |     
|                                   |  |     
|Property, plant and equipment      |  |      | 5   
|                                   |  |     
|Cost                               |  |      |     
|Less - accumulated depreciation    |  |      |     
|                                   |  |      |     
|                                   |  |     
|Net, property and equipment        |  |      |     
|                                   |  |      |     
|                                   |  |     
|Other assets                       |  |      | 7   
|                                   |  |      |     
|                                   |  |     
|                                   |  |     
|                                   |  |     
|Total assets                       |  |      |     
|                                   |  |      |     

|/S/ Avi Eizenman
Avi EizenmanChairman of the Board of Directors | /S/ Shaike Orbach
Shaike OrbachChief Executive Officer | /S/ Eran Gilad
Eran GiladChief Financial Officer
|----------------------------------------------------------------------------- | -------------------------------------------------------------------- | --------------------------------------------------------------

Kfar-Saba, Israel: April 24, 2006

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

F - 4

---

---



|Silicom Ltd. and its Consolidated Subsidiary
|--------------------------------------------
|                                            
|Consolidated Balance Sheets at December 31  
|                                            
|                                            

|                                                         |  | 2005 | 2004
|-------------------------------------------------------- |  | ---- | ----
|
|
|
|
|Liabilities and shareholders' equity                     |  |      |     
|                                                         |  |     
|Current liabilities                                      |  |     
|Short-term bank credit                                   |  |      |     
|Trade accounts payable                                   |  |      |     
|Other accounts payable and accrued expenses              |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Total current liabilities                                |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Long-term liability                                      |  |     
|                                                         |  |     
|Liability for employees severance benefits               |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Total liabilities                                        |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Commitments and contingencies                            |  |      |     
|                                                         |  |     
|                                                         |  |     
|Shareholders' equity                                     |  |      |     
|Ordinary shares, NIS 0.001 par value;                    |  |     
|authorized 10,000,000 shares;                            |  |     
|issued and outstanding 4,351,050 shares as of            |  |     
|December 31, 2005 and 4,213,550 as of December 31, 2004  |  |      |     
|Additional paid in capital                               |  |      |     
|Treasury shares (at cost) - 14,971 ordinary shares as at |  |     
|December 31, 2005 and 2004                               |  |      |     
|Retained deficit                                         |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Total shareholders' equity                               |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Total liabilities and shareholders' equity               |  |      |     
|                                                         |  |      |     

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

F - 5

---

---



|Silicom Ltd. and its Consolidated Subsidiary                     
|-----------------------------------------------------------------
|                                                                 
|Consolidated Statements of Income for the Year Ended December 31,
|                                                                 
|                                                                 

|                                          |  | 2005 | 2004 | 2003
|----------------------------------------- |  | ---- | ---- | ----
|
|
|
|
|Sales                                     |  |      | 12A  |     
|                                          |  |     
|Cost of sales                             |  |      | 12B  |     
|                                          |  |      |      |     
|                                          |  |     
|Gross profit                              |  |      |      |     
|                                          |  |      |      |     
|                                          |  |     
|Research and development costs            |  |      | 12C  |     
|Total costs                               |  |      |      |     
|Less: royalty-bearing participations, net |  |      | 8A   |     
|                                          |  |      |      |     
|                                          |  |     
|Research and development costs, net       |  |      |      |     
|                                          |  |      |      |     
|                                          |  |     
|Selling, marketing, general and           |  |     
|administrative expenses                   |  |     
|Selling and marketing expenses            |  |      | 12D  |     
|General and administrative expenses       |  |      |      |     
|                                          |  |      |      |     
|                                          |  |     
|                                          |  |      |      |     
|                                          |  |      |      |     
|                                          |  |     
|Operating income (loss)                   |  |      |      |     
|                                          |  |     
|Financial (expenses) income, net          |  |      | 12E  |     
|                                          |  |      |      |     
|                                          |  |     
|Net income (loss) for the year            |  |      |      |     
|                                          |  |      |      |     
|                                          |  |     
|Income (loss) per share:                  |  |     
|Basic income (loss) per ordinary share    |  |      |      |     
|                                          |  |      |      |     
|                                          |  |     
|Weighted average number of ordinary       |  |     
|shares used to compute basic income       |  |     
|(loss) per share (in thousands)           |  |      |      |     
|                                          |  |      |      |     
|                                          |  |     
|                                          |  |     
|Diluted income (loss) per ordinary share  |  |      |      |     
|                                          |  |      |      |     
|                                          |  |     
|Weighted average number of ordinary       |  |     
|shares used to compute diluted income     |  |     
|(loss) per share (in thousands)           |  |      |      |     
|                                          |  |      |      |     

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

F - 6

---

---



|Silicom Ltd. and its Consolidated Subsidiary 
|---------------------------------------------
|                                             
|Statements of Changes in Shareholders' Equity
|                                             
|                                             

|                        | Ordinary
shares | Share
capital | Additional
paid-in
capital | Cost of
shares held
by the
Subsidiary | Retained
earnings
(deficit)* | Total
|----------------------- | --------------- | ------------- | -------------------------- | ------------------------------------- | ---------------------------- | -----
|
|
|
|
|Balance at              |                 |               |                            |                                       |                              |      
|January 1, 2003         |                 |               |                            | 4,110,329                             |                              |      
|                        |                 |              
|Changes during 2003     |                 |              
|Ordinary shares issued  |                 |              
|in connection with the  |                 |              
|exercise of stock       |                 |              
|options                 |                 |               |                            | 1,500                                 |                              |      
|Net loss for the year   |                 |               |                            | -                                     |                              |      
|                        |                 |               |                            |                                       |                              |      
|                        |                 |              
|Balance at              |                 |              
|December 31, 2003       |                 |               |                            | 4,111,829                             |                              |      
|                        |                 |              
|Changes during 2004     |                 |              
|Ordinary shares issued  |                 |              
|in connection with the  |                 |              
|exercise of stock       |                 |              
|options                 |                 |               |                            | 86,750                                |                              |      
|                        |                 |              
|Net loss for the year   |                 |               |                            | -                                     |                              |      
|                        |                 |               |                            |                                       |                              |      
|                        |                 |              
|Balance at              |                 |              
|December 31, 2004       |                 |               |                            | 4,198,579                             |                              |      
|                        |                 |              
|Changes during 2005     |                 |              
|Ordinary shares issued  |                 |              
|in connection with the  |                 |              
|exercise of stock       |                 |              
|options                 |                 |               |                            | 137,500                               |                              |      
|Net income for the year |                 |               |                            | -                                     |                              |      
|                        |                 |               |                            |                                       |                              |      
|                        |                 |              
|Balance at              |                 |              
|December 31, 2005       |                 |               |                            | 4,336,079                             |                              |      
|                        |                 |               |                            |                                       |                              |      

|* | See
Note 9D.
|- | ------------

|** | Net
of 14,971 shares held by the subsidiary.
|-- | --------------------------------------------

