**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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FORM 10-K

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**Forthe fiscal year ended December 31, 2004**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**Forthe transition period from                              to                              **

**Commission File Number 0-24752**

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Wave Systems Corp.

(Exact name of registrantas specified in its charter)

| Delaware                                                        | **13-3477246**                        |
|-----------------------------------------------------------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |
| **480  Pleasant Street**                                        | **01238**                             |
| Lee, Massachusetts                                              | (Zip Code)                            |
| (Address of principal executive offices)                        | ** **                            |

 

**413-243-1600**

(Registrant’s telephonenumber, including area code)

**Securities registeredpursuant to Section 12(b) of the Act:**

None

**Securitiesregistered pursuant to Section 12(g) of the Act:**

**Class A Common Stock,$.01 par value**

(Title of Class)

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Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. YES x  NO o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act). YES x  NO o

The aggregate market value of the shares of CommonStock of the registrant held by non-affiliates as of March 1, 2005 was$87,107,656 (For purposes of this calculation, the market value of a share of Class BCommon Stock was assumed to be the same as a share of Class A CommonStock, into which it is convertible.)

Asof March 1, 2005 there were 76,177,617 shares of the registrant’s Class ACommon Stock and 205,725 shares of the registrant’s Class B Common Stockoutstanding.

 

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EXCEPT FOR HISTORICAL INFORMATION CONTAINED HEREIN,THIS FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THEMEANING OF THE U.S. SECURITIES LITIGATION REFORM ACT OF 1995. THESESTATEMENTS INVOLVE KNOWN AND UNKNOWN RISKS AND UNCERTAINTIES THAT MAY CAUSEWAVE’S ACTUAL RESULTS OR OUTCOMES TO BE MATERIALLY DIFFERENT FROM THOSEANTICIPATED AND DISCUSSED HEREIN. FURTHER, WAVE OPERATES IN AN INDUSTRY SECTORWHERE SECURITIES VALUES MAY BE VOLATILE AND MAY BE INFLUENCED BYREGULATORY AND OTHER FACTORS BEYOND WAVE’S CONTROL. IMPORTANT FACTORS THAT WAVEBELIEVES MIGHT CAUSE SUCH DIFFERENCES ARE DISCUSSED IN THE CAUTIONARYSTATEMENTS ACCOMPANYING THE FORWARD-LOOKING STATEMENTS AND IN THE RISK FACTORSDETAILED IN WAVE’S OTHER FILINGS WITH THE COMMISSION DURING THE PAST 12 MONTHS.IN ASSESSING FORWARD-LOOKING STATEMENTS CONTAINED HEREIN, READERS ARE URGED TOREAD CAREFULLY ALL RISK FACTORS AND CAUTIONARY STATEMENTS CONTAINED IN THIS FORM 10-KAND IN THOSE OTHER FILINGS WITH THE COMMISSION.

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**Table Of Contents**
| PART I   |                                                                                         |   | 2      |   |
|---------------|----------------------------------------------------------------------------------------------|--------|--------|--------|
| Item 1.       | Business                                                                                     |   |   | 2      |   |
| Item 2.       | Properties                                                                                   |   |   | 13     |   |
| Item 3.       | Legal Proceedings                                                                            |   |   | 13     |   |
| Item  4.      | Submission  of Matters to a Vote of Security Holders                                         |   |   | 13     |   |
| PART II  |                                                                                         |   | 14     |   |
| Item  5.      | Market  for Registrant’s Common Equity and Related Stockholder Matters                  |   |   | 14     |   |
| Item 6.       | Selected Financial Data                                                                      |   |   | 16     |   |
| Item  7.      | Management’s  Discussion and Analysis of Financial Condition and  Results of Operations |   |   | 17     |   |
| Item  7A.     | Quantitative  and Qualitative Disclosure about Market Risk                              |   |   | 37     |   |
| Item  8.      | Financial  Statements and Supplementary Data                                                 |   |   | 37     |   |
| Item  9.      | Changes  in and Disagreements with Accountant on Accounting and  Financial Disclosure        |   |   | 37     |   |
| Item 9A.      | Controls and  Procedures                                                                     |   |   | 38     |   |
| Item 9B.      | Other Information                                                                            |   |   | 39     |   |
| PART III |                                                                                         |   | 40     |   |
| Item  10.     | Directors  and Executive Officers of the Registrant                                          |   |   | 40     |   |
| Item 11.      | Executive  Compensation                                                                      |   |   | 40     |   |
| Item  12.     | Security  Ownership of Certain Beneficial Owners and Management                              |   |   | 40     |   |
| Item  13.     | Certain  Relationships and Related Transactions                                              |   |   | 40     |   |
| Item 14.      | Principal  Accountant’s Fees                                                            |   |   | 40     |   |
| PART IV  |                                                                                         |   | 41     |   |
| Item  15.     | Exhibits,  Financial Statement Schedules, and Reports on Form 8-K                       |   |   | 41     |   |
|               |                                                                                              |        |        |        |  |  |

 

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**PART I**

**Item 1.        Business**

Wave Systems Corp., a development stage company,develops, produces and markets products for hardware-based digital securityincluding security applications and services that are complementary to andcompliant with the specifications of the Trusted Computing Group, www.trustedcomputinggroup.org(“TCG”). Specifications developed by the TCG are designed to address a broadrange of current and evolving digital security issues. These issues include thefollowing: identity protection, data security, digital signatures, electronictransaction integrity, platform trustworthiness, network security, andregulatory compliance.

