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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, 2006

# 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)

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:

5,213,600

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

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.

2

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|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, 2006, are derived from our consolidated financial statements,
which have been audited by Somekh Chaikin, Certified Public Accountants (Isr.), a Member
Firm of KPMG International, independent registered public accounting firm. The
consolidated financial statements as of December 31, 2006, and for each of the years in
the three-year period ended December 31, 2006, and the report thereon, are included
elsewhere in this annual report. The selected 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 31In US$ Thousands
|---------------------------------------- | --------------------------------------
|
|
|
|
|Sales                                    |                                       
|                                         |                                       
|Cost of sales                            |                                       
|                                         |                                       
|                                         |                                       
|Gross profit                             |                                       
|                                         |                                       
|                                         |                                       
|Research and development costs, gross    |                                       
|(Less) grant participation               |                                       
|                                         |                                       
|                                         |                                       
|Research and development costs, net      |                                       
|Selling and marketing expenses           |                                       
|                                         |                                       
|General and administrative expenses      |                                       
|                                         |                                       
|                                         |                                       
|Total operating expenses                 |                                       
|                                         |                                       
|                                         |                                       
|Operating income (loss)                  |                                       
|                                         |                                       
|Financial income (expenses), net         |                                       
|                                         |                                       
|Income (loss) before income tax benefit  |                                       
|                                         |                                       
|Income tax benefit                       |                                       
|                                         |                                       
|Net income (loss)(1)                     |                                       
|                                         |                                       
|                                         |                                       
|Income (loss) per share                  |                                       
|                                         |                                       
|Basic income (loss) per ordinary share   |                                       
|                                         |                                       
|                                         |                                       
|Diluted income (loss) per ordinary share |                                       
|                                         |                                       
|Weighted average number of ordinary      |                                       
|shares used to compute basic income      |                                       
|(loss) per share (in thousands)          |                                       
|                                         |                                       
|Weighted average number of ordinary      |                                       
|shares used to compute diluted income    |                                       
|(loss) per share (in thousands)          |                                       
|                                         |                                       

(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. The Company selected the 2004 tax year
          and the 2006 tax year as its Year of Election, from which the period of benefits
          under the Investment Law are to commence. See Note 16C to the Financial
          Statements and Item 10  Additional Information 
          Taxation.

4

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|                                  | AS OF DECEMBER 31,
IN US$ THOUSANDS, EXCEPT PER SHARE DATA
|--------------------------------- | ----------------------------------------------------------
|
|
|
|
|Consolidated Balance Sheets Data: |                                                           
|Total assets                      |                                                           
|Total current liabilities         |                                                           
|Long-term liability               |                                                           
|Shareholders' equity              |                                                           
|Number of ordinary shares issued  |                                                           
|                                  |                                                           

# 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 2006 and in the first
months of 2007, 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 Multi 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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We may experience
difficulty in developing solutions for appliances with proprietary interfaces which may
be used by some of our potential customers.

The market for networking appliances
includes appliances that make use of proprietary interfaces. These appliances are offered
to our potential customers in addition to the customary server-based appliances which use
standard interfaces. Our potential customers may decide to use appliances with proprietary
interfaces instead of the customary server-based appliances for which several
manufacturers may provide add-on cards. There could be no assurance that we would be able
to develop non-standard add-on cards for appliances with proprietary interfaces or, if we
are successful in developing such cards, that manufacturers of the proprietary interfaces
or the customers electing to use these interfaces will make use of our cards in such
non-standard environments.

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 monitor 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 or discontinue product orders. 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.

Our OEM customers may
replace the appliances they currently use with appliances that do not require our cards or incorporate
cards other than ours.

Many of the OEMs that use appliances
which include our cards do so for a few years, and then consider migration to newer
generations of appliances. We cannot guarantee that our cards will be needed or selected
for such new appliances or compatible with them. A decision by a current OEM customer or
customers to select a new appliance without including our cards in such new appliance may
have a significant adverse effect on our results of operations.

7

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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 migration to 10Gbps solutions, the European Unions directive regarding
Restriction Of Hazardous Substances (ROHS) which requires products to be ROHS compliant,
the Chinese ROHS directive and the migration from the PCI-X server bus to the PCI-Express
(PCI-E) server bus, causes 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 technologies in a timely manner. Our OEMs may also select
competing products despite our ability to develop products incorporating new technologies.
Furthermore, the migration to 10Gbps, while presenting an opportunity for more cards and
solutions to be sold, may also result in a decrease in the need for multi port cards as
throughput performance may be achieved via a single port of 10Gbps. 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.

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, 2006,
and the first months of 2007 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. Additionally, a key component in many of our cards is manufactured by Intel, one
of our competitors. While we have not encountered difficulties in purchasing such
components from Intels distributors, we cannot guarantee that we will continue to be
able to purchase such components without delays or at reasonable prices. In the event that
we are not able to purchase key components of our products from our limited sources, or
are able to purchase these key components only under unreasonable terms, 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.

8

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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 is our competitor 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.

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.

9

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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.

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 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.

10

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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. As a result of our substantial cash
position, if the value of our shares declines, there is a substantial risk that we will be
classified as a PFIC under the asset test described above. We believe that we were not
deemed to be classified as a PFIC in prior years. However, the U.S. Internal Revenue
Service may not accept this determination and there can be no assurance that we will not
be classified as a PFIC in the future. We believe that our ordinary shares should not be
treated as stock of a passive foreign investment company for United States federal income
tax purposes, but this conclusion is a factual determination made annually and may be
subject to change. In light of the uncertainties described above, no assurance can be
given that we will not be a PFIC in any year. 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. Accordingly, our shareholders are urged to consult their tax
advisors regarding the application of PFIC rules.

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.

11

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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
NIS, 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 NIS (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.

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. There
has also been conflict and unrest between Israel, the Palestinian Authority and certain
terrorist groups operating within the Palestinian Authority and Lebanon. A significant
increase in violence began in September 2000 and has continued with varying levels of
severity into 2007, the most severe of which was Israels war with the Hizbullah
militant group in July and August of 2006. While the armed confrontation in 2006 and
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. 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.

12

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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.

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.

13

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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 and WAN (Wide Area Network) optimization
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, 2005 and 2006. 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.

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 $5.6 million. As of April 30, 2007, approximately 230,000 warrants were
exercised, resulting in proceeds of approximately $2.0 million. Exercise of additional
warrants in the future will contribute additional proceeds of up to approximately $1.4
million. 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.

14

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In May 2007, we conducted a private
placement, pursuant to which we issued to certain accredited investors and
qualified institutional purchasers 875,000 ordinary shares at a purchase price
of $20.50 per share and warrants to purchase up to 218,750 ordinary shares at an exercise
price of $28.25 per share. The warrants issued to the investors will expire three years
from the date of effectiveness of the registration statement we undertook to file with the
Securities Exchange Commission, covering the resale of the shares issued in the private
placement and the shares issuable upon exercise of the warrants. Net proceeds from the
private placement were approximately $16.7 million, net of $1.2 million of issuance costs.
We issued to the placement agents warrants to purchase up to an aggregate of 10,937
ordinary shares on the same terms as the warrants issued to the investors.

# Business Overview

We are currently active in the
product line of high-end Server networking cards with and without bypass (Server
Adapters), which is described in greater detail below. These are 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, WAN (Wide Area
Network) optimization appliances and other network appliances.

Server Adapters

In an effort to leverage our
strengths, in late 2002 we began exploring a new direction which has become our primary
growth driver and which we project will continue being our main source of growth in the
next few years: 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. Examples of these industries are security, WAN
optimization, load balancing and other network appliances, data storage, video on demand,
internet content delivery, high-performance computing and web servers.

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.

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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 an appliance failure. Upon the occurrence of an appliance 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 and WAN (Wide Area Network) optimization 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.

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:

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

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

| |  | WAN
(Wide Area Network) optimization 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.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 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.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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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, WAN (Wide Area Network) optimization
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

We also have a product line of legacy
products, including connectivity solutions for portable PCs and Broadband Internet access
products. This is our previous area of expertise, in which demand for our products
has significantly declined, and we expect our business in this product line to fully phase
out over time.

# Principal Markets

The principal markets in which we
compete are set forth more particularly in, and are incorporated by reference to Note 14
to the consolidated financial statements set forth in Item 18 of this annual report (the
financial statements). In 2004, 2005 and 2006, approximately 6%, 5% and 7%, respectively,
of our sales were in Europe, 84%, 77% and 72% respectively, were in the United States, and
10%, 18% and 21%, 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, WAN (Wide Area
Network) optimization market, other network appliances markets (such as load balancing and
traffic management), 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 and 2006 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 2006 constituted approximately 97% 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 97% 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, 2005 and 2006 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). During 2006 we launched a new product line of
high-performance encryption cards designed to improve the throughput of internet security
appliances and network gateways. The products improve the performance of networking
appliances by independently executing encryption tasks, thereby accelerating the
encryption process and freeing the CPUs of such appliances for other activities.

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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.

# 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.

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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.

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, Portwell and Adlink. 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 8 to the consolidated financial statements.

21

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# 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 2% 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.