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

F - 7

---

---



|Silicom Ltd. and its Consolidated Subsidiary            
|--------------------------------------------------------
|                                                        
|Statements of Cash Flows for the Year Ended December 31,
|                                                        
|                                                        

|                                                             | 2005 | 2004 | 2003
|------------------------------------------------------------ | ---- | ---- | ----
|
|
|
|
|Cash flows from operating activities                         |      |      |     
|Net income (loss) for the year                               |      |      |     
|Adjustments to reconcile net income to net cash              |      |     
|provided by operating activities:                            |      |     
|Depreciation and amortization of property, plant and         |      |     
|Equipment                                                    |      |      |     
|Severance, net                                               |      |      |     
|Amortization of discounts or premium of                      |      |     
|investment security and interest                             |      |      |     
|                                                             |      |     
|Changes in operating assets and liabilities                  |      |     
|Increase in trade receivables                                |      |      |     
|Increase in other receivables                                |      |      |     
|Increase in inventories                                      |      |      |     
|Increase (decrease) in trade payables and accruals           |      |      |     
|Increase  in other payables and accruals                     |      |      |     
|                                                             |      |      |     
|Net cash provided by (used in) operating activities          |      |      |     
|                                                             |      |      |     
|                                                             |      |     
|Cash flows from investing activities                         |      |     
|Acquisition of property and equipment                        |      |      |     
|Proceeds from maturity of investment securities and deposits |      |      |     
|Purchase of investment securities and deposits               |      |      |     
|                                                             |      |      |     
|Net cash provided by investing activities                    |      |      |     
|                                                             |      |      |     
|                                                             |      |     
|Cash flows from financing activities                         |      |     
|Short-term bank credit, net                                  |      |      |     
|Issuance of ordinary shares in connection with the           |      |     
|exercise of stock options                                    |      |      |     
|                                                             |      |      |     
|Net cash provided by financing activities                    |      |      |     
|                                                             |      |      |     
|                                                             |      |     
|Net increase (decrease) in cash and cash equivalents         |      |      |     
|                                                             |      |     
|Cash and cash equivalents at beginning of year               |      |      |     
|                                                             |      |      |     
|Cash and cash equivalents at end of year                     |      |      |     
|                                                             |      |      |     
|                                                             |      |     
|                                                             |      |     
|Supplementary disclosure of cash flow information:           |      |     
|Cash paid during the year for:                               |      |     
|Financing expenses                                           |      |      |     
|                                                             |      |      |     
|Taxes on income                                              |      |      |     
|                                                             |      |      |     

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

F - 8

---

---



|Silicom Ltd. and its Consolidated Subsidiary  
|----------------------------------------------
|                                              
|Notes to the Consolidated Financial Statements
|                                              
|                                              

|Note 1 |  | General
|------ | - | -------

| | Silicom
Ltd. (Silicom) is an Israeli corporation engaged in designing, manufacturing,
marketing and supporting server networking solutions for manufacturers of storage systems,
internet traffic management systems, security appliances and other manufacturers providing
a variety of server-based systems (Server Networking Products). It also offers
an extensive range of connectivity solutions for portable computers, broadband Internet
access, Multi Tenant Unit (MTU), home networking, and other hardware manufacturers
(Traditional Products). Silicoms products and technologies combine
hardware and software.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Silicom
markets its products directly, through (i) its US-based subsidiary, (ii) a worldwide
network of independent distributors and (iii) OEMs which sell the Companys
connectivity products under their own private labels or incorporate the Companys
products into their products.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Most
of the Companys raw materials are readily available, but certain key components are
currently available from only one source and others are available from a limited number of
sources.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
these financial statements the term Company refers to the Silicom Ltd. and its
wholly owned subsidiary, Silicom Connectivity Solutions, Inc. whereas the term
subsidiary refers to Silicom Connectivity Solutions, Inc., a wholly owned
subsidiary of Silicom Ltd., that is engaged in marketing the products of Silicom Ltd. in
North America.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | During
December 2005, Silicom obtained approval to list its shares on the Tel Aviv Stock Exchange
(TASE). Trading on the TASE commenced on December 27, 2005. Silicoms shares continue
to be listed on the Nasdaq and Silicom continues to be subject to all rules and
regulations of Nasdaq and the U.S. Securities and Exchange Commission (SEC).
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Note 2 |  | Significant
Accounting Policies
|------ | - | -------------------------------

| | The
significant accounting policies, applied on a consistent basis, are as follows:
| | -----------------------------------------------------------------------------------

| | A. | Financial
statements in U.S. dollars
| | -- | ------------------------------------

| | Substantially
all sales of the Company are made outside of Israel (see note 12A regarding geographical
destination), in U.S. dollars (dollars). Most purchases of materials and
supplies and marketing costs are made or incurred outside Israel, primarily in dollars.
Thus, the functional currency of the Company is the dollar.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Transactions
and balances in other currencies are remeasured into dollars in accordance with the
principles set forth in Statement No. 52- Foreign Currency Translations of the
Financial Accounting Standards Board of the United States (FASB).
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | All
exchange gains and losses from remeasurement of monetary balance sheet items denominated
in non-dollar currencies are reflected in the statement of income (loss) when they arise.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 9

---

---

|Note 2 |  | Significant
Accounting Policies (contd)
|------ | - | ----------------------------------------

| | B. | Principles
of consolidation
| | -- | ---------------------------

| | The
consolidated financial statements include the accounts of Silicom Ltd. and its wholly
owned subsidiary.
| | -----------------------------------------------------------------------------------------------------------

| | All
significant intercompany balances and transactions have been eliminated in consolidation.
| | ---------------------------------------------------------------------------------------------

| | C. | Estimates
and assumptions
| | -- | -------------------------

| | The
preparation of the consolidated financial statements in conformity with generally accepted
accounting principles in the United States of America (US GAAP) requires
management to make estimates and assumptions that affect the reported amounts of assets
and liabilities and the disclosure of contingent assets and liabilities at the date of the
consolidated financial statements, and the reported amounts of revenue and expenses during
the reporting years. These are managements best estimates based on experience and
historical data, however, actual results may vary from these estimates.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | D. | Cash
and cash equivalents
| | -- | -------------------------

| | The
Company considers all highly liquid debt instruments with original maturities of three
months or less at date of purchase, to be cash equivalents.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------

| | E. | Investment
securities
| | -- | ---------------------

| | Investments
which the Company has the intent and ability to hold to maturity are classified as
held-to-maturity investments as defined in Statement of Financial Accounting Standard No.
115 Accounting for Certain Investments in Debt and Equity Securities and are
recorded at amortized cost adjusted for the amortization or accretion of premiums or
discounts.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | A
decline in the market value of any held-to-maturity security below cost, that is deemed to
be other than temporary, results in a reduction in carrying amount to fair value. The
impairment is charged to the statement of income and a new carrying basis is established.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Interest
income is accrued as earned. Premiums and discounts are amortized over the life of the
related held-to-maturity security as an adjustment to yield using the effective interest
method.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | F. | Trade
receivables
| | -- | -----------------

| | Accounts
receivable are recorded at cost, less the related allowance for doubtful accounts
receivable. Management considers current information and events regarding the
customers ability to repay their obligation and judges accounts receivable to be
impaired when it is probable that the Company will be unable to collect all amounts due.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | G. | Inventories
| | -- | -----------

| | Inventories
are stated at the lower of cost or market. Cost is determined using the
average-cost method for raw materials.
| | ----------------------------------------------------------------------------------------------------------------------------

| | The
Company writes down obsolete or slow moving inventory to its lower of cost or market.
| | -----------------------------------------------------------------------------------------

F - 10

---

---

|Note 2 |  | Significant
Accounting Policies (contd)
|------ | - | ----------------------------------------

| | H. | Assets
held for severance benefits
| | -- | ----------------------------------

| | Assets
held for employee severance benefits represent contributions to severance pay funds and
cash surrender value of life insurance policies that are recorded at their current
redemption value, which also represents their fair value.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | I. | Property
plant and equipment
| | -- | ----------------------------

| | Property
plant and equipment are stated at cost.
| | ------------------------------------------------

| | Depreciation
is calculated on the straight-line method over the estimated useful life of the assets.
| | ----------------------------------------------------------------------------------------------------

| | Annual
rates of depreciation are as follows:
| | --------------------------------------------

| |  | %
| |  | -
|
|
|
|
| |  |  
| |  |  
| |  |  
| |  |  
| |  |  

| | (*) | Leasehold improvements are amortized by the straight-line method over the term
                    of the lease or the estimated useful life of the improvements, whichever is
                    shorter.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | J. | Other
assets
| | -- | ------------

| | Other
assets consist of patents. The cost of patents is amortized by the straight-line method
over the estimated useful lives of the respective assets. The remaining weighted average
life of patents at December 31, 2005 is six years.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company reviews its other assets for impairment whenever events or circumstances indicate
that the carrying amount of an asset may not be recoverable. If the sum of expected cash
flows, undiscounted and without interest is less than the carrying amount of the asset, an
impairment loss is recognized as the amount by which the carrying amount of the asset
exceeds its fair value.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | K. | Revenue
recognition
| | -- | -------------------

| | The
Company recognizes revenue on sales when products are shipped, the collectibility of debts
is probable, price is fixed and determinable and the customer takes ownership and assumes
risk of loss.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 11