The TCG is an industry standards body, comprised ofcomputer and device manufacturers, software vendors and others whose purpose isto develop, define and promote open industry standard specifications forembedded secure computing products, across multiple platforms, network devices,peripherals and mobile devices. The current released TCG specificationrecommends a hardware-based trusted computing platform, which is a platformthat uses a semiconductor device, known as a Trusted Platform Module (“TPM”)that performs protected activities including protected storage, platform authentication, protectedcryptographic processes and attestable state capabilities to provide the firstlevel of trust for the computing platform (a “Trusted Platform”). TheTPM is a hardware chip that is separate from the platform’s main CPU(s) thatenables secure protection of files and other digital secrets, and performscritical security functions such as generating, storing and protecting “cryptographickeys,” which are secret codes used to decipher encrypted or coded data. WhileTPMs provide the anchor for hardware security, trust is achieved by integratingthe TPM within a carefully architected trust infrastructure and supporting theTPM with essential operational and lifecycle services such as key managementand credential authentication.

Wave’s operations to date have consisted primarily ofproduct development, performance under contract to develop products andpreliminary marketing to personal computer (“PC”) original equipmentmanufacturers (“OEMs”), resellers, and enterprises. Products developed using TCG specifications require an evolving “ecosystem”of new development tools, applications, services and infrastructures. In 2003,Wave began the market introduction of its first commercial products designed tosupport the first emerging products that include TPM’s in this marketplace. In2004, Wave continued to develop enhancements to its existing products anddeveloped additional products in support of the emerging TCG-specifications.

Prior to the formation of the TCG, Wave developed itspioneering EMBASSY (*EMB*edded *A*pplication *S*ecurity *SY*stem) Trust System. The EMBASSY Trust System is acombination of client hardware consisting of the EMBASSY 2100 security chip(the “EMBASSY chip”); and software consisting of the Trust Assurance Network (“TAN”), a back-officeinfrastructure that manages its security functions. As the market for TPM-enabled products hasdeveloped with computing devices being shipped in volume by leaders in the PCindustry, Wave has enabled the development work on the EMBASSY Trust System tosupport security hardware based on the TCG specifications, by repurposing theseproduct assets. Wave has since developed a set of applications known asthe EMBASSY Trust Suite to work with various other chip manufacturers’ TCGcompliant TPMs that are now available.   Wave’s products are unique in the fact thatthey support cross platform interoperability for the currently available TPMchips from National Semiconductor, Atmel, Infineon, and STMicroelectronics andhave been verified for usage on TPM platforms shipped by Intel, IBM, HP,Fujitsu, and Dell.

Wave has not realized anysignificant revenues since we began our operations in 1988. While Wave was successful in signingdistribution contracts with both Intel and National Semiconductor in 2003, revenueshave been nominal in relation to our expenditures due to the early stage natureof the market for products that utilize this emerging technology. As a result,we have******experienced a slow pattern of corporatedevelopment. As of December 31, 2004, we had working capital ofapproximately $3.5 million. 

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Consideringour current cash balance and Wave’s projected operating cash requirements, weanticipate that we will need a minimum of $13 million of additional cash tosatisfy our current forecasted cash flow requirements for the year ending December 31,2005. As discussed above, Wave has begun market introduction of its softwareproducts for Trusted Platforms and has signed its first distribution contractsfor these applications. However, due to the early stage nature of its marketcategory, Wave is unable to predict with a high enough level of certaintywhether enough revenue will be generated in calendar 2005 to fund its cash flowrequirements. Given the uncertainty with respect to Wave’s revenue forecast for2005, it is likely that Wave will be required to raise additional capitalthrough either equity or debt financing in order to adequately fund its capitalrequirements for the year ending December 31, 2005. Furthermore, in theevent that we are successful in executing our business plan for 2005, we will likelystill be in a cash shortfall position and we will need to begin to generatesufficient sales to fund operations in future years, or we will be required toraise additional capital to continue beyond 2005. Due to our current cashposition, our capital needs over the next year and beyond, the fact that wehave not secured additional financing  atthis time and uncertainty as to whether we will achieve our sales forecast forour products and services, substantial doubt exists with respect to our abilityto continue as a going concern.

**Formationof the Trusted Computing Group and introduction of TCG Compliant Products**

In April, 2003 the TCG was formed. The PromotingFounders were AMD, HP, IBM, Intel, and Microsoft, and Wave Systems was invitedto join the founding group as a Contributing Member. The TCG formally acceptedthe initial technical specifications developed by the Trusted ComputingPlatform Alliance (“TCPA”) for Trusted Platform Modules Version 1.1. TCGformally superceded the TCPA organization. The TCG has significantly expandedthe industry participation in security hardware standards with membership fromindustry leaders for important additional platforms including cell phones, PDAsand consumer electronics. During 2003, several manufacturers of semiconductorsfor the PC industry including National Semiconductor, Atmel and Infineon wereoffering products that have the capability to function as TPMs that meet theTCG TPM Version 1.1 standard for trusted computing.  In addition, PC platforms which included TPMswere announced and/or available from IBM, Intel, and HP. In 2004 the rate ofadoption of TPMs accelerated with additional platforms announced by the majorOEMs already shipping platforms and an additional OEM, Fujitsu, announcedproducts with TPM’s. The TCG released a new version of the TPM specification,Version 1.2 which includes a number of enhancements and extensions over theVersion 1.1b. TPM Version 1.2 is fully backwards compatible to Version 1.1bwhich provides a smoother transition for deployment of the TPM technology andincreases the TPM functionality. In addition, vendors such as Atmel, announcedTPM products targeted to support embedded systems applications beyond thetraditional PC market. There are also TCG Working Groups that are developingspecifications to extend TCG technologies to other devices such as networkproducts, servers, peripherals and mobile devices.