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 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. 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. On November 1, 2006 we signed a lease agreement extending the
term of the lease for our Kfar Sava offices until October 31, 2007. The facility is 600
square meters in size and we currently pay a monthly rent of approximately $5,000.

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We conduct our manufacturing from a
facility in Yokneam, Israel, which was originally approximately 610 square meters in size,
and was recently increased to approximately 658 square meters. The monthly rent payments
for this facility are approximately $6,000. 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. Following a change in
ownership of the property, we signed an agreement extending the lease period until August
31, 2007.

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 was renewed for additional one-year periods through January 31,
2008. 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.

|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, 2005 and 2006. 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.

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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 moving inventory situation and
write down obsolete or slow moving inventory to its market value. 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, 2006, the allowance for doubtful debts was $20,000.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Deferred
Taxes  We account for income taxes under Statement of Financial Accounting
Standards (SFAS) No. 109 Accounting for Income taxes. Under SFAS
No. 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, 2006, we had carry forward tax losses in
Israel of approximately $538,000 and our subsidiary had federal carry forward tax losses
of approximately $568,000 to be realized through 2024 and New Jersey state carry forward
tax losses of approximately $433,000 to be realized through 2012. There is no assurance
that these carry forwards will be realized.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

24

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

| | n | Deferred
tax assets and liabilities are recognized for the future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets and
liabilities and their respective tax bases. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is recognized in income in
the period that includes the enactment date. Deferred tax assets and liabilities are
classified as current or non-current items in accordance with the nature of the assets or
liabilities to which they relate. When there are no underlying assets or liabilities the
deferred tax assets and liabilities are classified in accordance with the period of
expected reversal. Income tax expenses represent the tax payable for the period and the
changes during the period in deferred tax assets and liabilities. Beginning in 2006, we
recorded deferred income taxes in the amount of $46,000.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Accounting
for Stock-Based Compensation  Effective January 1, 2006, we adopted SFAS No.
123(R), which supersedes Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees. We elected the modified-prospective transition method
and therefore prior periods were not restated. Under the modified-prospective transition
method, compensation costs recognized in 2006 include also compensation costs for all
share-based payments granted prior to, but not yet vested, as of January 31, 2006. The
grant date fair value of the options awarded is calculated using the Black-Scholes option
pricing model and the associated compensation cost is recognized on a straight-line basis
over the requisite service period, which is generally the vesting period. The
Black-Scholes option pricing model requires critical assumptions such as determining the
expected life of the option, considering the outcome of service-related conditions (i.e.,
vesting requirements and forfeitures), expected volatility of the underlying shares as an
estimate of the future price fluctuation for a term commensurate with the expected life
of the option, expected dividend yield on the underlying shares, commensurate with the
expected life of the option, and risk-free interest rate commensurate with the expected
term of the option. These estimates introduce significant judgment into determining the
fair value of stock-based compensation awards. Due to the implementation of SFAS No.
123(R), we recorded share-based compensation expenses in the amount of $143,000. Prior to
January 1, 2006, we elected to apply the intrinsic value-based method prescribed in APB
Opinion No. 25 for our equity-based compensation to employees and directors and provide
the pro forma disclosure provisions of SFAS No.123, as amended by SFAS No. 148, Accounting
for Stock-Based Compensation  Transition and Disclosure, an amendment of SFAS No.
123". As such, we computed and recorded compensation expense for grants whose terms
were fixed with respect to the number of shares and option price only if the market price
on the date of grant exceeded the exercise price of the stock option. As of December 31,
2006, there was approximately $57 thousand of unrecognized compensation costs related to
non-vested options to be recognized over a weighted average period of 1.21 years.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

25

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# Recently Enacted
Accounting Pronouncements

In June 2006, the Financial
Accounting Standard Board (or FASB) issued FASB Interpretation No. 48 (FIN 48)
Accounting for Uncertain Tax Positions  An Interpretation of FASB Statement
No. 109", which clarifies the accounting for uncertainty in income taxes. This
interpretation prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or expected to be
taken in a tax return. This interpretation also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods, disclosure, and
transition. FIN 48 is effective for fiscal year beginning after December 15, 2006. We are
currently evaluating the effect that the application of FIN 48 will have on our results of
operations and financial condition.

In September 2006, the FASB issued
SFAS No. 157, Fair Value Measurements. SFAS No. 157 establishes a framework
for the measurement of fair value, and expands disclosures about fair value measurements.
The changes in current practice resulting from the application of the Statement relate to
the definition of fair value, the methods used to measure fair value, and the expanded
disclosures about fair value remeasurement. The statement is effective for fiscal years
beginning after November 15, 2007 and interim periods with those fiscal years. We do not
believe that the adoption of the provisions of SFAS 157 will have a material impact on our
consolidated financial position and results of operations.

In February 2007, the FASB issued
FASB Statement No 159, The Fair Value Option for Financial Assets and Financial
Liabilities  Including an amendment of FASB Statement No. 115", which permits
entities to choose to measure many financial instruments at fair value. The Statement
allows entities to achieve an offset accounting effect for certain changes in fair value
of certain related assets and liabilities without having to apply complex hedge accounting
provisions, and is expected to expand the use of fair value measurement consistent with
the Boards long-term objectives for financial instruments. This Statement is
effective as of the beginning of an entitys first fiscal year that begins after
November 15, 2007. We are currently reviewing this new standard to determine its effects,
if any, on our results of operations or financial position.

26

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# 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:

# Year Ended December 31,

|                                        | 2004 | 2005 | 2006
|--------------------------------------- | ---- | ---- | ----
|
|
|
|
|Sales                                   |      |      |     
|Cost of sales                           |      |      |     
|Gross profit                            |      |      |     
|Research and development costs, gross   |      |      |     
|(Less) grant participation              |      |      |     
|Research and development costs, net     |      |      |     
|Selling and marketing expenses          |      |      |     
|General and administrative expenses     |      |      |     
|Operating Income (loss)                 |      |      |     
|Financial income (expenses), net        |      |      |     
|Income (loss) before income tax benefit |      |      |     
|Income tax benefit                      |      |      |     
|Net Income (loss)                       |      |      |     

Sales in 2006 increased to $16,118
thousand compared to $10,876 thousand in 2005, mainly due to Design Wins which matured
during 2006 and due to additional Design Wins that were secured, all of which were related
to our Server Adapters and Server Bypass Adapters. Approximately 97% of our sales in 2006
were attributable to our line of Server Adapters and 3% were attributed to our legacy
products.

Sales in 2005 increased to $10,876
thousand compared to $4,559 thousand 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.

Gross profit in 2006 was $6,291
thousand compared to $4,369 thousand in 2005. Gross profit as percentage of sales in 2006
was 39.0%, compared to 40.2% in 2005. Our gross profit is largely dependent on the mix of
products we sell during a specific year. The slightly lower gross profit percentage in
2006 was a result of such change in the mix of our sold products.

Gross profit in 2005 was $4,369
thousand compared to $1,560 thousand 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.

27

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Research and development expenses,
gross, in 2006 increased by 16.6% to $1,820 thousand compared to $1,561 thousand in 2005.
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.

Research and development expenses,
gross, in 2005 decreased insignificantly by 2.2% to $1,561 thousand compared to $1,596
thousand in 2004.

Selling and marketing expenses in
2006 increased by 22.4% to $1,105 thousand compared to $903 thousand in 2005, 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 in
2005 increased by 25.8% to $903 thousand compared to $718 thousand in 2004, mainly due to
the fact that we continued investing resources in promoting the sales and marketing of our
server networking products.

General and administrative expenses
in 2006 increased by 41.0% to $980 thousand compared to $695 thousand in 2005, mainly due
to the significant growth in our activity as demonstrated by the considerable increase in
our revenues which amounted to 48.2%.

General and administrative expenses
in 2005 increased by 13.2% to $695 thousand compared to $614 thousand in 2004, mainly due
to the significant growth in our activity as demonstrated by the considerable increase in
our revenues which amounted to 138.6%.

Beginning in 2006, we recorded
share-based compensation expenses in the amount of $143 thousand, in accordance with SFAS
No. 123(R). The following summarizes the allocation of the stock-based compensation
expenses: Cost of sales $4 thousand, Research and development costs $36 thousand, Selling
and marketing expenses $20 thousand, General and administrative expenses $83 thousand.

Beginning in 2006, we recorded a
deferred income tax asset in the amount of $46 thousand. This tax income was derived
primarily from the release of the valuation allowance on deferred tax assets due to our
belief that it is more likely than not that this benefit will be realized by us.

Net income for 2006 was $2,599
thousand compared to a net income of $1,322 thousand in 2005, mainly due to our higher
sales in 2006.

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

28

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# 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.

# Liquidity and Capital
Resources

At December 31, 2006, we had working
capital of $9,433 thousand and our current ratio (current assets to current liabilities)
was 3.73. 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, 2006 increased by $2,237 thousand to $4,513 thousand
compared with $2,276 thousand as at December 31, 2005. Short-term investments increased by
$1,009 thousand, long-term investments increased by $3,811 thousand and short term bank
credits decreased by $500 thousand. The net increase of $7,557 thousand in these four
balance sheet items in 2006 was mainly due to the net proceeds provided by the sale of
800,000 ordinary shares and due to the net cash provided by operating activities.