---

---

|Note 2 |  | Significant
Accounting Policies (contd)
|------ | - | ----------------------------------------

| | L. | Research
and development costs
| | -- | ------------------------------

| | Research
and development costs are expensed as incurred.
| | --------------------------------------------------------

| | M. | Royalty
bearing participations
| | -- | ------------------------------

| | Royalty
bearing participations from the Government of Israel for funding research and development
activities are recognized at the time the Company is entitled to such grants based on the
related cost incurred. See Note 8A.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | N. | Service
warranty
| | -- | ----------------

| | The
Company grants service warranties related to certain products to end-users. The Company
estimates its obligation for such warranties to be immaterial on the basis of historical
experience. Accordingly, these financial statements do not include an accrual for the
subject warranty obligations.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | O. | Treasury
shares
| | -- | ---------------

| | Treasury
shares are recorded at cost and presented as a reduction of shareholders equity.
| | ------------------------------------------------------------------------------------------

| | P. | Taxes
on income
| | -- | ---------------

| | The
Company accounts for income taxes in accordance with Statement of Financial Accounting
Standards No. 109 Accounting for Income Taxes. The statement prescribes the
use of the liability method whereby deferred tax assets and liability account balances are
determined based on differences between financial reporting and tax bases of assets and
liabilities and are measured using the enacted tax rates and laws that will be in effect
when the differences are expected to reverse. See also Note 10G.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Q. | Stock
option plans
| | -- | ------------------

| | The
Company applies the intrinsic value-based method of accounting prescribed by Accounting
Principles Board (APB) Opinion No. 25 Accounting for Stock Issued to
Employees, and related interpretations including FASB Interpretation No.44
Accounting for Certain Transactions Involving Stock Compensation an Interpretation
of APB Opinion No. 25 to account for its stock option plans. Under this method,
compensation expense is measured on the date of grant only if the current market price of
the underlying stock exceeded the exercise price. Any compensation cost measured is
recognized over the vesting period.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 12

---

---

|Note 2 |  | Significant
Accounting Policies (contd)
|------ | - | ----------------------------------------

| | Q. | Stock
option plans (contd)
| | -- | ---------------------------

| | FASB
Statement No. 123, Accounting for Stock-Based Compensation and FASB Statement
No. 148, Accounting for Stock-Based Compensation  Transition and Disclosure,
an amendment of FASB Statement No. 123", established accounting and disclosure
requirements using a fair-value-based method of accounting for stock-based employee
compensation plans. As permitted by existing accounting standards, the Company has elected
to continue to apply the intrinsic-value-based method of accounting for employee stock
options and has adopted the disclosure requirements of SFAS No. 123, as amended. The
following table illustrates the effect on net income (loss), and income (loss) per share
for the fiscal years ended December 2005, 2004 and 2003 if the fair-value-based method had
been applied to all outstanding and unvested awards in each period:
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 2005 | 2004                            | 2003
| |  | ---- | ------------------------------- | ----
|
|
|
|
| |  |      | Net income (loss) as reported   |     
| |  |      | Add: compensation expenses      |     
| |  |      | according to APB 25             |     
| |  |      | Deduct: compensation expenses   |     
| |  |      | according to SFAS 123           |     
| |  |      |                                 |     
| |  |      | Net income (loss) pro forma     |     
| |  |      |                                 |     
| |  |      | Basic income (loss) per share   |     
| |  |      | as reported (US$)               |     
| |  |      |                                 |     
| |  |      | Pro forma basic income (loss)   |     
| |  |      | per share (US$)                 |     
| |  |      |                                 |     
| |  |      | Diluted income (loss) per share |     
| |  |      | as reported (US$)               |     
| |  |      |                                 |     
| |  |      | Pro forma diluted income (loss) |     
| |  |      | per share (US$)                 |     
| |  |      |                                 |     

| | The
Company will adopt the provisions of FASB Statement No. 123 (Revised 2004)
Share-Based Payment as discussed in Note 17 below.
| | -----------------------------------------------------------------------------------------------------------------------------------

| | R. | Impairment
or disposal of long-lived assets
| | -- | -------------------------------------------

| | The
Company accounts for long-lived assets in accordance with the provisions of SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets. This Statement
requires that long-lived assets be reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be recoverable.
Recoverability of assets to be held and used is measured by a comparison of the carrying
amount of an asset to future net cash flows expected to be generated by the asset. If the
carrying amount of an asset exceeds its estimated future cash flows, an impairment charge
is recognized for the amount by which the carrying amount of the asset exceeds the fair
value of the asset. Assets to be disposed would be separately presented in the balance
sheet and reported at the lower of the carrying amount or fair value less costs to sell.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 13

---

---

|Note 2 |  | Significant
Accounting Policies (contd)
|------ | - | ----------------------------------------

| | S. | Earnings
per share (EPS)
| | -- | ------------------------

| | Basic
earnings (loss) per ordinary shares (EPS) are calculated by dividing net
income (loss) available to ordinary shareholders by the weighted average number of
ordinary shares outstanding during the period according to SFAS 128 Earnings per
Share. The computation of diluted EPS assumes the issuance of ordinary shares for
all dilutive-potential ordinary shares outstanding during the reporting period. The
dilutive effect of stock options is considered in earnings per ordinary share
calculations, if dilutive, using the treasury stock method.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
2005, the total number of shares relating to outstanding options included in the
calculation of the diluted net income per share was 108,415.
| | ------------------------------------------------------------------------------------------------------------------------------------------------

|Note 3 |  | Cash
and Cash Equivalents
|------ | - | -------------------------

| |  | December 31
2005 | December 31
2004 
| |  | ---------------- | -----------------
|
|
|
|
| |  |                  | Cash             
| |  |                  | Cash equivalents*
| |  |                  |                  
| |  |                 
| |  |                  |                  
| |  |                  |                  

| | * | Cash
deposits in bank as at December 31, 2005 carrying interest of 3.5%.
| | - | ------------------------------------------------------------------------

|Note 4 |  | Investment
Securities
|------ | - | ---------------------

| | The
amortized cost, gross unrealized holding losses and fair value of held-to-maturity
securities at December 31, 2004, were as follows:
| | ----------------------------------------------------------------------------------------------------------------------------------------

| |  | 
| |  | 
|
|
|
|
| |  | 
| |  | 

| | * | Investment
securities are due within one year
| | - | ---------------------------------------------

| | Proceeds
from redemption of investment securities held-to-maturity are $537, $2,342 thousand and
$4,676 thousand in fiscal years 2005, 2004 and 2003, respectively.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | During
2005, all securities were realized.
| | ------------------------------------------

F - 14

---

---

|Note 5 |  | Property
Plant and Equipment
|------ | - | ----------------------------

| |  | Cost | Accumulated depreciation
and amortization
| |  | ---- | -----------------------------------------
|
|
|
|
| |  |      | Research and development                 
| |  |      | equipment                                
| |  |      | Manufacturing equipment                  
| |  |      | Motor vehicles                           
| |  |      | Office furniture and equipment           
| |  |      | Leasehold improvements                   
| |  |      |                                          
| |  |     
| |  |      |                                          
| |  |      |                                          

| | Depreciation
expense amounted to $148, $150 and $145 thousand for the years ended December 31, 2005,
2004 and 2003 respectively.
| | --------------------------------------------------------------------------------------------------------------------------------

|Note 6 |  | Assets
Held for Severance Benefits
|------ | - | ----------------------------------

| | A. | Under Israeli law and labor agreements, Silicom is required to make severance
          payments to retired or dismissed employees and to employees leaving employment
          in certain other circumstances.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
respect of the liability to the employees, individual insurance policies are purchased
and deposits are made with recognized severance pay funds.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------

| | The
liability for severance pay is calculated on the basis of the latest salary paid to each
employee multiplied by the number of years of employment. The liability is covered by the
amounts deposited including accumulated income thereon as well as by the unfunded
provision.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Details
of the provision and amounts funded:
| | --------------------------------------------

| |  | December 31
| |  | -----------
|
|
|
|
| |  |            
| |  |            
| |  |            
| |  |            
| |  |            

| | B. | The net severance pay expense was $145 thousand, $100 thousand and $168 thousand
          in the years ended December 31, 2005, 2004 and 2003 respectively.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 15