The offering of productsusing TCG specifications to the PC market is an important development in thecreation of the market for hardware-based computer security. As a result ofthis development, Wave had begun executing a strategy to put the work it hasdone in developing the EMBASSY Trust System to use in becoming a leadingdeveloper of software, applications and services for this market.  Wave formed business relationships with someof these companies as a developer of products that will be essential to thedeployment and use of these new products, thereby creating a new revenueopportunity for Wave. Wave is providing solutions in the market that work withall available products using TCG specifications in these commercially availableproducts.

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**Products and Services**

*Client-sideApplications*

*The EMBASSY TrustSuite*

The current version of the EMBASSY Trust Suite isa set of applications and services that are designed to bring functionality anduser value to the TPM enabled products. Designed to make the TPM easy for usersto set up and use, the EMBASSY Trust Suite includes the EMBASSY SecurityCenter (the “ESC”), Document Manager Vault (“Vault”), Private InformationManager (“PIM”), SmartSignature and Key Transfer Manager (“KTM”).

The ESC enables the user to set up and configure theTPM platform. In addition to the basic function of making the TPM operational,ESC is designed to enable the user to manage extended TPM-based securitysettings and policies, including strong authentication, Windows logonpreferences to add biometrics and streamlined password policy management.

Data Protection is addressed by the Vault which providesdocument encryption, decryption and client side storage of documents. TheVault, which works with Microsoft Windows, including Microsoft Office, securesdocuments against unauthorized users and hackers.

Password management is a security challenge due to theincreasing number of passwords required and the tendency of users to selecteasily guessed passwords. To help improve the password issues, PIM uses the TPMto securely store and manage user information such as user names, passwords,credit card numbers and other personal information. It retrieves logininformation to efficiently fill in applications, web forms and web logininformation.

Backup and recovery of keys used for logon, signing,and protection of data is an essential requirement for deployment of TPM basedsystems. KTM is an archive application for the cryptographic keys that isdesigned to provide a simple, yet fully featured method to securely archive,restore and transfer keys having migratable properties that are secured by theTPM.

Legally binding electronic documents are enabledthrough authenticatable digital signatures and data protection. SmartSignatureis a digital signing application that utilizes the signing keys generated bythe TPM. Wave plans to continue to develop and enhance the current productsbeing developed within this product group and will develop new applications andservices as the trusted computing market continues to evolve.

Additionally,in 2004, Wave began developing a new set of TPM Wizards as part of theEmbassy Trust Suite which allow users to setup and use the TPM forsecuring 802.11x wireless networks, the Windows Encrypting File and encryptingemail. The TPM Wizardenhancement was released during the 1st quarter of 2005.

*Middleware andTools*

*TCG-Enabled Toolkit*

The Wave TCG-EnabledToolkit is a compilation of software ** **designed to assist applicationdevelopers writing new applications or modifying existing ones to function onTCG-compliant platforms. Wave provides two versions of the Toolkit, Discoveryand Commercial, which enable developers to leverage basic and enhanced TCGservices such as integrated key lifecycle management, including key escrow andkey recovery. The Discovery Toolkit offers application developers a license forinternal evaluation only, whereas the Commercial Toolkit is a license forexternal redistribution.

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*Wave TCG-EnabledCryptographic Service Provider (“CSP”)*

Wave offers a TCG-enabled CSP, which allows softwaredevelopers to utilize the enhanced security of a TCG standards-based platform,facilitating a common user experience independent of the platform. It alsoenables applications to utilize functionality available on TCG-compliantplatforms directly through the Microsoft cryptographic application programminginterface, without requiring user knowledge of any specific TCG software stacklayer.

Current planneddevelopment costs for this product group are expected to be approximately $3.8million for 2005.

*EMBASSY TrustServer Applications*

The EMBASSY Trust Server applications include Key TransferManager Enterprise Server for Active Directory (“KTM ES AD”), an essentialapplication for managing Trusted Platforms. KTM ES AD is a server application that is designed to eliminate the risk ofserious data loss in the event that a TPM, hard drive or motherboard becomescorrupted, or a user leaves the organization. For instance, an organization mayrequire access to a former employee’s encrypted data or TPM-secured keys forbusiness continuity or disaster recovery purposes. KTM ES AD enables enterpriselevel key protection services while ensuring proper archive procedures andrecovery capabilities. KTM ES AD was released for availability in 2004.

Current planneddevelopment costs for this product are expected to be approximately $1.5million for 2005.

*Digital Signatureand Electronic Document Management*

On October 4, 2001 Wave acquired the digitalsignature and electronic document management technology, SmartSignature andSmartSAFE, from SignOnLine, Inc. (“SignOnLine”), a California-basedcompany. This group of products now makes up our eSign Transaction ManagementSuite, also known as eTMS (“eTMS”), which now consists of four core products:SmartIdentity, SmartSignature, SmartSAFE and SmartConnect. SmartSignatureVersion 3.0 is a digital signature application that connects signers andinstitutions—banks, insurance companies, enterprises etc.—through a legallybinding digital signature. To increase the security associated with identityprotection and digital signing credentials, Wave’s SmartSignature is currentlyenabled for the support of TPMs. SmartSAFE Version 3.0 is a web-baseddocument management application where signed documents are archived and tracked.SmartSAFE provides an easy to use environment where a client institution canview, manage, store and transfer sensitive signed and unsigned documents. SmartSAFEalso supports archival and management of unsigned documents in virtually anyformat. These products allow a document to be executed, verified, accepted andfiled in minutes at a lower cost compared to traditional documentation methods.SmartSignature Version 3.0 and SmartSAFE Version 3.0 have been completed andWave commercially released these products in the first quarter of 2003.   SmartIdentity, an optional service to verifya signer’s identity through strong authentication methods, including issuingencrypted digital certificates based on public key infrastructure technology,was completed and released in January of 2003. Development for eTMS isbeing based on specific industry and customer opportunities. Wave will continueto allocate resources towards marketing and sales to promote these products. Currentplanned development costs for enhancements for this product group are expectedto be at least $300,000 in 2005.