Trade receivables increased to $3,277
thousand at December 31, 2006 from $2,395 thousand on December 31, 2005, mainly due to the
significant increase in sales in the fourth quarter of 2006, as compared to sales in the
fourth quarter of 2005. Other receivables decreased from $444 thousand to $301 thousand.

Cash provided by operating activities
in 2006 amounted to $2,001 thousand compared to cash provided by operating activities in
the amount of $41 thousand in 2005. The cash provided by operating activities in 2006 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.

29

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Inventories increased from $2,994
thousand at the end of 2005 to $3,739 thousand at the end of 2006, 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 2006 were $257 thousand compared with $200 thousand in 2005, mainly due to
the fact that in 2006 we increased investment in development and testing tools for our new
product lines of server networking cards.

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 $5.6 million. As of
April 30, 2007, approximately 230,000 warrants were exercised, resulting in proceeds of
approximately $2.0 million. Exercise of additional warrants in the future will contribute
additional proceeds of up to approximately $1.4 million. See Item 4. Information on
the Company  History and Development of the Company.

In May 2007, we conducted a private
placement, pursuant to which we issued to certain accredited investors and
qualified institutional purchasers 875,000 ordinary shares at a purchase price
of $20.50 per share and warrants to purchase up to 218,750 ordinary shares at an exercise
price of $28.25 per share. The warrants issued to the investors will expire three years
from the date of effectiveness of the registration statement we undertook to file with the
Securities Exchange Commission, covering the resale of the shares issued in the private
placement and the shares issuable upon exercise of the warrants. Net proceeds from the
private placement were approximately $16.7 million, net of $1.2 million of issuance costs.
We issued to the placement agents warrants to purchase up to an aggregate of 10,937
ordinary shares on the same terms as the warrants issued to the investors.

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
one-time payment for a license fee of $150 thousand 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 thousand payment as an intangible asset. The remainder of the license fee to be
amortized as of December 31, 2006 was approximately $48 thousand.

Trade payables increased from $2,020
thousand at the end of 2005 to $2,481 thousand at the end of 2006, mainly due to the
growing sales resulting in growing operating expenses. Other payables and accrued
liabilities increased from $822 thousand at the end of 2005 to $971 thousand at the end of
2006.

30

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# 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.

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
2% 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 have any new grant programs with the OCS in 2005 or 2006. 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.

31

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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 Koril-RDF, and the net cost to us of our research
and development activities:

|                                        | 2006 | 2005 | 2004 | 2003  | 2002
|--------------------------------------- | ---- | ---- | ---- | ----- | ----
|
|
|
|
|Gross research and development expenses |      |      | $    | 1,820 |     
|Portion funded by Chief Scientist       |      |      |      | -     |     
|Portion funded by Korea-Israel          |      |     
|Industrial Research and Development     |      |     
|Foundation                              |      |      |      | -     |     
|Net research and development expenses   |      |      | $    | 1,820 |     

* 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 April 30, 2007, the
Company employed 20 persons in research and development. Our gross research and
development expenses constituted approximately 11.3%, 14.4% and 35.0% of our sales, and
our net research and development expenses constituted approximately 11.3%, 13.5% and 31.8%
of such sales, in the respective years ended December 31, 2006, 2005 and 2004. 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 12 to our
financial statements included elsewhere in this annual report and see Item 10.
Additional Information  Taxation.

# 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 2006, we believe that this trend will continue,
and that over time 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 2004, 2005 and 2006 sales to the broadband internet access
and multi tenant unit, or MTU, industries constituted 7%, 1% 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.

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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 is growing due to an increase in demand for security
appliances, most of which are server based, and the WAN (Wide Area Network) optimization
market, is growing due to an increase in demand for better WAN (Wide Area Network)
connection between branch offices and headquarters. These two markets are additional
markets 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, 2005 and 2006 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.

# 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.

33

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# Tabular disclosure of
contractual obligations

The following table shows our
outstanding contractual obligations by category and by payments due as of December 31,
2006:

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

The Companys total outstanding
contingencies in respect of royalty-bearing participations received or accrued, net of
royalties paid or accrued before interest, amounted to approximately $3,003 thousand as of
December 31, 2006 ($3,084 thousand as of December 31, 2005), of which $2,782 thousand are
attributable to sales of our legacy products and $221 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 April
30, 2007.

|Name             | Age |  | Position with Company                       
|---------------- | --- |  | --------------------------------------------
|
|
|
|
|Avi Eizenman     | 50  |  | Active Chairman of the Board                
|Shaike Orbach    | 56  |  | President, Chief Executive Officer, Director
|Yehuda Zisapel   | 64  |  | Director                                    
|Einat Domb-Har   | 40  |  | External Director                           
|Ilan Kalmanovich | 41  |  | External Director                           
|David Hendel     | 46  |  | Vice President Research and Development     
|Eran Gilad       | 40  |  | Chief Financial Officer                     

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 Orbach has 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.

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---



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 Chief Financial Officer of Olista Ltd., a company providing unique solutions
for the cellular industry, since June 2006. From April 2004 to April 2006 Ms. Domb-Har
served as the Chief Financial Officer of Stage One Venture Capital, which focuses on seed
investment in the telecom industry. 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.

Ilan Kalmanovich
has managed Leaders Consulting & Management, a business consulting firm, since
March 2006. Mr. Kalmanovich acted as an independent consultant from 2003 to February 2006
and as Vice President of Fahn Kaneh Consulting from 2004 to February 2006. 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 Hendel has
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.

35

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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, 2006 was $736,000. 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
external 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 April 30, 2007, 160,000 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 50,000 options (at an average exercise price of
$4.4 and a termination date that ranges from May 2007 to April 2010) were granted to Mr.
Yehuda Zisapel.

36

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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 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 April 30, 2007, 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 April 30, 2007, 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. 17,000 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.

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.

37

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# Board Practices

Each of Yehuda Zisapel, Avi Eizenman
and Shaike Orbach was elected to the board of directors most recently on December 21, 2006
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. Our external directors Ms. Einat Domb-Har and Mr. Ilan Kalmanovich were
elected to board of directors on June 30, 2004 to hold office as external directors for a
period of three years in accordance with Section 245(a) of the Companies Law  1999.
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 and Shaike
Orbach, who also functions as President and Chief Executive Officer.

# 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 external 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-1999 requires 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 external
director, the substitute may only be another external director who possesses the same
expertise as the external 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.

38

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# External 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 external
directors. No person may be appointed as an external 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 external 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 external director only if he or she possesses
accounting and financial expertise or professional qualifications. At least one external
director must posses accounting and financial expertise.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Regulations have been 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.

39

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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 external
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 external director or
may otherwise interfere with the persons ability to serve as an external director.
If, at the time external directors are to be appointed, all current members of the board
of directors are of the same gender, then at least one external director must be of the
other gender.

External 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 external
director is three years and may be extended for one additional term of three years.
External 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 external 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. External 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 external
director.

40

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An external 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 external director. Ms. Einat Domb-Har and Mr. Ilan
Kalmanovich were elected to the board of directors as external 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 external 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.

# Employees

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

|As at December 31                       | 2004 | 2005 | 2006
|--------------------------------------- | ---- | ---- | ----
|
|
|
|
|Total Employees                         |      |      |     
|Marketing, Sales, Customer Services     |      |      |     
|Research & Development                  |      |      |     
|Manufacturing                           |      |      |     
|Corporate Operations and Administration |      |      |     

41

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At April 30, 2007, we had 62
employees, including 8 in marketing, sales and customer services, 20 in research and
development, 28 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 11 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.

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.

42

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# Share Ownership

The following table sets forth, as of
April 30, 2007, the number of Shares owned by officers, directors and senior management of
the Company:

|Name and Address                      | Number of Shares and Options Owned1 | Percent of Outstanding 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 April 30, 2007. 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.

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.

43

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|Name of Shareholder          | Number of Shares andOptions Owned2 | Percentage of Outstanding Shares | Any Significant Change in Past 3 Years
|---------------------------- | ---------------------------------- | -------------------------------- | --------------------------------------
|
|
|
|
|Yehuda Zisapel               |                                    |                                  |                                       
|Zohar Zisapel                |                                    |                                  |                                       
|Robert Sussman3              |                                    |                                  |                                       
|Bjurman, Barry & Associates4 |                                    |                                  |                                       

---

2                The
table above includes the number of shares and underlying options that are
          exercisable within 60 days of April 30, 2007. 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.

3             Based
on Form 4/A filed on April 30, 2007.

4    
          Based on Schedule 13G/A filed on December 27, 2006.

As of April 30, 2007, there were
approximately 16 record holders of ordinary shares, including approximately 9 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 was renewed for additional one-year periods through January 31, 2008.
          Currently, the monthly rent payments for this space are approximately $500.

44

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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. In January 2006 our board of directors 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).