---

---

|Note 7 |  | Other
Assets
|------ | - | ------------

| | The
subsidiary entered into a non-exclusive limited patent license agreement in
April 2002. The agreement included a one-time license fee of $150 thousand which
represented a licensing fee for both past (six years) and future (ten years) sales of
certain connectors and PC cards under patents of the licensor. The total amortization
expense for 2005 was approximately $9,375.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
maturities of other assets were as follows at December 31, 2005:
| | --------------------------------------------------------------------

| | Years | U.S. dollars
In thousands
| | ----- | -------------------------
|
|
|
|
| |       |                          
| |       |                          
| |       |                          
| |       |                          
| |       |                          
| |       |                          
| |       |                          
| |       |                          
| |       |                          
| |       |                          

|Note 8 |  | Commitments
and Contingencies
|------ | - | -----------------------------

| | A. | Royalty
commitments
| | -- | -------------------

| | The
Company is obligated to pay royalties to the Government of Israel and Korea Israel
Industrial Research and Development foundation on revenues from product sales related to
research and development, which was undertaken with Government grants and other grants.
Since January 1, 1997, royalty rates are 2% to 5%. The royalty rates applicable for the
Companys Research and Development projects are 2%  3.5%, except for one
project that took place in the period July 1, 1997  January 31, 2000, where the
royalty rate is 4%.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Royalties
are payable from the commencement of sales of each of these products until the cumulative
amount of the royalties paid equals 100% of the dollar linked amounts of the grants
received, without interest for projects approved prior to December 31, 2000 and with LIBOR
interest for amounts received after that date.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Companys total outstanding contingencies in respect of royalty-bearing
participations received or accrued, net of royalties paid or accrued, amounted to
approximately $3,084 thousand as of December 31, 2005 ($3,142 thousand as of December 31,
2004).
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 16

---

---

|Note 8 |  | Commitments
and Contingencies (contd)
|------ | - | --------------------------------------

| | B. | Lease
commitments
| | -- | -----------------

| | The
premises and facilities occupied by the Company are leased under various lease agreements.
Furthermore, the Company has entered into several operating lease agreements for motor
vehicles in Israel.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
agreements are in local currencies or linked to the dollar or to the Israeli Consumer
Price Index. The minimum future rental payments under the above leases in effect as of
December 31, 2005 are as follows:
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | U.S. dollars
in thousands
| |  | -------------------------
|
|
|
|
| |  |                          
| |  |                          
| |  |                          
| |  |                          

| | C. | Guarantees
| | -- | ----------

| | Silicom
has provided bank guarantees in respect of certain future rental payments in the amount of
$31,110.
| | -----------------------------------------------------------------------------------------------------------

| | D. | See
also Note 13.
| | -- | -----------------

F - 17

---

---

|Note 9 |  | Shareholders Equity
|------ | - | --------------------

| | A. | Share
capital
| | -- | -------------

| | Silicoms
Ordinary Shares are traded in the United States on the National Association of Securities
Dealers Automated Quotation System (NASDAQ) capital market, since February
1994. Silicoms Ordinary Shares are traded in Israel on Tel-Aviv Stock Exchange
(TASE) since December 2005.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | Stock
compensation plans
| | -- | ------------------------

| | At
December 31, 2005, Silicom had four stock-based compensation plans, which are described
below. Silicom applies APB Opinion 25 and related interpretations in accounting for its
plans. Accordingly, since the current market price of the underlying stock at the date of
grant equaled the exercise price, no compensation cost has been recognized for fixed stock
option plans.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
fair value for option grants is estimated on the date of grant using the Black-Scholes
option pricing model with the following weighted average assumptions for 2005 and 2004.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 2005 | 2004                          
| |  | ---- | ------------------------------
|
|
|
|
| |  |      | Risk-free interest rate       
| |  |      | Dividend yield                
| |  |      | Volatility factor             
| |  |      | Weighted average expected life

| | No
options were granted in 2003.
| | --------------------------------

| | Had
compensation cost for Silicoms four stock-based compensation plans been determined
based on the fair value at the grant dates for awards under those plans consistent with
the method of Statement 123, Silicoms net income and earnings per share would have
been reduced to the pro forma amounts indicated below:
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 2005 | 2004                                                    | 2003
| |  | ---- | ------------------------------------------------------- | ----
|
|
|
|
| |  |      | Net income (loss) as reported                           |     
| |  |      | Add: compensation expenses according to APB25           |     
| |  |      | Deduct: compensation expenses                           |     
| |  |      | According to SFAS 123                                   |     
| |  |      |                                                         |     
| |  |      | Net income (loss) pro forma                             |     
| |  |      |                                                         |     
| |  |      | Basic net income (losses) per share as reported (US$)   |     
| |  |      |                                                         |     
| |  |      | Pro forma basic net income (losses) per share (US$)     |     
| |  |      |                                                         |     
| |  |      | Diluted net income (losses) per share as reported (US$) |     
| |  |      |                                                         |     
| |  |      | Pro forma diluted net income (losses) per share (US$)   |     
| |  |      |                                                         |     

F - 18

---

---

|Note 9 |  | Shareholders Equity
(contd)
|------ | - | -----------------------------

| | B. | Stock
compensation plans (contd)
| | -- | ---------------------------------

| | Fixed
Stock Option Plans
| | ------------------------

| | 1. | In
1993 the Board of Directors of Silicom adopted a share option plan (the           Share
Option Plan) covering up to 88,676 options at a conversion           rate of 1:1,
to be granted to certain employees and consultants of Silicom. In           June 1997,
the Board of Directors of Silicom expanded the number of options           covered by
this plan by 211,324 options to 300,000 options. In April 2002, the           Board of
Directors expanded the number of options covered by this plan by           200,000
options to 500,000 options. The Share Option Plan is administered by the           Board
of Directors, which designates the options and dates of grant. The price           of
shares to be issued under this plan is equal to the market price of Silicom
          shares on the date upon which the options were granted. The options are for a
          10-year term and are non-assignable except by the laws of succession.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | In
1994 the Board of Directors of Silicom approved a Directors Share Incentive
          Option Plan (1994) (the Directors Plan) covering up to 200,000
          options at a conversion rate of 1:1.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
June 1999, the Board of Directors of Silicom expanded the number of options covered by
this plan by 120,000 options to 320,000 options.
| | ------------------------------------------------------------------------------------------------------------------------------------------

| | In
January 2002, the Board of Directors of Silicom expanded again the number of options
covered by this plan by 180,000 options to 500,000 options.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------

| | The
price of shares to be issued to the directors under the Directors Plan is equal to the
market price of Silicom shares on the dates upon which the options were granted
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3. | In
October 2000, the Board of Directors of Silicom adopted the Silicom Ltd. US
          Share Option Plan (2000) (US Plan). The US Plan provides that options may be
          granted to any officer, consultants and certain other present and future
          employees and directors of Silicom and its subsidiary. Under the terms of the
US           Plan, up to a maximum of 200,000 ordinary shares of Silicom are reserved for
          issuance, subject to certain adjustments. The exercise price of the options
          granted under the US Plan shall be not less than 100 percent (or, in the case
of           a grant to a holder of more than 10% of Silicoms outstanding shares,
110           percent) of the fair market value of the ordinary shares subject to the
option           on the date the option is granted. The vesting period of the options is
subject           to the discretion of the Board. The term of the option shall not exceed
10 years           from the date that the option was granted (or five years, in the case
of           optionees who hold more than 10% of Silicoms outstanding shares).
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 19