Wave’s eTMS, in additionto being part of the EMBASSY Trust Suite applications and supporting TPMs,is also being independently marketed in the insurance, mortgage, finance,government, and other markets which are seeking ESIGN digital signaturesolutions. In 2004, Wave announced that it had signed a licensing agreementwith a la mode, inc., the nation’s largest developer of valuation workflowsoftware to offer a comprehensive solution for securely managing real estateand mortgage transactions online. Wave 

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hasfocused on digital signature applications that can make effective use of thestronger security features provided by trusted computing platforms.

*The EMBASSY TrustSystem*

The EMBASSY Trust Systemis Wave’s proprietary co-processor cryptographic subsystem and supporting infrastructure;a separate chip with its own processor designed to provide security functionssuch as hidden processing of software applications and the protected storage ofcryptographic keys and encrypted data, that works with client and serversoftware applications that provide and/or manage various security functions. Productsthat make up the EMBASSY Trust System include hardware and software. Thehardware products that make up this product group are the EMBASSY 2100 securitychip (referred to above) and secure user input devices such as EMBASSY SmartCard Readers and EMBASSY Smart Card Reader Keyboards that use EMBASSY 2100chips. These devices are being marketed, on a limited basis, to government andmilitary markets. The software products included in this product group are theTrust Assurance Network, which is the back office security infrastructure ofthe EMBASSY Trust System; Assistant, a client interface that allows the user tosecurely enter and store their personal and financial data, personal identificationnumbers, passwords, digital certificates and other information that requiressecurity; the Cyber-Comm applet, a secure French banking application that runson an EMBASSY chip; and  FINREAD, a JAVAinterface for online transactions. No further development activities areplanned for this product group. The primary assets of this product group haveserved as the basis for the development of the TCG compliant products in theEMBASSY Trust Suite and EMBASSY Trust Server applications.

*Broadband Media Distribution*

Wave offers its data broadband content distributionproducts through Wavexpress, Inc. (“Wavexpress”), a joint venture betweenWave and Sarnoff Corporation. The joint venture was established on October 15,1999. Under the joint venture agreement, Sarnoff and its affiliates received a40% equity stake in Wavexpress. Wave received a 53% equity interest and itsaffiliates, who purchased founders stock in April 1999 for a nominalamount, owned the remaining 7% of the outstanding capital stock. The affiliatesof Wave include Peter Sprague, former Chairman of Wave, Steven Sprague, ChiefExecutive Officer of Wave, certain members of the Board of Directors of Wave;and certain Wave employees.

Wavexpress has developed a vertically integrated suiteof products designed to enable the optimum broadband distribution of digitalprogramming. This system is offered to content providers looking to deliverhigh-quality broadband media services, either to generate enhanced advertisingrevenue or subscription fees for premium services. Wavexpress provides itscustomers with tools for publishing content through the network and clientsoftware for presenting the content to the end user. The client software isintegrated and promoted through Microsoft’s Media Center Edition operatingsystem as well as with Microsoft’s internet explorer web browser.

We believe Wavexpress’ products deliver value tocontent providers because the technology enables a broadband-delivered videoexperience which, to the end-user, is more like watching a DVD than streamingvideo over the Internet. Rather than steaming, Wavexpress utilizes a managedmedia cache at the point of presentation: the end-user PC. Media is downloadedto subscribers at off-peak hours and made available for playback once fullystored on the subscriber’s PC. This provides a higher-quality, more reliablevideo experience than streaming video.

Planned future development expenditures are expectedto approximate $1.6 million for the year ending December 31, 2005. As of December 31,2004, Wave owned 69% of Wavexpress and Sarnoff owned 26%.

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Wave was incorporated in Delaware under the nameIndata Corp. on August 12, 1988. We changed our name to CryptologicsInternational, Inc. on December 4, 1989. We changed our name again toWave Systems Corp. on January 22, 1993. Our principal executive officesare located at 480 Pleasant Street, Lee, Massachusetts 01238 and our telephonenumber is (413) 243-1600.

Wave, as well asWavexpress, is a development stage company and has realized minimal operatingrevenues since our inception. For the years ended December 31, 2004, 2003,and 2002 Wave incurred losses to common shareholders of approximately$14,498,000, $25,292,000 and $43,467,000,  respectively. At December 31, 2004 wehad an accumulated deficit of approximately $267,184,000. There can be noassurance that we will ever be successful in achieving commercial acceptance ofour products and services.

**Markets and Business Strategy**

Software has traditionally secured criticalinformation on networks and PCs and allowed for user access to variousapplications. However, virus attacks and breaches of security have proven thatsoftware, on its own, is not capable of completely securing a network orplatform. Because ofthese persistent security concerns, there is now a recognized need in thecomputer industry for the development and deployment of a more robust andreliable security infrastructure including new security hardware in devicesto guard against these persistent security risks. The TCG was formed todevelop, define and promote open industry standard specifications for embeddedhardware-enabled trusted computing and security technologies, including securehardware and software interfaces across multiple platforms, peripherals anddevices. Because Wave has been a pioneer in developing hardware-based computersecurity systems, we believe that we are distinctively positioned to takeadvantage of our unique knowledge, significant technology assets and trustedcomputing intellectual properties.

Because products developedusing the TCG specifications involve a new approach to conducting business andexchanging information using computer systems, and will require thattraditional software-based security be augmented with next generation securityproducts and an enhanced support infrastructure, intensive marketing and salesefforts have been and will continue to be necessary in order to generate demandfor products using Wave’s technology and to ensure that Wave’s solution isaccepted in this emerging market. Our objective is to make our EMBASSY brandedproducts and services the preferred applications and infrastructure for TrustedPlatforms. Key components in achieving this goal include:

*Capitalizing onInformation Security Industry Trends*

For 2004 and 2005 security remains one of the topindustry priorities across multiple segments of the user and product valuechains. This top priority is supported by increased spending budgets and highproduct adoption rates of new security offerings. Virtually all segments withinthe security markets are seeing increased focus.