45

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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 beginning
February 1, 2006 and ending January 31, 2007. Shareholder approval for this renewal was
given at the annual and extraordinary meeting of our shareholders held on December 21,
2006, except that with regard to Yehuda Zisapel, who is deemed a controlling shareholder,
the voting results were inconclusive as a result of inconsistencies appearing in the proxy
cards returned to our transfer agent. Consequently, on January 16, 2007, our audit
committee and board of directors unanimously approved the renewal of the directors and
officers insurance policy with respect to Yehuda Zisapel (in each case excluding any vote
by Mr. Zisapel). On January 22, 2007 we announced the adoption of such resolution. As we
did not receive any notices of objection from shareholders with respect to the renewal of
the insurance policy for Yehuda Zisapel, the policy was deemed renewed in accordance with
an exemption set forth in regulations promulgated under the Israeli Companies Law 
1999. On February 27, 2007 we announced that our audit committee and board of directors
approved an additional renewal of the directors and officers insurance policy for the
period beginning February 1, 2007 and ending January 31, 2008. Our audit committee and
board of directors determined that the terms of renewal with respect to Yehuda Ziapel are
identical to those of all our other office holders, are on market terms and are not likely
to have a material affect on any of our profits, properties or commitments. Based on this
determination and the exemption mentioned above, and as no notices of objection were
received from our shareholders, approval of the insurance renewal for Yehuda Zisapel will
only require the vote of an ordinary majority of our shareholders. We will seek
shareholder approval for the latest renewal of the directors and officers insurance policy
for all our directors at the next meeting of our shareholders. All of our directors are
parties to our Indemnification Agreement and are covered by our directors and officers
insurance policy.

46

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

Our
consolidated financial statements and other financial information are incorporated herein
by reference to pages F-1 through F-30.

# 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.

|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                       |      |    
|April, 2007                                  |      |    
|March, 2007                                  |      |    
|February, 2007                               |      |    
|January, 2007                                |      |    
|December, 2006                               |      |    
|November, 2006                               |      |    
|FINANCIAL QUARTERS DURING THE PAST TWO YEARS |      |    
|First Quarter, 2007                          |      |    
|Fourth Quarter, 2006                         |      |    
|Third Quarter, 2006                          |      |    
|Second Quarter, 2006                         |      |    
|First Quarter, 2006                          |      |    
|Fourth Quarter, 2005                         |      |    
|Third Quarter, 2005                          |      |    
|Second Quarter, 2005                         |      |    
|FIVE MOST RECENT FULL FINANCIAL YEARS        |      |    
|2006                                         |      |    
|2005                                         |      |    
|2004                                         |      |    
|2003                                         |      |    
|2002                                         |      |    

47

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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:

|PERIOD                                       | HIGH | LOW
|-------------------------------------------- | ---- | ---
|
|
|
|
|LAST SIX CALENDAR MONTHS                     |      |    
|April, 2007                                  |      |    
|March, 2007                                  |      |    
|February, 2007                               |      |    
|January, 2007                                |      |    
|December, 2006                               |      |    
|November 2006                                |      |    
|FINANCIAL QUARTERS DURING THE PAST TWO YEARS |      |    
|First Quarter, 2007                          |      |    
|Fourth Quarter, 2006                         |      |    
|Third Quarter, 2006                          |      |    
|Second Quarter, 2006                         |      |    
|First Quarter, 2006                          |      |    
|Fourth Quarter, 2005                         |      |    
|Third Quarter, 2005                          |      |    
|Second Quarter, 2005                         |      |    
|FIVE MOST RECENT FULL FINANCIAL YEARS        |      |    
|2006                                         |      |    
|2005                                         |      |    
|2004                                         |      |    
|2003                                         |      |    
|2002                                         |      |    

48

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|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.

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

49

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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.

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:

50

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| |  | 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:
| | - | ---------------------------------------------------------------

| |  | 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.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------

51

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| |  | 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.

# 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.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

52

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| |  | 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 external 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 external directors conduct, regularly scheduled
meetings at which only they are present. In addition, with the exception of our external
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.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 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.

53

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# 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.

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 31% of taxable income 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.

54

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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.

An 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 determines 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 reduced 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 operation, 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 corporate tax rate is the result of a weighted
combination of the various applicable rates.

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:

55

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|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.

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 expired in
2006, as explained below.

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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.

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. Under the Investment Law, a
company that has elected the alternative package of benefits is not required to distribute
exempt retained profits, and may generally decide from which years profits to
declare dividends.

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.

57

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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. 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 to an
Israeli resident will be taxed at a rate of 15%, 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.

58

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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 the tax will be the rate which would have
been applicable had the company not been tax exempt. 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.

We have selected the 2004 tax year
and the 2006 tax year as our Year of Election, from which the period of benefits under the
Investment Law are to commence, by submitting two separate requests 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.

59

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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 6% 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 2005, the Research Law stated that such know-how may not be transferred to
non-Israeli third parties at all. An 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.

Tax Benefits 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.

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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) is eligible to
calculate its taxable income in accordance with these regulations, and therefore,, if we
elect to follow such regulations, our taxable income or loss is to be calculated in
dollars. We have elected to apply these regulations and accordingly our taxable income or
loss is calculated in dollars in the manner set forth in such regulations.

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 companies, 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.

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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.

62

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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% (25% if the
shareholder holds 10% or more of the means of control of the company, as such
term is defined by the law). 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 non-U.S. 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.

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:

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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 liability.

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.

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.

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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.

You may review a copy of our filings
with the SEC, including any exhibits and schedules, at the SECs public reference
room at 100 F Street N.E., Washington, D.C. 20549. You may call the SEC at 1-800-SEC-0330
for further information on the public reference room. 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. These SEC filings are
also available to the public on the Israel Securities Authoritys Magna website at
www.magna.isa.gov.il and 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.

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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, 2006 we did not have
any short or long term interest bearing loans or debts, hence there was no exposure to
interest rate risk.

# Equity Price Risk

At December 31, 2006 we did not have
any marketable securities which were recorded at a fair value, hence there was no exposure
to equity price risk.

# Foreign Currency
Exchange Risk

At December 31, 2006 we had accounts
receivable in New Israeli Shekels (NIS) or in funds linked thereto in the amount of
$473,000. 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
$43,000. At December 31, 2006 we had accounts payable in New Israeli Shekels (NIS) or in
funds linked thereto in the amount of $2,945,000. 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 $327,000.

In 2006 there was a decrease of 8.21%
in the Dollar exchange rate which resulted in an aggregate increase in the fair value of
our assets of $77,000 and an aggregate increase in the fair value of our liabilities of
$141,000.

As at December 31, 2006 we were not
engaged in any hedging transactions.

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|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, 2006, 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
|-------- |  | --------

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

Our board of directors has determined
that Ms. Einat Domb-Har is our audit committee financial expert, and that Ms. Domb-Har is
independent as such term is defined under the Nasdaq Capital Market listing requirements.

|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 be provided without charge to any person upon receipt of written
request at our principal executive offices located at 8 Hanagar Street, Kfar Sava, Israel
44000.

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|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, 2006 and 2005,
and fees billed for other services rendered by Somekh Chaikin, a member firm of KPMG
International.

|              | 2006 | 2005
|------------- | ---- | ----
|
|
|
|
|Audit Fees(1) |      |     
|              |      |     
|Tax Fees(2)   |      |     

|(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.

# PART III.

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

Not applicable

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

See pages F-1 to F-30.

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

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

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

May 30, 2007

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# Silicom Ltd.

# and its Consolidated
Subsidiary

# Consolidated Financial
Statements

# As at and for the year
ended December 31, 2006

F - 1

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                                         
|---------------------------------------------------------
|Consolidated Financial Statements as at December 31, 2006
|                                                         

Contents

|                                                           | Page 
|---------------------------------------------------------- | -----
|
|
|
|
|Report of Independent Registered Public Accounting Firm    | F - 3
|                                                          
|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 the Consolidated Financial Statements             | F - 9

F - 2

---

---



# Report of Independent
Registered Public Accounting Firm

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

We have audited the accompanying consolidated
balance sheets of Silicom Ltd. (the Company) and its subsidiary as of December
31, 2006 and 2005 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, 2006. These consolidated financial statements are the responsibility of
the Companys 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 about
whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the consolidated
financial statements referred to above present fairly, in all material respects, the
financial position of the Company and its subsidiary as of December 31, 2006 and 2005, and
the consolidated results of their operations and their cash flows for each of the years in
the three-year period ended December 31, 2006, in conformity with U.S. generally accepted
accounting principles.

As discussed in Note 2R to the
consolidated financial statements, effective January 1, 2006, the Company changed its
method of accounting for share-based compensation upon adoption of Financial Accounting
Standards Board Statement 123(R), Share-Based Payment.