---

---

|Note 9 |  | Shareholders Equity
(contd)
|------ | - | -----------------------------

| | B. | Stock
compensation plans (contd)
| | -- | ---------------------------------

| | Fixed
Stock Option Plans (contd)
| | ---------------------------------

| | 4. | On
July 21, 2004, the Board resolved, subject to shareholder approval that was
          given on December 30, 2004, to adopt the Share Option Plan (2004) (the
          2004 Plan) and to cancel any authorized share capital of the
Company           that had been previously reserved under the 1993 and 1994 plans, which
was not           then allocated under such plans or which would become unallocated from
time to           time as outstanding options expire or are forfeited (the Cancelled
          Reserve). At such time, the Cancelled Reserve consisted of 282,750
          authorized Ordinary Shares of the Company.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
2004 Plan covering up to 282,750 options at a conversion rate of 1:1 to be granted to
Israeli employees and directors. The vesting period of the options and the price of
shares to be issued to the directors under the 2004 Plan is subject to the shareholders
approval. The term of the options shall not exceed 10 years from the date that the option
was granted.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 5. | No
options have been granted other than to employees and directors.
| | -- | -------------------------------------------------------------------

| | 6. | A
summary of the status of Silicoms four fixed stock option plans as of
          December 31, 2005, 2004 and 2003 and changes during the years ending on those
          dates, is presented below:
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Shares
(in thousands) | Weighted
Average
Exercise Price | Shares
(in thousands) | Weighted
Average
Exercise Price | Shares
(in thousands) | Weighted
Average
Exercise Price
| |  | --------------------- | ------------------------------- | --------------------- | ------------------------------- | --------------------- | -------------------------------
|
|
|
|
| |  |                       | Outstanding at                  |                       |                                 |                       |                                
| |  |                       | beginning of year               |                       |                                 |                       | 728,500                        
| |  |                       | Granted                         |                       |                                 |                       | 20,000                         
| |  |                       | Exercised                       |                       |                                 |                       | (137,500                       
| |  |                       | Forfeited                       |                       |                                 |                       | (159,000                       
| |  |                       |                                 |                       |                                 |                       |                                
| |  |                       | Outstanding at                  |                       |                                
| |  |                       | end of year                     |                       |                                 |                       | 452,000                        
| |  |                       |                                 |                       |                                 |                       |                                
| |  |                       | Options                         |                       |                                
| |  |                       | exercisable at                  |                       |                                
| |  |                       | year-end                        |                       |                                 |                       | 343,800                        
| |  |                       |                                 |                       |                                 |                       |                                
| |  |                       | Weighted average                |                       |                                
| |  |                       | fair value of                   |                       |                                
| |  |                       | options granted                 |                       |                                
| |  |                       | during the year                 |                       |                                 |                       |                                
| |  |                       |                                 |                       |                                 |                       |                                

F - 20

---

---

|Note 9 |  | Shareholders Equity
(contd)
|------ | - | -----------------------------

| | C. | Stock
options granted under the Employee Share Option Plan are as follows:
| | -- | --------------------------------------------------------------------------

| | The
following table summarizes information about stock options outstanding at December 31,
2005:
| | ------------------------------------------------------------------------------------------------

| |  | Options outstanding | Option exercisable
| |  | ------------------- | ------------------
|
|
|
|
| |  |                     | 0.9               
| |  |                     | 1.69              
| |  |                     | 2.25 - 2.53       
| |  |                     | 3.19 - 5.75       
| |  |                     |                   
| |  |                    
| |  |                     |                   
| |  |                     |                   

| | D. | Retained earnings:
| | -- | ------------------

| | 1. | In
the event of distribution by the Company of cash dividends out of retained
          earnings which were tax exempt due to the Approved Enterprises          status,
the Company would be subject to a 25% corporate tax on the amount           distributed,
and further 15% withholding tax would be deducted from the amounts           distributed
to the recipients. The Company has decided not to distribute the           said
tax-exempt income as dividends. In the event of dividend distribution as           above,
the said tax amount would be charged as an expense in the statement of           income.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | In
the event that cash dividends are declared by the Company, such dividends           will
be declared and paid in Israeli currency. Under current Israeli           regulations,
any cash dividend in Israeli currency paid in respect of Ordinary           Shares
purchased by non-residents of Israel with non-Israeli currency may be           freely
repatriated in such non-Israeli currency, at the rate of exchange           prevailing at
the time of conversion.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Note 10 |  | Taxes
on Income
|------- | - | ---------------

| | A. | Israel
Tax Reform
| | -- | -----------------

| | During
2003, tax reform legislation was enacted with effect from January 1, 2003, which
significantly changed the taxation basis of corporate and individual taxpayers from a
territorial basis to a worldwide basis. From such date, an Israeli resident taxpayer will
be taxed on income produced and derived both in and out of Israel. The main provisions of
the tax reform that may affect the Company are as follows:
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1. | Transfer
pricing of international transactions with related parties
| | -- | -------------------------------------------------------------------

| | The
Income Tax Ordinance was amended to include provisions concerning transfer pricing
between related parties, where one of the parties is situated abroad. Detailed provisions
are to be included in Income Tax Regulations that have yet to be issued. Although the
Company considers that the transfer pricing policy adopted with foreign affiliates is
economically fair, an adjustment may be required following the issue of the said
Regulations.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 21

---

---

|Note 10 |  | Taxes
on Income (contd)
|------- | - | ------------------------

| | A. | Israel
Tax Reform (contd)
| | -- | --------------------------

| | 2. | Employee
stock incentive plans
| | -- | ------------------------------

| | The
tax reform codified past practice and determined three alternative tracks for taxing
employee stock option plans. Where a trustee arrangement is in place, the employer can
either claim a deduction for tax purposes while the employee will be fully taxed up to
the maximum marginal tax rate of 50% or the Company can waive the tax deduction and the
employee will pay a reduced tax rate of 25%. Where there is no trustee arrangement, the
employee is fully taxable and no deduction is allowed to the Company. There are detailed
provisions for implementing these tracks. The tax reforms new practice is not in
effect for options granted before December 31, 2002 under plans adopted before December
31, 2002. The options granted under the 2004 Plan are in accordance with the capital
gains track.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3. | Controlled
foreign company (CFC)
| | -- | --------------------------------

| | The
amendment to the law introduced Controlled Foreign Company (CFC) provisions, which, in
certain circumstances, will lead to the Israeli company being charged tax on passive
income of foreign affiliates as if it had received a dividend from such companies.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4. | Capital
gains tax is reduced to 25% from 36%, except with respect to capital           gains from
marketable securities, with transitional provisions for assets           acquired prior
to January 1, 2003.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 5. | The
seven year limit for carrying forward of capital losses has been removed           with
respect to capital losses arising from 1996 and thereafter.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------

| | On
June 29, 2004, the Israeli Knesset passed Income Tax Ordinance (No. 140 and Temporary
Order), 2004 (hereinafter  the Amendment) The amendment provides for
gradual reduction of the tax rates for companies, from the rate of 36% to the rate of 30%,
in the following manner: in the 2004 tax year the tax rate will be 35%, in the 2005 tax
year the tax rate will be 34%, in the 2006 tax year the tax rate will be 32%, and in the
2007 tax year and thereafter the tax rate will be 30%.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
current taxes and the balances of the deferred taxes as at December 31, 2005 are
calculated in accordance with the new tax rates, as provided in the Amendment.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | On
July 25, 2005 the Israeli Parliament passed the Law for the Amendment of the Income Tax
Ordinance (No. 147 and Temporary Order)  2005 (hereinafter  Amendment 147).
The Amendment provides for a gradual reduction in the company tax rate in the following
manner: in 2006 the tax rate will be 31%, in 2007 the tax rate will be 29%, in 2008 the
tax rate will be 27%, in 2009 the tax rate will be 26% and from 2010 onward the tax rate
will be 25%. Furthermore, as from 2010, upon reduction of the company tax rate to 25%,
real capital gains will be subject to tax of 25%.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 22