Wave believes that a key differentiator of its EMBASSYTrust Suite is that it is interoperable across all of the currentlyavailable TPM-enabled Windows platforms and provides for ease of use. Key industryinitiatives and security specifications that will require the addition oftrusted hardware are moving forward in a number of platforms includingMicrosoft’s Next Generation Secure Computing Base (“NGSCB”), Intel’s LaGrandesecure computing program, and AMD’s Secure Execution Mode (“SEM”). Similarprograms are under consideration in network devices, and mobile devices such asPDAs and cell phones and consumer electronics devices.

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Wave has designedits products with features and functionality that it believes uniquelypositions them to capitalize on information security industry issues and trends.Wave sees these issues and trends as follows:

·       Requirementsto authenticate the identity of both platforms and users for access toprotected resources and information

·       Usermanaged security features

·       Majorprivacy concerns

·       Rapiddevelopment of new e-commerce business and distribution models

·       Lackof adequate security for e-commerce and vulnerability to attacks

·       Convergenceof consumer electronics and PC’s

·       Legalstatus of digital identities and digital signatures, including development ofnext generation web services which require digital signature solutions.

·       Increasedfocus on security and privacy by government entities

·       Rampantpiracy of digital goods including music, video, software and the need fordigital goods providers to securely distribute their content and prevent theft

Wave will continue topursue strategic relationships with hardware manufacturers, independentsoftware vendors, systems integrators and companies involved in the developmentof commerce in electronic content and services to achieve broad marketacceptance of its products as a platform for security solutions and commerceperformed in user devices.

*Pursue StrategicMarketing and Distribution Alliances*

We intend to expand Wave’sstrategic alliances with key partners that could distribute our products inenterprise, government and eventually consumer markets, and to build upon ouralliances with such industry leaders as Intel, Dell, HP, IBM and others in thePC industry. In addition, we are engaged in strategic activities withsemi-conductor manufacturers National Semiconductor, Atmel, STMicroelectronicsand Infineon Technologies to support and/ordeployEMBASSY applications with theirTPMs designed to the TCG specifications. TCGhas expanded its scope to include network devices, trusted peripherals, cellphones, PDAs and consumer electronics devices. Wave believes its trustedcomputing offerings can provide significant value in these new markets andplatforms and thus, is working to establish relationships with key partners ineach of these markets. For example, in 2004 Wave announced a relationship withARM as part of the ARM Connected Community of technology partners as a importantstep in pursuing opportunities in these markets.

*Enhancing OurCurrent Product Offerings and Products in Development*

We intend to continue to develop and extend ourexisting product offerings to include features and functionality to meetcustomer requirements and market demand. Planned development efforts thatenhance or utilize existing technologies include building upon and enhancingour EMBASSY Trust Suite,eTMS applications and Wavexpress broadband media distribution softwareapplications.

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Client and serversolutions supporting both the operations and life cycle management of TrustedPlatforms is a major focus area for Wave. New products that Wave is planning ondeveloping over the ensuing period will consist primarily of new TCG client andserver software services and enabling tools that will expand upon its portfolioof TCG trusted computing applications and services in the following areas:

·       Crossplatform interoperability:  There is TCGhardware coming from multiple suppliers, as well as supporting software frommultiple vendors. In order for applications from independent software vendorsto work with any of these multiple combinations of products, Wave is developingTCG specific toolkits that provide for this interoperability across platforms. Wavewill continue to expand the functions available to systems integrators (“SIs”),independent software vendors (“ISVs”) and independent hardware vendors (“IHVs”)within these enabling toolkits to make it easier to bring new applications toTrusted Platforms.

·       Clientapplications:  Wave’s EMBASSY Trust Suite providesimportant applications for the end user that run on their PCs such as EmbassySecurity Center, Document Manager, Private Information Manager, Key TransferManager and SmartSignature. Wave will continue to add new client applicationsand enhance the current applications with advanced functions to exploit thestrong security of the TCG platforms.

·       Serverapplications:  Trusted devices require anumber of life cycle management products to address the set up, registration,operations and systems management requirements of the platforms. Wave’s currentoffering consists of the KTM ES AD. The server products will be enhanced withfuture versions and expanded to offer additional trust services.

These development effortswill likely be significant and Wave intends to expend a substantial portion ofits research and development resources towards these enhancements as well assignificant marketing and corporate development funds to introduce the productsand build market demand. As a result, although Wave reduced its research anddevelopment expenditures in 2004, the continued research and developmentefforts will require substantial capital resources, which will likelynecessitate the need for further funding so that Wave may ultimately be able tocapitalize on the emerging market opportunities for its products and services. Waveannounced major products in 2004, primarily for TPM applications, and isdeveloping significant new client and server based products and productenhancements which are planned to be introduced in 2005.

*Marketing, Salesand Customers*

Because Wave’s products involve a new approach toconducting business and exchanging information using computer systems, it willrequire that traditional software-based security be enhanced and/or replacedwith next generation products designed using the TCG and related specifications.Intensive marketing and sales efforts have been and will continue to benecessary in order to increase recognition of and generate demand for productsusing Wave’s technology and to ensure that Wave’s solutions are accepted inthis emerging market. The current primary focus is on closing business withchip OEMs, PC OEMs, enterprise customers and systems integrators. Wave has alsoundertaken steps to develop and establish a reseller channel for our products.

Wave’s business model targets revenues from varioussources: licensing of our technology including EMBASSY Trust Suite clientapplications; tools and enabling software; and client/server based trustedsoftware solutions for the lifecycle management of keys and authentication ofTrusted Platforms.