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

Tel Aviv, Israel May 29,
2007

F - 3

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                             
|---------------------------------------------
|Consolidated Balance Sheets as of December 31
|                                             

|                                              |  | 2005 | 2006
|--------------------------------------------- |  | ---- | ----
|
|
|
|
|Assets                                        |  |      |     
|                                              |  |     
|Current assets                                |  |     
|Cash and cash equivalents                     |  |      |     
|Marketable securities                         |  |      |     
|Accounts receivable:                          |  |     
|Trade, net                                    |  |      |     
|Other                                         |  |      |     
|Inventories                                   |  |      |     
|Deferred taxes                                |  |      |     
|                                              |  |      |     
|                                              |  |     
|Total current assets                          |  |      |     
|                                              |  |     
|Marketable securities                         |  |      |     
|                                              |  |     
|Assets held for employees' severance benefits |  |      |     
|                                              |  |     
|Property, plant and equipment, net            |  |      |     
|                                              |  |     
|Other assets, net                             |  |      |     
|                                              |  |      |     
|                                              |  |     
|Total assets                                  |  |      |     
|                                              |  |      |     

|                                                |                                       |                                   
|----------------------------------------------- | ------------------------------------- | ----------------------------------
|/s/ Avi Eizenman                  | /s/ Shaike Orbach       | /s/ Eran Gilad      
|Avi Eizenman
Chairman of the Board of Directors | Shaike Orbach
Chief Executive Officer | Eran Gilad
Chief Financial Officer

Kfar-Saba, Israel
May 29, 2007

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

F - 4

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                             
|---------------------------------------------
|Consolidated Balance Sheets as of December 31
|                                             

|                                                         |  | 2005 | 2006
|-------------------------------------------------------- |  | ---- | ----
|
|
|
|
|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 0.01 par value; 10,000,000 shares   |  |     
|authorized; 4,351,050 and 5,213,600 issued as at         |  |     
|December 31, 2005 and 2006, respectively;                |  |     
|4,336,079 and 5,198,629 outstanding as at                |  |     
|December 31, 2005 and 2006, respectively                 |  |      |     
|Additional paid-in capital                               |  |      |     
|Treasury shares (at cost) - 14,971 ordinary shares as at |  |     
|December 31, 2005 and 2006                               |  |      |     
|Retained earnings (accumulated deficit)                  |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Total shareholders' equity                               |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Total liabilities and shareholders' equity               |  |      |     
|                                                         |  |      |     

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

F - 5

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                                                
|----------------------------------------------------------------
|Consolidated Statements of Income for the Year Ended December 31
|                                                                

|                                         |  | 2004 | 2005 | 2006
|---------------------------------------- |  | ---- | ---- | ----
|
|
|
|
|Sales                                    |  |      |      | 14  
|Cost of sales                            |  |      |      |     
|                                         |  |      |      |     
|                                         |  |     
|Gross profit                             |  |      |      |     
|                                         |  |      |      |     
|                                         |  |     
|Operating expenses                       |  |     
|Research and development costs, gross    |  |      |      |     
|Less: grant participation                |  |      |      | 12A 
|                                         |  |      |      |     
|Research and development costs, net      |  |      |      |     
|                                         |  |     
|Selling and marketing expenses           |  |      |      |     
|General and administrative expenses      |  |      |      |     
|                                         |  |      |      |     
|                                         |  |     
|Total operating expenses                 |  |      |      |     
|                                         |  |      |      |     
|                                         |  |     
|Operating income (loss)                  |  |      |      |     
|Financial income (expenses), net         |  |      |      | 15  
|                                         |  |      |      |     
|                                         |  |     
|Income (loss) before income tax benefit  |  |      |      |     
|                                         |  |     
|Income tax benefit                       |  |      |      | 16  
|                                         |  |      |      |     
|                                         |  |     
|Net income (loss)                        |  |      |      |     
|                                         |  |      |      |     
|                                         |  |     
|Income (loss) per share:                 |  |     
|Basic income (loss) per ordinary share   |  |      |      |     
|                                         |  |      |      |     
|                                         |  |     
|Diluted income (loss) per ordinary share |  |      |      |     
|                                         |  |      |      |     
|                                         |  |     
|Weighted average number of ordinary      |  |     
|shares used to compute basic income      |  |     
|(loss) per share (in thousands)          |  |      |      |     
|                                         |  |      |      |     
|                                         |  |     
|Weighted average number of ordinary      |  |     
|shares used to compute diluted income    |  |     
|(loss) per share (in thousands)          |  |      |      |     
|                                         |  |      |      |     

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

F - 6

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                                          
|----------------------------------------------------------
|Consolidated Statements of Changes in Shareholders' Equity
|                                                          

|                             | Ordinary shares | Additional
paid-in
capital | Treasury
shares | Retained
earnings
(accumulated
deficit) | Total
shareholders'
equity
|---------------------------- | --------------- | -------------------------- | --------------- | --------------------------------------- | --------------------------
|
|
|
|
|                             |                 |                            |                 |                                         |                           
|Balance at January 1, 2004   |                 |                            |                 | 4,111,829                               |                           
|                             |                 |                           
|Exercise of options          |                 |                            |                 | 86,750                                  |                           
|Net loss                     |                 |                            |                 | -                                       |                           
|                             |                 |                            |                 |                                         |                           
|                             |                 |                           
|Balance at December 31, 2004 |                 |                            |                 | 4,198,579                               |                           
|                             |                 |                           
|Exercise of options          |                 |                            |                 | 137,500                                 |                           
|Net income                   |                 |                            |                 | -                                       |                           
|                             |                 |                            |                 |                                         |                           
|                             |                 |                           
|Balance at December 31, 2005 |                 |                            |                 | 4,336,079                               |                           
|                             |                 |                           
|Exercise of options          |                 |                            |                 | 62,550                                  |                           
|Issuance of shares and       |                 |                           
|option certificates, net of  |                 |                           
|issuance cost                |                 |                            |                 | 800,000                                 |                           
|Share-based compensation     |                 |                            |                 | -                                       |                           
|Net income                   |                 |                            |                 | -                                       |                           
|                             |                 |                            |                 |                                         |                           
|                             |                 |                           
|Balance at December 31, 2006 |                 |                            |                 | 5,198,629                               |                           
|                             |                 |                            |                 |                                         |                           

(1) Net of 14,971 shares held by the subsidiary

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

F - 7

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                                                    
|--------------------------------------------------------------------
|Consolidated Statements of Cash Flows for the Year Ended December 31
|                                                                    

|                                                           | 2004 | 2005 | 2006
|---------------------------------------------------------- | ---- | ---- | ----
|
|
|
|
|Cash flows from operating activities                       |      |      |     
|Net income (loss)                                          |      |      |     
|                                                           |      |     
|Adjustments required to reconcile net income (loss) to     |      |     
|net cash provided by (used in) operating activities:       |      |     
|Depreciation and amortization                              |      |      |     
|Liability for employees' severance benefits, net           |      |      |     
|Income from marketable securities                          |      |      |     
|Share-based compensation expense                           |      |      |     
|Deferred taxes                                             |      |      |     
|Accounts receivable - trade                                |      |      |     
|Accounts receivable - other                                |      |      |     
|Inventories                                                |      |      |     
|Trade account payable                                      |      |      |     
|Other account payable and accrued expenses                 |      |      |     
|                                                           |      |      |     
|Net cash provided by (used in) operating activities        |      |      |     
|                                                           |      |      |     
|                                                           |      |     
|Cash flows from investing activities                       |      |     
|Purchases of property, plant and equipment                 |      |      |     
|Proceeds from maturity of marketable securities            |      |      |     
|Purchases of marketable securities                         |      |      |     
|                                                           |      |      |     
|Net cash provided by (used in) investing activities        |      |      |     
|                                                           |      |      |     
|                                                           |      |     
|Cash flows from financing activities                       |      |     
|Short-term bank credit                                     |      |      |     
|Issuance of shares and option certificates, net of US$ 405 |      |     
|thousand of issuance cost                                  |      |      |     
|Exercise of 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 cash flow information                        |      |     
|Cash paid during the year for:                             |      |     
|Interest expenses                                          |      |      |     
|                                                           |      |      |     
|Taxes on income                                            |      |      |     
|                                                           |      |      |     

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

F - 8

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 1  General

| | Silicom
Ltd. 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
a broad range of its traditional PC cards, PCI cards and USB products.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
these financial statements the terms Company or Silicom refer to
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.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

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

# Note 2 
Significant Accounting Policies

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

| | A. | Financial
statements in US dollars
| | -- | ----------------------------------

| | Substantially
all sales of the Company are made outside of Israel (see Note 14A regarding geographical
destination), in US dollars (dollars). Most purchases of materials and
components, and most marketing costs are made or incurred outside Israel, primarily in
dollars. Therefore, 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 of Financial Accounting Standards (SFAS) 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

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 2 
Significant Accounting Policies (contd)

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

| | The
consolidated financial statements have been prepared in accordance with principles
generally accepted in the United States of America and 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 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. Actual results may vary from these estimates.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

| | All
highly liquid debt instruments with original maturities of three months or less from the
date of purchase are considered to be cash equivalents.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------

| | E. | Marketable
securities
| | -- | ---------------------

| | Investments
which the Company has the intent and ability to hold to maturity are classified as
held-to-maturity investments as defined in SFAS 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 or accreted over the
life of the related held-to-maturity security as an adjustment to yield using the
effective interest method.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | F. | Provision
for doubtful accounts receivable
| | -- | ------------------------------------------

| | The
provision for doubtful accounts receivable is calculated on the basis of specific
identification of balances, the collection of which, in managements opinion, is
doubtful. In determining the adequacy of the provision, management bases its opinion on
the estimated risk, in reliance on available information with respect to the debtors
financial position and an evaluation of any collateral received.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As
of December 31, 2005 and 2006, the provision for doubtful accounts receivable amounted to
US$ 20 thousand.
| | -------------------------------------------------------------------------------------------------------------