---

---

|Note 10 |  | Taxes
on Income (contd)
|------- | - | ------------------------

| | B. | Tax benefits under the Law for the Encouragement of Capital Investments, 1959
          (hereinafter the Law)
| | -- | ---------------------------------------------------------------------------------------------------------------

| | 1. | Rates
| | -- | -----

| | a. | The
Companys first investment program has been granted Approved
               Enterprise status under the Law. For this program, the Company has
elected                to be taxed under the alternative benefits method, whereby the
Company waives                grants in return for tax exemptions. Pursuant thereto, the
income of the Company                derived from the first investment program was
tax-exempt until 1997.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | b. | The
Companys program for expansion of its approved enterprise in Yokneam
               was approved in September 1995. As the Company has elected to apply the
               alternative benefits method for this program, the company is entitled to a
tax                exemption with respect to the additional income derived from that
expansion for                ten years. In June 1995 the Israeli tax authorities and the
Company have agreed                that for the purpose of determining the Companys
tax liability, the                Companys income will be allocated to its
manufacturing plant and to its                research and development center, according
to a formula based on the net costs                plus royalties of the research and
development center and the Companys                profitability. Income allocated
to the expansion of the manufacturing plant will                benefit from a ten-year
tax exemption, commenced in 1997 to be expired in 2006,                while income
allocated to the research and development center will benefit from                a
two-year exemption and for a five-year period immediately following to be
               expired in 2004 will be taxed at a 25% rate.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
final report as to the completion of investments under this program has been submitted to
the Investment Center. The final approval was received in October 2001.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | c. | In
the event of distribution by the Company of cash dividends out of retained
               earnings which were tax exempt due to the Approved Enterprise               status,
the Company would be subject to a 25% corporate tax on the amount
               distributed, and a further 15% withholding tax would be deducted from the
               amounts distributed to the recipients.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | d. | Should
the Company derive income from sources other than the Approved
               Enterprise during the relevant period of benefits, such income will
be                taxable at regular corporate tax rates  34% (in 2005).
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | Accelerated
depreciation
| | -- | ------------------------

| | The
Company is entitled to claim accelerated depreciation for a period of five years in
respect of property and equipment of an Approved Enterprise. The Company has
not utilized this benefit to date.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 23

---

---

|Note 10 |  | Taxes
on Income (contd)
|------- | - | ------------------------

| | B. | Tax benefits under the Law for the Encouragement of Capital Investments, 1959
          (hereinafter the Law) (contd)
| | -- | ------------------------------------------------------------------------------------------------------------------------

| | 3. | Conditions
for entitlement to the benefits
| | -- | ------------------------------------------

| | Entitlement
to the benefits of the Companys Approved Enterprise is dependent upon
the Company fulfilling the conditions stipulated by the Law and the regulations published
thereunder, as well as the criteria set forth in the approval for the specific investment
in the Companys Approved Enterprise.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
the event of failure to comply with these conditions, the tax benefits may be canceled,
and the Company may be required to refund the amount of the cancelled benefits, with the
addition of linkage differences and interest. As of the date of these financial
statements, the Company believes it complies with these conditions.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4. | Changes
to the law:
| | -- | -------------------

| | On
March 30, 2005, the Israeli Parliament approved a reform of the above Law. The primary
changes are as follows:
| | -----------------------------------------------------------------------------------------------------------------

| | (a) | Companies
that meet the criteria of the Alternate Path of tax benefits will                receive
those benefits without prior approval. In addition, there will be no
               requirement to file reports with the Investment Center. Audit will take
place                via the Income Tax Authorities as part of the tax audits. Request
for pre-ruling                is possible.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (b) | Tax
benefits of the Alternate Path include lower tax rates or no tax depending
               on area and the path chosen, lower tax rates on dividends and accelerated
               depreciation.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (c) | In
order to receive benefits in the Grant Path or the Alternate Path, the
               Industrial enterprise must contribute to the economic independence of the
               Countrys economy in one of the following ways:
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1. | Its
primary activity is in the Biotechnology or Nanotechnology fields and
          pre-approval is received from the head of research and development at the
Office           of the Chief Scientist;
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | Its
revenue from a specific country is not greater than 75% of its total           revenues
that year;
| | -- | ------------------------------------------------------------------------------------------------------

| | 3. | 25%
or more of its revenues are derived from a specific market of at least 12
          million residents.
| | -- | ----------------------------------------------------------------------------------------------------------

| | (d) | Upon
the establishment of an enterprise, an investment of at least NIS 300
               thousand in production machinery and equipment within three years is
required.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 24

---

---

|Note 10 |  | Taxes
on Income (contd)
|------- | - | ------------------------

| | B. | Tax benefits under the Law for the Encouragement of Capital Investments, 1959
          (hereinafter the Law) (contd)
| | -- | ------------------------------------------------------------------------------------------------------------------------

| | (e) | For
an expansion, a company is required to invest within three years the higher
               of NIS 300 thousand in production machinery and equipment or a
certain                percentage of its existing production machinery and equipment.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
amendments to the Law do not retroactively apply for investment programs having an
Approved Enterprise approval certificate from the Investment Center issued up to December
31, 2004. Therefore, the amendments do not impact an existing Approved Enterprise which
received written approval. The new tax regime shall apply for a new Approved Enterprise
and for an Approved Enterprise expansion for which the first year of benefits is 2004 and
thereafter.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Silicom
selected the tax year of 2004, as the year of election, from which the period of benefits
under the investment law are to commence, by notifying the Israeli Tax Authority.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | C. | Measurement of results for tax purposes under the Income Tax Regulations
          (Rules for Maintaining Accounting Records of Foreign Invested Companies
          and Certain Partnerships and Determining Their
Taxable Income)  1986
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As
a foreign invested company (as defined in the Law for the Encouragement of
Capital Investments  1959), the Companys management has elected to apply
Income Tax Regulations (Rules for Maintaining Accounting Records of Foreign Invested
Companies and Certain Partnerships and Determining Their Taxable Income)  1986 from
January 1, 2002. Accordingly, its taxable income or loss is calculated in U.S. Dollars.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

| | The
Company believes that it is currently qualifies as an Industrial Company under
the above Law. As such it is entitled to certain tax benefits, mainly the right to deduct
share issuance costs for tax purposes in the event of a public offering, and to amortize
know-how acquired from third parties.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | E. | Tax
assessments of Silicom Ltd.
| | -- | -------------------------------

| | Silicom
received final tax assessments for all years up to and including the tax year ended
December 31, 2001.
| | --------------------------------------------------------------------------------------------------------------

| | Silicoms
carryforward tax losses are approximately $3,639 thousand as of December 31, 2005.
| | --------------------------------------------------------------------------------------------

F - 25

---

---

|Note 10 |  | Taxes
on Income (contd)
|------- | - | ------------------------

| | F. | Taxation
of the subsidiary
| | -- | --------------------------

| | At
December 31, 2005, the subsidiary had approximately $569 thousand net operating loss
carryforwards for U.S. federal income tax reporting purposes expiring $65 thousand in
2018, $265 thousand in 2021, $188 thousand in 2022 and $17 thousand in 2023 and $34
thousand in 2024. At December 31, 2005, the subsidiary had approximately $445 thousand
net operating loss carryforwards for New Jersey state income tax reporting purposes
expiring $ 251 thousand in 2010, $188 thousand in 2011 and $6 thousand in 2012.