Wave has identifiedfive key markets where we believe our products would provide unique benefits:

·       PCs—TCG’sstandards-based specifications for trusted hardware is leading the industrytoward increased deployment of TPM hardware by a growing number of PC OEMs. Thecurrent focus for both TCG and Wave is for business PC platforms, but will beextending into consumer PCs over 

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time. Wave anticipatesproviding enablingtoolsto SIs, ISVs, and IHVs  in order to takeadvantage of the new trusted computing features of these platforms.

·       Networkproducts, Peripherals and Mobile Devices—As TCG based specifications arereleased and product deployment begins, Wave anticipates extending its productsto support these new trusted computing platforms and marketing to theassociated OEMs, SI, ISVs, IHVs, and service providers for these devices.

·       Bankingand Finance**—**In addition to our Europeaninitiatives to be a leader in delivering solutions for European standards,which can provide strong authentication to services, we are aggressivelycultivating interest and support from financial institutions for utilizing TCG-compliant platforms.

·       BroadbandMedia—Through our Wavexpress joint venture, we have developed a broadbandarchitecture for the distribution and subsequent management of secured mediachannels to subscribers in the home and enterprise**.**

·       Governmentand Enterprise—The market for electronic security systems in governmental unitsand large business enterprises is growing and Wave believes this marketrepresents a key opportunity for both our eTMS as well as Wave’s TCG offerings.

Directly and through our partners, Wave isaggressively targeting opportunities in these markets, as we believe ourproducts provide a wide range of security and trust capabilities not offered inany other single solution.

Wavexpress offers its technology and services on thebasis of a per-user fee and/or revenue share with the content owner, with aparticular focus on advertising supported entertainment services. In addition,Wavexpress publishes to the installed base of Microsoft Media Center PCs fivegeneral interest channels of entertainment programming offered under theTVTonic brand. Wavexpress’ client software and TVTonic channels arepre-installed with one high-end Microsoft Media Center PC OEM. Wavexpress islooking to expand to other manufacturers in 2005.

Wave’s sales for the yearended December 31, 2004 consisted primarily of licensing its softwareapplications, engineering and support services. Of the total revenue realizedfor the year ended December 31, 2004, 79% was derived from activitiesrelated to Wave’s computer security products and services and the remaining 21%was derived from Wavexpress’ broadband media distribution segment.  None of the customers from which Wave derivedrevenue in 2004 in excess of 10%, would have a material adverse effect on Wave’sbusiness if Wave were to lose such customers, because the level of sales duringthe year overall was not significant to Wave’s level of expenditures. However,Wave’s business plan on a forward-looking basis, will depend heavily on a smallnumber of OEM customers, partners and prospective customers, the loss of, orlack of substantial future revenues from, any may have a material adverseeffect on our business plan going forward. These include NationalSemiconductor, Intel, ST Microelectronics, Dell Computers, Inc. andothers.

**Competition**

*Wave EMBASSY DigitalSecurity Products*

We operate in the information security market, ahighly competitive and fragmented environment that is characterized by rapidlyevolving technology. Many of our competitors and potential competitors havesubstantially greater financial, technical and marketing resources than us. Also,many current and potential competitors have greater name recognition and moreextensive customer bases to leverage, allowing these competitors to gain marketshare or product acceptance to our detriment. In addition, the rate of marketacceptance of trusted computing solutions is still in the formative and earlystages. The markets for our products are developing and, while the TCGspecifications have provided the basis for the industry to 

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move forward, thereremains significant standards work efforts in order for the eco-systemsupporting trusted computing to move forward.  Wave’s potential competitors include securitysolutions providers such as RSA Security, Inc., Symantec, ComputerAssociates, Verisign, Inc., Entrust, Inc., Ultimaco, Safenet andmajor systems integrators such as IBM, HP and EDS. In addition, Wave competeswith other client security applications companies that are developing trustedcomputer applications including Softex, Phoenix, Infineon and Microsoft. Thecompetitive factors defining these evolving markets include product features,compatibility, standards compliance, quality and reliability, ease of use,performance, customer service and support, distribution and price. Wavebelieves its products meet the requirements to be successful viable products inthese markets. The features of Wave’s products that should allow it  to compete favorably through productdifferentiation include: cross-platform, interoperable solutions; easy-to-usefeatures; and leading edge trusted client/server infrastructure solutions. Inaddition, Wave continues to have leading solutions with its digital signatureproducts, especially when combined with trusted computing platforms andfeatures.

One of the market challengesfacing Wave is the establishment of a newly defined market category within theoverall information security market for trusted computing software and servicesthat includes a more complex business model for adoption. While the TCGspecifications define a very complex and comprehensive cryptographic systemthat require significant skills and resources, the market for securitysolutions that are as complex as those developed by Wave is in a formativestage of development. As a result, commercialization of these technologies hasbeen slow to develop. It is also possible for other competitors to developsimilar offerings to compete with our products or new technologies may emergethat could replace existing technology that our products rely on, thereby makingour products non-competitive or obsolete. We can offer no assurances that Wave’sproducts will become industry standards or become widely accepted by themarketplace.

*WavexpressBroadband Media Distribution*

Wavexpress competes in amarket dominated by traditional content delivery methods. Wavexpress prospectsrely on traditional broadcast television, Internet streaming and onlinewebsites. Wavexpress’ technology augments these services with a higher qualityplayback experience and more reliable delivery method. Several companiescompete for the digital delivery of content over broadband, including CDNs(content delivery networks) such as Akamai, startup caching companies such asMaven Networks and streaming service providers such as The Feedroom.