F - 10

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 2 
Significant Accounting Policies (contd)

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

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

| | The
Company writes down obsolete or slow moving inventory to its market value.
| | ------------------------------------------------------------------------------

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

| | Assets
held for employees severance benefits represent contributions to severance pay
funds and cash surrender value of life insurance policies that are recorded at their
current redemption 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 at the following annual rates:
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |                                                      | %
| | ---------------------------------------------------- | -
|
|
|
|
| | Manufacturing and research and development equipment |  
| | Motor vehicles                                       |  
| | Office furniture and equipment                       |  
| | Leasehold improvements                               |  

| | * Leasehold
improvements are fully amortized.
| | ---------------------------------------------

| | 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, 2006 is five years.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | K. | 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 - 11

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 2 
Significant Accounting Policies (contd)

| | L. | Revenue
recognition
| | -- | -------------------

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

| | The
Company routinely evaluates its products for inclusion of any embedded software that is
more than incidental thereby requiring consideration of AICPA Statement of Position 97-2,
Software Revenue Recognition. Based on such evaluation, the Company has
concluded for all reported periods that none of its products have such embedded software.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Sales
taxes collected from customers and remitted to governmental authorities are accounted for
on a net basis and, therefore, are excluded from revenues in the consolidated statements
of income.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | M. | Research
and development costs
| | -- | ------------------------------

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

| | N. | 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 also Note 12A.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Royalty
expenses are recognized pursuant to sale of related products and are classified as cost
of sales.
| | ---------------------------------------------------------------------------------------------------------

| | O. | Allowance
for product 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
warranty obligations.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | P. | Treasury
shares
| | -- | ---------------

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

| | Q. | Income
taxes
| | -- | ------------

| | The
Company accounts for income taxes in accordance with SFAS No. 109 Accounting for
Income Taxes. Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statements carrying
amounts of existing assets and liabilities and their respective tax bases, and operating
loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which those
temporary differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in the consolidated
statement of operations in the period that include the enactment date. The Company
provides a valuation allowance to reduce deferred tax assets to the extent it believes it
is more likely than not that such benefits will not be realized.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 12

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 2 
Significant Accounting Policies (contd)

| | R. | Share-based
compensation
| | -- | ------------------------

| | Effective
January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No.
123 (revised 2004), Share-Based Payment (Statement 123R). This
Statement requires compensation cost relating to share-based payments to be recognized in
the financial statements and measured based on grant date fair value of the award. Under
the fair value method, the estimated fair value of awards is recognized on a
straight-line basis over the requisite service period, which is generally the vesting
period. The Company elected the modified-prospective transition method and therefore
prior periods were not restated. Under the modified-prospective transition method,
compensation costs recognized in 2006 include also compensation costs for all share-based
payments granted prior to, but not yet vested, as of January 1, 2006.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
effect of the implementation of SFAS 123R was to increase expenses by US$ 143 thousand,
which changed income before taxes on income and net income to the year by the same
amount, the basic and diluted income per share effect was a decrease of US$ 0.03.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Prior
to January 1, 2006, the Company has followed SFAS No. 123, Accounting for
Stock-Based Compensation (Statement 123) which permitted entities to
recognize as an expense over the vesting period, the fair value on the date of grant of
all stock-based awards. Alternatively, Statement 123 allowed entities to continue to
apply the provisions of Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees (APB Opinion No. 25) and related
interpretations and provide pro forma net income and pro forma earnings per share
disclosures for employee stock option grants as if the fair-value based method defined in
Statement 123 had been applied.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company elected to apply the intrinsic value-based method prescribed in APB Opinion No.
25 for its stock compensation to employees and directors and provide the pro forma
disclosure provisions of Statement 123, as amended by Statement 148, Accounting for
Stock-Based Compensation  Transition and Disclosure, an amendment of Statement No.
123".
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As
such, the Company computed and recorded compensation expense for grants whose terms were
fixed with respect to the number of shares and option price only if the market price on
the date of grant exceeded the exercise price of the stock option. The compensation cost
for the fixed plans was recorded over the period the employee performs the service to
which the stock compensation relates.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
following table shows the effect on net income (loss) per ordinary share as if the
Company had applied the fair value recognition provisions of Statement 123:
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |                                                                    | Year ended December 31
| | ------------------------------------------------------------------ | ----------------------
|
|
|
|
| | Net income (loss), as reported                                     |                       
| | Add: share-based compensation expense under intrinsic value method |                       
| | Deduct: share-based compensation expense under fair value method   |                       
| |                                                                    |                       
| | Pro forma income (loss)                                            |                       
| |                                                                    |                       
| | Basic net income (loss) per ordinary share (US$):                  |                       
| | As reported                                                        |                       
| |                                                                    |                       
| | Pro forma                                                          |                       
| |                                                                    |                       
| | Diluted net income (loss) per ordinary share (US$):                |                       
| | As reported                                                        |                       
| |                                                                    |                       
| | Pro forma                                                          |                       
| |                                                                    |                       

F - 13

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 2 
Significant Accounting Policies (contd)

| | S. | Income
(loss) per share
| | -- | -----------------------

| | Basic
and diluted income (loss) per ordinary share is presented in conformity with SFAS No.
128, Earnings Per Share, for all years presented. Basic income (loss) per
ordinary share is calculated by dividing the net income (loss) attributable to ordinary
shares, by the weighted average number of ordinary shares outstanding. Diluted income
(loss) per ordinary share calculation is similar to Basic Earnings Per Share except that
the weighed average of common shares outstanding is increased to include the number of
additional common shares that would have been outstanding if the dilutive potential
common shares from options and option certificates had been exercised.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
following table summarizes information related to the computation of basic and diluted
income (loss) per ordinary share for the years indicated.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------

| |                                                              | Year ended December 31
| | ------------------------------------------------------------ | ----------------------
|
|
|
|
| | Net income (loss) attributable to ordinary shares            |                       
| | (US$ thousands)                                              |                       
| |                                                              |                       
| |                                                              |                       
| | Weighted average number of ordinary shares outstanding       |                       
| | used in basic income (loss) per ordinary share calculation   |                       
| |                                                              |                       
| | Add assumed exercise of outstanding dilutive potential       |                       
| | ordinary shares                                              |                       
| |                                                              |                       
| |                                                              |                       
| | Weighted average number of ordinary shares outstanding       |                       
| | used in diluted income (loss) per ordinary share calculation |                       
| |                                                              |                       
| |                                                              |                       
| | Basic income (loss) per ordinary shares (US$)                |                       
| |                                                              |                       
| |                                                              |                       
| | Diluted income (loss) per ordinary shares (US$)              |                       
| |                                                              |                       
| |                                                              |                       
| | Number of options and option certificates excluded           |                       
| | from the diluted earnings per share calculation              |                       
| | because of anti-dilutive effect                              |                       
| |                                                              |                       

F - 14

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 2 
Significant Accounting Policies (contd)

| | T. | Recent
accounting pronouncements
| | -- | --------------------------------

| | 1. | In
June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48)
          Accounting for Uncertain Tax Positions  An Interpretation of FASB
          Statement No. 109", which clarifies the accounting for uncertainty in
          income taxes. This interpretation prescribes a recognition threshold and
          measurement attribute for the financial statement recognition and measurement
of           a tax position taken or expected to be taken in a tax return. This
          interpretation also provides guidance on derecognition, classification,
interest           and penalties, accounting in interim periods, disclosure, and
transition. FIN 48           is effective for fiscal year beginning after December 15,
2006. The Company is           currently evaluating the effect that the application of
FIN 48 will have on its           results of operations and financial condition.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | In
September 2006, the FASB issued FASB Statement No. 157,
          Fair Value Measurements (SFAS 157). SFAS 157 establishes a framework
          for the measurement of fair value, and expands disclosures about fair value
          measurements. The changes in current practice resulting from the application of
          the statement relate to the definition of fair value, the methods used to
          measure fair value, and the expanded disclosures about fair value
remeasurement.           The statement is effective for fiscal years beginning after
November 15, 2007           and interim periods within those fiscal years. The Company
does not believe that           the adoption of the provisions of SFAS 157 will have a
material impact on its           consolidated financial position and results of
operations.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3. | In
February 2007, the FASB issued FASB Statement No 159, The Fair Value Option           for
Financial Assets and Financial Liabilities  Including an amendment of
          FASB Statement No. 115, which permits entities to choose to measure many
          financial instruments at fair value. The statement allows entities to achieve
an           offset accounting effect for certain changes in fair value of certain
related           assets and liabilities without having to apply complex hedge accounting
          provisions, and is expected to expand the use of fair value measurement
          consistent with the FASBs long-term objectives for financial instruments.
          This statement is effective as of the beginning of an entitys first
fiscal           year that begins after November 15, 2007. The Company is currently
reviewing           this new standard to determine its effects, if any, on its results of
operations           or financial position
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | U. | Reclassifications
| | -- | -----------------

| | Certain
prior year amounts have been reclassified to the current year presentation. Such
reclassifications did not have any impact on the Companys shareholders equity
or net income.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 15