The
subsidiary has not yet been assessed for tax purposes since incorporation (1993). In
accordance with the provisions of the Income Tax Ordinance, tax returns submitted up to
and including the 2001 tax year can be regarded as final.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | G. | Deferred income taxes:
| | -- | ----------------------

| | 1. | Most
of Silicoms income is tax exempt due to the Approved           Enterprise status
granted to its production facilities. Silicom has           decided to permanently
reinvest the amount of the said tax-exempt income, and           not to distribute such
income as dividends. The amount of tax that would be           payable had such
tax-exempt income been distributed as dividends is           approximately $ 0 thousand
at December 31, 2005 (December 31, 2004  $ 0           thousand).
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | The
components of deferred tax assets and liabilities, assuming taxation at           maximum
rates, are as follows:
| | -- | --------------------------------------------------------------------------------------------------------------------

| |  | December 31 | December 31                            
| |  | ----------- | ---------------------------------------
|
|
|
|
| |  |             | Employees' rights liabilities          
| |  |             | Allowance for doubtful debts           
| |  |             | Deferred research and development costs
| |  |             | Loss for tax purposes                  
| |  |             |                                        
| |  |             |                                        
| |  |             | Valuation allowance                    
| |  |             |                                        
| |  |             |                                        
| |  |             |                                        
| |  |            
| |  |             | Statutory tax rate                     
| |  |             |                                        

| | The
Company has recognized a valuation allowance for its deferred tax assets for which it is
more likely than not that they will not be realized.
| | -------------------------------------------------------------------------------------------------------------------------------------------------

F - 26

---

---

|Note 10 |  | Taxes
on Income (contd)
|------- | - | ------------------------

| | H. | Reconciliation
of the statutory tax expense to actual tax expense
| | -- | -----------------------------------------------------------------

| | A
reconciliation of the statutory tax expense, assuming all income is taxed at the statutory
rate of 34% for the year ended December 31, 2005, 35% for the year ended December 31, 2004
and 36% for the year ended December 31, 2003 applicable to income of companies in Israel,
and the actual tax expense, are as follows:
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Year ended December 31
| |  | ----------------------
|
|
|
|
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       

F - 27

---

---

|Note 11 |  | Supplementary
Balance Sheet Information
|------- | - | ---------------------------------------

| |    |                                                         | December 31
| | -- | ------------------------------------------------------- | -----------
|
|
|
|
| | A. | Receivables - trade                                     |            
| |    | In Israel                                               |            
| |    | Abroad:                                                 |            
| |    | The United States                                       |            
| |    | Europe                                                  |            
| |    | Other                                                   |            
| |    |                                                         |            
| |    |                                                         |            
| |    |                                                         |            
| |    |                                                         |            
| |    | Net of allowance for doubtful accounts in the amount of |            
| |    |                                                         |            
| |    |                                                         |            
| | B. | Receivables - other                                     |            
| |    | Government of Israel                                    |            
| |    | Prepaid expenses                                        |            
| |    | Income receivable                                       |            
| |    | Advanced to suppliers                                   |            
| |    | Sundry                                                  |            
| |    |                                                         |            
| |    |                                                         |            
| |    |                                                         |            
| |    |                                                         |            
| | C. | Inventories                                             |            
| |    | Raw materials and components                            |            
| |    | Products in process                                     |            
| |    | Finished products                                       |            
| |    |                                                         |            
| |    |                                                         |            
| |    |                                                         |            
| |    |                                                         |            
| | D. | Other accounts payable and accrued expenses             |            
| |    | Employees and employee institutions                     |            
| |    | Provision for vacation pay                              |            
| |    | Government royalties                                    |            
| |    | Sundry                                                  |            
| |    |                                                         |            
| |    |                                                         |            
| |    |                                                         |            

F - 28

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---

|Note 12 |  | Supplementary
Income Statement Data
|------- | - | -----------------------------------

| |    |                                     | Year ended December 31
| | -- | ----------------------------------- | ----------------------
|
|
|
|
| | A. | Sales* - classified by geographical |                       
| |    | destination:                        |                       
| |    | In Israel                           |                       
| |    | Abroad:                             |                       
| |    | United States                       |                       
| |    | Europe                              |                       
| |    | Other                               |                       
| |    |                                     |                       
| |    |                                     |                       
| |    |                                     |                       
| |    |                                     |                       

| |    |                                       |  |  | 
| | -- | ------------------------------------- |  |  | 
|
|
|
|
| | *  | Including - sales to single customers |  |  | 
| |    | exceeding 10% of sales                |  | 
| |    | Customer "A"                          |  |  | 
| |    | Customer "B"                          |  |  | 
| |    | Customer "C"                          |  |  | 
| |    |                                       |  | 
| | ** | Less than 10% of sales                |  |  | 

| |    |                                   | Year ended December 31
| | -- | --------------------------------- | ----------------------
|
|
|
|
| | B. | Cost of sales:                    |                       
| |    | Materials consumed and            |                       
| |    | subcontracted work                |                       
| |    | Payroll and related expenses      |                       
| |    | Royalties                         |                       
| |    | Other costs                       |                       
| |    | Written off inventory             |                       
| |    |                                   |                       
| |    |                                   |                       
| |    |                                   |                       
| |    | Increase in products in process   |                       
| |    | and finished products inventories |                       
| |    |                                   |                       
| |    |                                   |                       
| |    |                                   |                       
| |    |                                   |                       

F - 29

---

---

|Note 12 |  | Supplementary
Income Statement Data (contd)
|------- | - | --------------------------------------------

| |    |                                           | Year ended December 31
| | -- | ----------------------------------------- | ----------------------
|
|
|
|
| | C. | Research and development costs, net       |                       
| |    | Payroll and related expenses              |                       
| |    | Materials consumed and subcontracted work |                       
| |    | Other costs                               |                       
| |    |                                           |                       
| |    |                                           |                       
| |    |                                           |                       
| |    | Less royalty-bearing participations from  |                       
| |    | the Government of Israel and others       |                       
| |    |                                           |                       
| |    |                                           |                       
| |    | Research and development costs, net       |                       
| |    |                                           |                       

| |    |                                 | Year ended December 31
| | -- | ------------------------------- | ----------------------
|
|
|
|
| | D. | Selling and marketing expenses: |                       
| |    | Payroll and related expenses    |                       
| |    | Commissions                     |                       
| |    | Advertising                     |                       
| |    | Trade shows and travel          |                       
| |    | Other expenses                  |                       
| |    |                                 |                       
| |    |                                 |                       
| |    |                                 |                       
| |    |                                 |                       

| |    |                                             | Year ended December 31
| | -- | ------------------------------------------- | ----------------------
|
|
|
|
| | E. | Financial (expenses) income, net            |                       
| |    | Interest income                             |                       
| |    | Exchange rate differences, net              |                       
| |    | Interest expenses on short-term bank credit |                       
| |    | and bank charges                            |                       
| |    |                                             |                       
| |    |                                             |                       
| |    |                                             |                       
| |    |                                             |                       

F - 30

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---

|Note 13 |  | Short-term
Bank Credit
|------- | - | ----------------------

| |  | December 31
| |  | -----------
|
|
|
|
| |  |            
| |  |            

| | In
December 2005 the Company entered into a bank loan in the amount of $ 500 thousand bearing
annual interest of Libor + 1.6% (5.79% at December 31, 2005), payable in one installment
in November 2006.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
connection with this loan the Company registered a floating charge on all of its assets in
favor of the bank and a fixed charge in favor of the bank on all of its share
capital not yet issued. Furthermore, the Company undertook to comply with certain
financial criteria.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (1) | Cash
and cash equivalents will not be less than $ 500 thousand.
| | --- | ---------------------------------------------------------------

| | (2) | Rate
of shareholders equity to total assets will not be less than 40%, or           $ 2
million.
| | --- | -------------------------------------------------------------------------------------------------

| | As
at December 31, 2005 the Company complies with the financial criteria above. See also Note
18.
| | -------------------------------------------------------------------------------------------------

|Note 14 |  | Related
Party Balances and Transactions
|------- | - | ---------------------------------------

| | A. | Balances
with related parties:
| | -- | ------------------------------

| |  | December 31
| |  | -----------
|
|
|
|
| |  |            
| |  |            

| | B. | Expenses
to (income from) related parties:
| | -- | ------------------------------------------

| |  | Year ended December 31
| |  | ----------------------
|
|
|
|
| |  |                       
| |  |                       
| |  |                       
| |  |                       
| |  |                       

| | * | Most
of the transactions are sales to a related party, which is a distributor of the Companys
products in Israel. The terms of the transactions are not different from regular market
terms.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | ** | Mainly
participation in insurance, recruiting expenses and public relations expenses.
| | -- | -------------------------------------------------------------------------------------