**International Market**

Most of our software products and many components ofthe EMBASSY Trust System are controlled under various United States exportcontrol laws and regulations and may require export licenses for certainexports of the products and components outside of the United States and Canada.We have received export licenses from the U.S. Department of Commerce’s Bureauof Export Administration (the “BXA”) for the sale and export of our EMBASSYchip and related products and technology to any end-user in any countrythroughout the world with the exception of Cuba, Iran, Iraq, Libya, NorthKorea, Sudan and Syria, subject to certain restrictions and, in some cases,certain reporting requirements. With respect to our EMBASSY Trust Suite softwareapplications, we have applied for and received export classifications thatallow us to export our products, without a license and with no restrictions, toany country throughout the world with the exception of Cuba, Iran, Iraq, Libya,North Korea, Sudan and Syria.

We believe the exportclassifications that we have received for our software products allow us tosell our products internationally in an effective, competitively advantageousmanner. Enhancements to existing products may, and new products, including theEMBASSY Trust Server applications, will be subject to reviews by the BXA todetermine what export classification they will receive. Some of our partnersdemand that our products be allowed to be exported without restrictions and/orreporting requirements. Current 

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exportregulations have, in part, allowed us to receive the desired classificationwithout undue cost or effort. However, the export regulations may be modifiedat any time. Modifications to the export regulations could prevent us fromexporting our existing and future products in an unrestricted manner without alicense, as we are currently allowed for the products that we’ve receivedclassification, or makeit more difficult to receive the desired classification. If exportregulations were to be modified in such a way, we may be put at a competitivedisadvantage with respect to selling our products internationally.

**ProprietaryRights and Licenses and Intellectual Property**

Our success depends, in part, on our ability to enjoyor obtain protection for our products and technologies under United States andforeign patent laws, copyright laws and other intellectual property laws, topreserve our trade secrets and to operate without infringing the proprietaryrights of third parties. Any issued patent owned or licensed by us may not,however, afford adequate protection to us and may be challenged, invalidated,infringed upon or circumvented. Furthermore, you should understand that ouractivities may infringe upon patents owned by others.

Wave has been issued eleven (11) United States patentsrelating to encryption and to our proprietary EMBASSY and Wave Commercetechnology. We also have eight (8) patents pending before the UnitedStates Patent Office. In addition, we have two (2) foreign patents andtwenty-nine (29) pending foreign patent applications. Our patents are materialto protecting some of our technology.

We rely on trade secrets and proprietary know-how,which we protect, in part, by confidentiality agreements with our employees andcontract partners. However, we caution you that our confidentiality agreementsmay be breached and we may not have adequate remedies if such a breach occurs. Furthermore,we can provide no assurance that our trade secrets will not otherwise becomeknown or be independently discovered by competitors.

We also rely on copyrightlaw to prevent the unauthorized duplication of our software and hardwareproducts. We have and will continue to protect our software and our copyrightinterest therein through agreements with our consultants. We can provide noassurance that copyright laws will adequately protect our technology.

**Research and Development**

Wave’s productsincorporate encryption/decryption, client and server software applications andother technologies in which we have made a substantial investment in researchand development. We will likely be required to continue to make substantialinvestments in the design of information security applications and services,including the EMBASSY Trust Suite, EMBASSY Server applications, eTMS products,and broadband media distribution products. For the years ended December 31,2004, 2003 and 2002 we spent approximately $6.9 million, $7.4 million and $12.0million, respectively, on research and development activities. Planneddevelopment expenditures for the year ended December 31, 2005 are expectedto be approximately $7.1 million.

**Employees**

As of December 31,2004, we employed seventy-nine (79) full-time employees, thirty-eight(38) of whom were involved in sales, marketing and administration and forty-one(41) of whom were involved in research and development (including fourteen (14)employed by Wavexpress, four (4) of whom were in sales, marketing andadministration and ten (10) of whom were involved in research anddevelopment). As of December 31, 2004, we retained the services of seven (7) full-timeconsultants, two (2) of whom were retained by Wavexpress. We believe ouremployee relations are satisfactory.

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**Item 2.        Properties**

Summarizedbelow is a listing of properties leased by Wave. Our principal research anddevelopment activities are conducted at the Princeton and Cupertino facilities.
| **Facility**    | ** ** | ** ** | ** ** | **Sq. Ft.** | ** ** | **Annual Lease  Cost** | ** ** | **Lease Expires** | ** **     |
|-----------------|------------|------------|------------|------------------|------------|-----------------------------|------------|------------------------|----------------|
| Lee, MA         |       | 13,048     |       |             | $          | 124,268                     |       |                   | July 2007 |   |
| Princeton, NJ   |       | 5,000      |       |             | 126,750    |                        |       | —                 |           |
| Cupertino, CA   |       | 10,028     |       |             | 294,864    |                        |       | Feb. 2008         |           |
| New York, NY    |       | 7,169      |       |             | 364,932    |                        |       | Apr. 2006         |           |
| Orvault, France |       | 1,000      |       |             | 67,260     |                        |       | Sept. 2007             |           |

 

**Item 3.        Legal Proceedings**

*Securities and Exchange Commission Investigation*

On December 17, 2003Wave received an Order by the Securities and Exchange Commission (the “Commission”)regarding a formal investigation. The focus of this investigation is on certainpublic statements made by Wave during and around August 2003, as well ascertain trading in Wave’s securities during such time. The Commission has notconcluded that there has been any wrongdoing and Wave is cooperating fully withthe Commission on this matter. Wave cannot predict the potential effect on Waveas a result of this investigation at this time.