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 3  Cash and
Cash Equivalents

| |                    | December 31
| | ------------------ | -----------
|
|
|
|
| | Cash               |            
| | Cash equivalents * |            
| |                    |            
| |                    |            
| |                    |            

| | * | Cash
deposits in bank as at December 31, 2005 and 2006 carrying interest of 3.5% and 5.04%,
respectively.
| | - | ---------------------------------------------------------------------------------------------------------

# Note 4  Marketable
Securities

| | As
at December 31, 2006, investment securities consist of corporate debt securities (the
Bonds), which the Company classified as held-to-maturity.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
amortized cost, gross unrealized losses and fair value of the Bonds by major interest
type were as follows:
| | ---------------------------------------------------------------------------------------------------------------

| |            | December 31, 2006
| | ---------- | -----------------
|
|
|
|
| | Up to 5%   |                  
| | 5.01% - 6% |                  
| |            |                  
| |            |                  
| |            |                  

| | Maturities
of the Bonds at December 31, 2006 are as follows:
| | ------------------------------------------------------------

| |                                        | Amortized cost | Fair value
| | -------------------------------------- | -------------- | ----------
|
|
|
|
| | Current maturities                     |                |           
| | Due after one year through three years |                |           
| |                                        |                |           
| |                                        |                |           
| |                                        |                |           

F - 16

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

Note 5  Accounts Receivable  Other

| |                       | December 31
| | --------------------- | -----------
|
|
|
|
| | Government of Israel  |            
| | Prepaid expenses      |            
| | Income receivable     |            
| | Advanced to suppliers |            
| | Sundry                |            
| |                       |            
| |                       |            
| |                       |            

Note 6  Inventories

| |                              | December 31
| | ---------------------------- | -----------
|
|
|
|
| | Raw materials and components |            
| | Products in process          |            
| | Finished products            |            
| |                              |            
| |                              |            
| |                              |            

Note 7  Property, Plant and
Equipment, Net

| |                                                      | December 31
| | ---------------------------------------------------- | -----------
|
|
|
|
| | Manufacturing and research and development equipment |            
| | Motor vehicles                                       |            
| | Office furniture and equipment                       |            
| | Leasehold improvements                               |            
| |                                                      |            
| |                                                      |            
| | Property, plant and equipment                        |            
| |                                                      |            
| | Accumulated depreciation                             |            
| |                                                      |            
| |                                                      |            
| |                                                      |            
| |                                                      |            

| | Depreciation
expense for the years ended December 31, 2004, 2005 and 2006 was US$138 thousand, US$140
thousand and US$170 thousand, respectively.
| | -------------------------------------------------------------------------------------------------------------------------------------------------

F - 17

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 8  Other
Assets, Net

| |                              | December 31
| | ---------------------------- | -----------
|
|
|
|
| | License fee for patent costs |            
| | Accumulated amortization     |            
| |                              |            
| |                              |            
| |                              |            
| |                              |            

| | Amortization
expense for each of the years ended December 31, 2004, 2005 and 2006 was US$ 9 thousand.
Estimated amortization expense for each of the next five years is US$ 9 thousand per
year.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Note 9  Other
Accounts Payable and Accrued Expenses

| |                                     | December 31
| | ----------------------------------- | -----------
|
|
|
|
| | Employees and employee institutions |            
| | Provision for vacation pay          |            
| | Royalty payable                     |            
| | Sundry                              |            
| |                                     |            
| |                                     |            
| |                                     |            
| |                                     |            

# Note 10 
Short-term Bank Credit

| | 1. | In
December 2005 the Company received a bank loan in the amount of $500 thousand
          bearing annual interest of LIBOR + 1.6%, 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 its share capital not yet issued.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | On
February 2006, the loan was repaid and all charges and undertakings were removed.
| | ------------------------------------------------------------------------------------

| | 2. | The
Company has one line of credit provided to it by Bank Hapoalim           (approximately
US$ 142 thousand). The Bank Hapoalim is allowed to cancel or           change the line of
credit with no notice.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 18

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

Note 11 
Liabilities for Employees 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.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | The expenses recorded in respect of the provision for employee severance
          payments for the years ended December 31, 2004, 2005 and 2006 were $62 thousand,
          $74 thousand and $189 thousand, respectively.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Note 12 
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 before interest,
amounted to approximately US$ 3,003 thousand as at December 31, 2006 (US$ 3,084 thousand
as of December 31, 2005).
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 19

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 12 
Commitments and Contingencies (contd)

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

| | The
premises and facilities occupied by the Company are leased under various operating 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 at exchange rates
in effect on December 31, 2006 are as follows:
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Year ended December 31 | US$ thousands
| | ---------------------- | -------------
|
|
|
|
| | 2007                   |              
| | 2008                   |              
| | 2009                   |              

| | Rental
expenses under the lease agreements for each of the years ended December 31, 2004 and
2005 were US$ 136 thousand and US$ 142 thousand for the year ended December 31, 2006.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | C. | Bank
guarantee
| | -- | --------------

| | The
Company has provided a bank guarantee to the third party in respect of certain future
rental payments in the amount of US$ 32 thousand. The guarantees provided for one year
and is renewed each year according to the contract terms and conditions. The guarantee
may be exercised by the third party subject to the terms in the contract between the
Company and the third party.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Note 13 
Shareholders Equity

| | A. | Share
capital and option certificates
| | -- | -------------------------------------

| | The
Companys shares are traded in the United States on the National Association of
Securities Dealers Automated Quotation System (NASDAQ) capital market, since
February 1994.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | On
January 25, 2006, the Company completed a public offering of ordinary shares and option
certificates (Series 1) in Israel on the Tel-Aviv Stock Exchange. The Company issued a
total of 10,000 units at a price of NIS 2,771.20 (approximately US$ 600) per unit,
with each unit comprising 80 shares and 40 option certificates. Each option certificate
is exercisable into one ordinary share until January 31, 2008 at an exercise price per
share of NIS 39.84 (equivalent to US$ 8.64) calculated on the date on the exercise of
such option certificate. Net proceeds to the Company from the offering were approximately
US$ 5.6 million at the time of the sale, net of US$ 405 thousand of issuance costs.
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 option certificates have been registered under the U.S. Securities Act of
1933, as amended.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As
of December 31, 2006, there were no option certificates exercised into shares.  See Note
19.
| | -----------------------------------------------------------------------------------------------

F - 20

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 13 
Shareholders Equity (contd)

| | B. | Stock options
| | -- | -------------

| | 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 of its employees and consultants. 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 shared 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
exercise price of the options 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) (the 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).
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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 and unexercised 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
collectively           (the Cancelled Reserve). At July 21, 2004, 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 was available to be
granted to Israeli employees and directors. The vesting period of the options and the
price of shares to be issued to the employees and 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.
| | -- | -------------------------------------------------------------------

F - 21

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 13 
Shareholders Equity (contd)

| | B. | Stock
options (contd)
| | -- | ----------------------

| | 6. | Awards
granted to Israeli residents may be granted under Section 102 of the           Israeli
Income Tax Ordinance pursuant to which the awards of the ordinary shares           issued
upon their exercise must be deposited with a trustee following the date           of the
grant. Under Section 102, any tax payable by an employee from the grant           or
exercise of the awards is deferred until the transfer of the awards or           ordinary
shares by the trustee to the employee or upon the sale of the awards or
          ordinary shares.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 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,
as no options were granted during 2006.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |                                 | 2004 | 2005
| | ------------------------------- | ---- | ----
|
|
|
|
| | Risk-free interest rate (1)     |      |     
| | Dividend yield                  |      |     
| | Average expected volatility (2) |      |     
| | Weighted average expected life  |      |     

| | (1) | Risk-free interest rate represents risk free US$ zero- coupon Government Bonds
| | --- | ------------------------------------------------------------------------------

| | (2) | Expected average volatility represents a weighted average standard deviation
          rate for the price of the Companys ordinary shares on the NASDAQ National
          Market.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
following table summarizes information regarding stock options as at December 31, 2006:
| | -------------------------------------------------------------------------------------------

| |             | Options outstanding | Options exercisable
| | ----------- | ------------------- | -------------------
|
|
|
|
| | 0.90        |                     |                    
| | 2.25 - 2.53 |                     |                    
| | 3.19 - 5.75 |                     |                    
| |             |                     |                    
| |             |                     |                    
| |             |                     |                    
| |             |                     |                    