F - 31

---

---

|Note 15 |  | Financial
Instruments and Risk Management
|------- | - | -----------------------------------------

| | A. | Concentrations
of credit risk
| | -- | -----------------------------

| | Financial
instruments, which potentially subject Silicom to significant concentrations of credit
risk, consist principally of cash and cash equivalents, short-term and long-term
investments and trade receivables. Cash and cash equivalents balances of Silicom, which
are subject to credit risk, consist of cash accounts held with major financial
institutions. Concentrations of credit risk with respect to trade receivables are limited
due to the Companys diverse customer base and their wide geographical dispersion.
The Company closely monitors extensions of credit and has never experienced significant
credit losses.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | Concentrations
of business risk
| | -- | -------------------------------

| | Although
the Company generally uses standard parts and components for products, certain key
components used in the products are currently available from only one source, and others
are available from a limited number of sources. Components currently available from one
source include a proprietary LAN (Fast Ethernet and Ethernet) chipset, modem chipsets and
other components, including other semiconductor devices, transformers and plastic and
metal product housings. The Company believes that it maintains a sufficient inventory of
these components to protect against delays in deliveries. There can be no assurance that
it will not experience delays in the supply of critical components in the future or that
it will have a sufficient inventory of critical components at such time to produce
products at full capacity. If the Company experiences such delays and there is an
insufficient inventory of critical components at that time, the Companys operations
and financial results would be adversely affected.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Companys OEMs, distributors and resellers are not within the Companys control.
They are not obligated to purchase products from the Company and may represent other lines
of products. A reduction in sales effort or discontinuance of sales of products by OEMs,
distributors and resellers could lead to reduced sales and could materially adversely
affect our operating results. Use of distributors and OEMs also entails the risk that
distributors or OEMs will build up inventories in anticipation of a growth. If such growth
does not occur as anticipated, these distributors or OEMs may substantially decrease the
amount of products ordered in subsequent quarters, discontinue product orders or even
attempt to return unsold products (although the Companys standard agreements do not
allow return of products). The distribution industry has been characterized by rapid
change, including consolidations and financial difficulties of distributors and the
emergence of alternative distribution channels. In addition, an increasing number of
companies are competing for access to these channels. The loss or ineffectiveness of any
of the major distributors or OEMs (see Note 12A) could have a material adverse effect on
the operating results. The Company believes that no termination of a single distributor is
likely to have a material adverse effect. However, the termination or loss of several
distributors at approximately the same time might have a temporary material adverse
effect.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Note 16 |  | Fair
Value of Financial Instruments
|------- | - | -----------------------------------

| | The
Companys financial instruments consist of cash and cash equivalents, investment
securities, trade and other receivables, assets held for severance benefits and trade
accounts payable. The carrying amounts of these financial instruments, except for
investment securities, approximate fair value because of the short maturity of these
investments.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
fair value of investment securities is presented in Note 4 to these consolidated financial
statements.
| | ----------------------------------------------------------------------------------------------------------

F - 32

---

---

|Note 17 |  | Recently
Enacted Accounting Pronouncements
|------- | - | ------------------------------------------

| | A. | In November 2004, the FASB issued FASB Statement No. 151, Inventory Costs
           an amendment to ARB 43, Chapter 4 (SFAS 151). The
          amendment made by SFAS 151 clarify that abnormal amounts of idle facility
          expense, freight, handling costs, and wasted material (spoilage) should be
          recognized as current-period charges, and also require the allocation of fixed
          production overhead to inventory based on the normal capacity of the production
          facilities. The guidance is effective for inventory costs incurred during fiscal
          years beginning after June 15, 2005.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Adoption
of this statement is not expected to have a material impact on the Companys
financial statements.
| | -----------------------------------------------------------------------------------------------------------

| | B. | In December 2004, the Financial Accounting Standards Board issued SFAS No. 123
          (revised2004), Share-Based Payments (SFAS 123R). SFAS
          123R requires entities to measure the cost of employee services received in
          exchange for an award of equity instruments based on the grant-date fair value
          of the award and recognize the cost over the period during which an employee is
          required to provide service in exchange for the award. SFAS 123R does not change
          the accounting guidance for share-based payment transactions with parties other
          than employees provided in FAS 123 as originally issued and EITF Issue No.
          96-18, Accounting for Equity Instruments That Are Issued to Other Than
          Employees for Acquiring, or in Conjunction with Selling, Goods or
          Services. SFAS 123R is effective for public entities as of the beginning
          of the first annual reporting period that begins after June 15, 2005.
          Accordingly, the Company is required to adopt SFAS 123R on January 1, 2006. As a
          result, the Company will implement FAS 123R using the modified prospective
          method. Under this method, the Company will begin recognizing compensation cost
          for equity-based compensation for all new awards and to awards modified,
          repurchased or cancelled after January 1, 2006. Furthermore, the Company will be
          required to recognize compensation cost attributable to the unvested portion of
          outstanding options as of January 1, 2006, based on the grant date fair value of
          those awards, as previously calculated and reported for pro-forma disclosure
          purposes. The Company expects stock-based compensation expense under SFAS 123R,
          related to stock-based awards issued through fiscal 2005, to be approximately
          US$ 143 thousand and US$ 52 thousand in fiscal 2006 and 2007, respectively. In
          addition, the Company expects to grant additional stock-based awards in fiscal
          2006 which will result in additional stock-based compensation expense.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | C. | In December 2004, the Financial Accounting Standards Board issued SFAS No. 153,
          Exchanges of Nonmonetary Assets  an amendment of
          Accounting Principles Bulletin (APB) Opinion No. 29, Accounting for
          Nonmonetary Transactions(SFAS 153).The guidance in
          APB Opinion No. 29 is based on the principle that exchanges of nonmonetary
          assets should be measured based on the fair value of the assets exchanged. The
          guidance in Opinion No. 29, however, included certain exceptions to that
          principle. SFAS 153 amends Opinion No. 29 to eliminate the exception for
          nonmonetary assets exchanges of similar productive assets and replaces it with a
          general exception for exchanges of nonmonetary assets that do not have
          commercial substance. A nonmonetary exchange has commercial substance if the
          future cash flows of the entity are expected to change significantly as a result
          of the exchange. SFAS 153 is effective for fiscal periods beginning after June
          15, 2005 and shall be applied prospectively. The adoption of this statement is
          not expected to result in a material impact on the Companys financial
          position and results of operations.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 33

---

---

|Note 17 |  | Recently
Enacted Accounting Pronouncements (contd)
|------- | - | ---------------------------------------------------

| | D. | In May 2005, the Financial Accounting Standards Board issued SFAS No. 154,
          Accounting Changes and Errors Corrections(SFAS
          154). SFAS 154 replaces APB Opinion No. 20, Accounting
          Changes, and FASB Statement No. 3, Reporting Accounting
          Changes in Interim Financial Statements, although it carries
          forward some of their provisions. SFAS 154 requires retrospective application to
          prior periods financial statements of changes in accounting principle,
          unless it is impracticable to determine either the period-specific effects or
          the cumulative effect of the change. A change in depreciation, amortization, or
          depletion method for long-lived, nonfinancial assets will be accounted for as a
          change in accounting estimate effected by a change in accounting principle. SFAS
          154 is effective for changes in accounting principle made in fiscal years
          beginning after December 15, 2005. The Company does not expect the adoption of
          SFAS 154 will have a material impact on its financial position and results of
          operations.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Note 18 |  | Subsequent
Events
|------- | - | -----------------

| | A. | On January 25, 2006 the Company has completed a public Dutch auction in
          connection with an oversubscribed underwritten offering of Ordinary Shares
          (Shares) and Option Certificates (Series 1) (Option
          Certificates) in Israel.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As
such, Silicom issued a total of 10,000 units at a price of NIS 2,771.20 (approximately
$600) per unit, with each unit comprising 80 Shares and 40 Option Certificates. Each
Option Certificate will be exercisable into one Share until January 31, 2008 at an
exercise price of $8.63 per Share.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Net
proceeds to the Company from the offering were approximately $6 million at the time of
the sale, and any exercise of Option Certificates in the future would contribute
additional proceeds to the Company.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Neither
the Shares, Option Certificates nor the Shares issuable upon exercise of the Option
Certificates have been registered under the U.S. Securities Act of 1933, as amended.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | On February 2006 the loan in the amount of US$ 500 thousand was repaid and all
          charges and undertakings were removed until March 2006.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------

F - 34

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