F - 22

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 13 
Shareholders Equity (contd)

| | B. | Stock
options (contd)
| | -- | ----------------------

| | The
stock option activity under the abovementioned plans is as follows:
| | -----------------------------------------------------------------------

| |                              | Number
of options | Weighted
average
exercise price | Weighted
average
grant date
fair value
| | ---------------------------- | ----------------- | ------------------------------- | --------------------------------------
|
|
|
|
| | Balance at January 1, 2004   |                   |                                 |                                       
| | Granted                      |                   |                                 |                                       
| | Forfeited                    |                   |                                 |                                       
| | Exercised                    |                   |                                 |                                       
| |                              |                   |                                 |                                       
| |                              |                   |                                
| | Balance at December 31, 2004 |                   |                                 |                                       
| | Granted                      |                   |                                 |                                       
| | Forfeited                    |                   |                                 |                                       
| | Exercised                    |                   |                                 |                                       
| |                              |                   |                                 |                                       
| |                              |                   |                                
| | Balance at December 31, 2005 |                   |                                 |                                       
| | Granted                      |                   |                                 |                                       
| | Forfeited                    |                   |                                 |                                       
| | Exercised                    |                   |                                 |                                       
| |                              |                   |                                 |                                       
| |                              |                   |                                
| | Balance at December 31, 2006 |                   |                                 |                                       
| |                              |                   |                                 |                                       

| | The
intrinsic value of the options at the date of grant is zero.
| | ----------------------------------------------------------------

| | During
2006, the Company recorded share-based compensation expenses. The following summarizes
the allocation of the stock-based compensation expenses:
| | ------------------------------------------------------------------------------------------------------------------------------------------------------

| |                                     | Year ended
December 31
2006
| | ----------------------------------- | ---------------------------
|
|
|
|
| | Cost of sales                       |                            
| | Research and development costs      |                            
| | Selling and marketing expenses      |                            
| | General and administrative expenses |                            
| |                                     |                            
| |                                     |                            
| |                                     |                            
| |                                     |                            

| | As
at December 31, 2006, there was approximately US$ 57 thousand of unrecognized
compensation costs related to non-vested options to be recognized over a weighted average
period of 1.21 years. The total grant date fair value of options vested during the year
ended December 31, 2006, was US$ 169 thousand.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 23

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 14  Sales

| | A. | Information
on sales by geographic distribution:
| | -- | ------------------------------------------------

| | Sales
are attributed to geographic distribution based on the location of the customer.
| | --------------------------------------------------------------------------------------

| |                   | Year ended December 31
| | ----------------- | ----------------------
|
|
|
|
| | Israel            |                       
| | United States     |                       
| | Europe            |                       
| | Rest of the world |                       
| |                   |                       
| |                   |                       
| |                   |                       

| | B. | Sales
to single customers exceeding 10% of sales:
| | -- | -------------------------------------------------

| | Customer "A" |  |  |  | 1,522 |  |  | *     |  |  | *     | 
| | ------------ |  |  |  | ----- |  |  | ----- |  |  | ----- | 
| | Customer "B" |  |  |  | 807   |  |  | 1,229 |  |  | *     | 
| | Customer "C" |  |  |  | *     |  |  | 1,072 |  |  | *     | 
| | Customer "D" |  |  |  | *     |  |  | 2,065 |  |  | 3,156 | 

| | * | Less
than 10% of sales.
| | - | -----------------------

# Note 15  Financial
Income (expenses), Net

| |                                                  | Year ended December 31
| | ------------------------------------------------ | ----------------------
|
|
|
|
| | Interest income                                  |                       
| | Exchange rate differences, net                   |                       
| | Interest expenses on borrowings and bank charges |                       
| |                                                  |                       
| |                                                  |                       
| |                                                  |                       
| |                                                  |                       

# Note 16  Taxes on
Income

| | A. | Measurement of results for tax purposes under the Israeli 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 Israeli 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 US Dollars.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 24

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 16  Taxes on
Income (contd)

| | B. | Israel tax reform
| | -- | -----------------

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

| | 2. | 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  31%, in 2007           29%,
in 2008  27%, in 2009  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%.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

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

| | a. | The
Company has been granted for its first investment program an 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. Tax exemption of
the manufacturing plant expired in 2006, tax                benefits allocated to the
research and development center expired in 2004.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
final report as to the completion of investments under this program was final approved by
the Investment Center 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.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 25

---

---



Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 16  Taxes on
Income (contd)

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

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

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

| | 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. Audits will take
place                via the Israeli Income Tax Authorities as part of the tax audits.
The Company                will be required to notify the Israeli Tax Authority regarding
the                implementation of the Alternate Path of tax benefits. 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 - 26

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Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 16  Taxes on
Income (contd)

| | C. | Tax benefits under the Israeli 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 elected year is 2004.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
respect to the abovementioned changes to the law, 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.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

| | The
Company considers that it 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 over three years,
and to deduct purchases of know-how and patents over an eight-year period for tax
purposes.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | E. | Tax
assessments and carryforward tax losses
| | -- | -------------------------------------------

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

| | Silicom
Ltd.s carryforward tax losses are approximately $538 thousand as of December 31, 2006
and can be carried forward indefinitely.
| | ---------------------------------------------------------------------------------------------------------------------------------------

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

| | At
December 31, 2006, the subsidiary had approximately $568 thousand net operating loss
carryforwards for US federal income tax reporting purposes expiring through 2024. At
December 31, 2006, the subsidiary had approximately $433 thousand net operating loss
carryforwards for state income tax reporting purposes expiring through 2012.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 27

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Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 16  Taxes on
Income (contd)

| | G. | Income
(loss) before taxes and tax expenses (benefit) included in the           statements of
income
| | -- | ----------------------------------------------------------------------------------------------------

| |                                       | Year ended December 31
| | ------------------------------------- | ----------------------
|
|
|
|
| | Income (loss) before taxes on income: |                       
| | Israel                                |                       
| | Foreign jurisdiction                  |                       
| |                                       |                       
| |                                       |                       
| |                                       |                       
| |                                       |                       
| |                                       |                       
| | Taxes on income                       |                       
| | Deferred taxes:                       |                       
| | Israel                                |                       
| | Foreign jurisdiction                  |                       
| |                                       |                       
| |                                       |                       
| | Income tax benefit                    |                       
| |                                       |                       

| | H. | 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.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | Deferred taxes reflect the tax effects of temporary differences between the
          carrying amounts of assets and liabilities for financial reporting purposes and
          for tax purposes. The components of deferred tax assets and liabilities are
          as follows:
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |                                | December 31
2005 | December 31
2006
| | ------------------------------ | ---------------- | ----------------
|
|
|
|
| | Employees' rights liabilities  |                  |                 
| | Allowance for doubtful debts   |                  |                 
| | Research and development costs |                  |                 
| | Carryforward losses            |                  |                 
| |                                |                  |                 
| |                                |                  |                 
| |                                |                  |                 
| | Less: valuation allowance      |                  |                 
| |                                |                  |                 
| |                                |                  |                 
| | Deferred income tax assets     |                  |                 
| |                                |                  |                 

| | The
net change in valuation allowance for the years ended December 31, 2004, 2005 and 2006
was an increase of US$ 50 thousand, and a decrease of US$ 605 thousand and US$ 1,298
thousand, respectively.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company has recognized a valuation allowance to reduce deferred tax assets to the extent
it is more likely than not that such benefits will not be realized.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 28

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Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 16  Taxes on
Income (contd)

| | I. | Reconciliation
of the statutory tax expense (benefits) to actual taxes on           income
| | -- | ------------------------------------------------------------------------------------------

| |                                                   | Year ended December 31
| | ------------------------------------------------- | ----------------------
|
|
|
|
| | Income (loss) before taxes on income, as reported |                       
| | in the statements of income                       |                       
| |                                                   |                       
| | Primary statutory tax rate                        |                       
| |                                                   |                       
| |                                                   |                       
| | Statutory tax on the above amount                 |                       
| |                                                   |                       
| | Increase (decrease) in taxes resulting from       |                       
| | permanent differences:                            |                       
| | Non-deductible operating expenses                 |                       
| | Share-based compensation                          |                       
| | Change in valuation allowance during the year     |                       
| | Effect of approved enterprise tax rate            |                       
| | Other                                             |                       
| |                                                   |                       
| |                                                   |                       
| | Income tax benefit                                |                       
| |                                                   |                       

# Note 17  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.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 29

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Silicom Ltd. and its Consolidated Subsidiary

|                                              
|----------------------------------------------
|Notes to the Consolidated Financial Statements
|                                              

# Note 17  Financial
Instruments and Risk Management

| | B. | Concentrations
of business risk (contd)
| | -- | ----------------------------------------

| | 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
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 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 18  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
marketable securities, approximate fair value because of the short maturity of these
investments.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

# Note 19 
Subsequent Events

| | A. | As of April 30, 2007, approximately 230 thousand option certificates (Series 1)
          were exercised. As a result, net proceeds to the Company were approximately US$
          2 million.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | In May 2007, the Company conducted a private placement, pursuant to which the
          Company issued to certain accredited investors and qualified institutional
          purchasers 875,000 ordinary shares at a purchase price of $20.50 per share and
          warrants to purchase up to 218,750 ordinary shares at an exercise price of
          $28.25 per share. The warrants issued to investors will expire three years from
          the date of effectiveness of the registration statement. The Company undertook
          to file with the U.S. Securities and Exchange Commission, covering the resale of
          the shares issued in the private placement and the shares issuable upon exercise
          of the warrants. Net proceeds from the private placement were approximately
          $16.7 million, net of $1.2 million of issuance costs. In addition, the Company
          issued to the placement agents warrants to purchase up to an aggregate of 10,937
          ordinary shares on the same terms as the warrants issued to the investors.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 30

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