*Purported Class Actions*

Several (9 known) similarpurported class action complaints have been filed between January 23, 2004and February 23, 2004, most in the United States District Court for theDistrict of Massachusetts, seven (7) of which name Wave, its ChiefExecutive Officer and its Chief Financial Officer and two (2) of whichalso name Wave’s Chairman, as defendants. The purported class action complaintshave been filed by alleged purchasers of Wave’s Class A Common Stockduring the purported class period July 31, 2003 through February 2,2004. The complaints claim that Wave and the named individuals violated thefederal securities laws by publicly disseminating materially false andmisleading statements regarding Wave, relating to Intel and IBM agreements,resulting in the artificial inflation of Wave’s Class A Common Stock priceduring the purported class periods. The complaints do not specify the amount ofalleged damages plaintiffs seek to recover.

Wave intends to defend theactions vigorously. At this time, Wave is unable to predict the outcome ofthese actions.

*Derivative Actions*

Wave has learned of three (3) othercomplaints filed in the United States District Court for the District ofMassachusetts. Wave believes that the complaints name all of its directors asdefendants and allege claims for breach of fiduciary duties and other claims. Theallegations are very similar to the allegations made in the purportedsecurities class actions because the allegations concern the very same allegedstatements alleged in the purported class actions. Wave is also named as anominal defendant, although the actions are derivative in nature andpurportedly asserted on behalf of Wave. Wave is in the process of evaluatingthese claims.

Other than the mattersdescribed above, Wave was not involved in any material litigation, nor, tomanagement’s knowledge is any material litigation threatened against them ortheir properties other than routine litigation arising in the ordinary courseof business.

**Item4.        Submission of Matters to a Voteof Security Holders**

None.

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**PART II**

**Item 5.**                        Market forRegistrant’s Common Equity and Related Stockholder Matters

*Market Information &Dividends*

The Class A Common Stock trades on the NasdaqNational Market under the symbol “WAVX”. The following table sets forth, forthe periods indicated, the high and low sales prices per share for the Class ACommon Stock. There is no established trading market for our Class BCommon Stock.
| ** **                         | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------|------------|----------|------------|---------|------------|
| Year Ended  December 31, 2004 |       |     |       |    |       |
| First Quarter                      |       | $        | 2.34       |    | $          | 1.03 |   |
| Second Quarter                     |       | 2.29     |       | 1.02    |       |
| Third Quarter                      |       | 1.37     |       | 0.71    |       |
| Fourth Quarter                     |       | 1.72     |       | 0.78    |       |
| Year Ended December 31, 2003  |       |     |       |    |       |
| First Quarter                      |       | $        | 1.63       |    | $          | 0.75 |   |
| Second Quarter                     |       | 1.29     |       | 0.76    |       |
| Third Quarter                      |       | 5.24     |       | 0.80    |       |
| Fourth Quarter                     |       | 3.16     |       | 1.28    |       |

 

As of February 28, 2005, there were approximately32,000 holders of our Class A Common Stock. As of such date, there were 16holders of our Class B Common Stock.

On February 28, 2005, the last sale pricereported on the Nasdaq National Market for the Class A Common Stock was$1.15.

We have never declared norpaid any cash dividends on our capital stock. We currently anticipate that wewill retain all future earnings, if any, to fund the development and growth ofour business and do not anticipate paying any cash dividends on our capitalstock in the foreseeable future

*Securities Authorized for Issuance Under EquityCompensation Plans*
| **Plan Category**                                                 | ** ** | ** ** | ** ** | **Number of Securities  to be issued upon  exercise of  outstanding options,  warrants and rights  (a)** | ** ** | **Weighted Average  exercise price of  outstanding options,  warrants and rights  (b)** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities reflected  in column (a))  (c)** | ** ** |
|------------------------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders                |       |       | 11,337,053 |                                                                                                                                                  |       |                                                                                                                  | $          | 4.20                                                                                                                                                                                                                  |       |   |   | 6,900,900 |   |   |
| Wave equity  compensation plans not approved by security holders       |       |       | 507,296    |                                                                                                                                                  |       |                                                                                                                  | 1.16       |                                                                                                                                                                                                                  |       |   | 2,667,069 |   |   |
| Total Company  plans                                                   |       |       | 11,844,349 |                                                                                                                                                  |       |                                                                                                                  | $          | 4.07                                                                                                                                                                                                                  |       |   |   | 9,567,969 |   |   |
| Wavexpress equity  compensation plans not approved by security holders |       |       | 1,302,829  |                                                                                                                                                  |       |                                                                                                                  | $          | 1.21                                                                                                                                                                                                                  |       |   |   | 1,169,394 |   |   |

 

Wave equity compensation plans not approved bysecurity holders are comprised of the following:

In November 2004, the Board of Directors approvedan Employee Stock Purchase Plan (the “Purchase Plan”) which will be voted on bysecurity holders at the Annual Meeting scheduled in May 2005. The purposeof the Purchase Plan is to provide employees of the Company with an opportunityto purchase Common Stock of the Company at a purchase price equal to 85% of the Fair Market Value of a Shareon the Offering Commencement Date or on the Offering Termination Date,whichever is lower. 

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Each Offering Period willbegin on December 1 or June 1 and end on the next following May 31or November 30, respectively. For the current Offering Period, the FairMarket Value on December 1, 2004 was $0.90 per share (that day’s closingprice). After calculating the estimated current Offering Period employeecontributions by 85% of $0.90, approximately 332,931 shares of common stock areexpected to be purchased on May 31 2005.

In connection with an agreement that the Companyentered into with nClose, Inc., an outside software development firm, on January 2,2004 the Company issued a warrant to purchase 30,000 shares of Class ACommon Stock at an exercise price of $1.00 per share, pursuant to an individualcompensation plan with nClose. Also, in connection with the same agreement, on April 30,2004 an additional warrant was issued to nClose, Inc. to purchase 35,000shares of Class A Common Stock at an exercise price of $1.00 per share.The warrants are currently exercisable and expire on January 2, 2009 and April 30,2009, respectively. No additional warrants are required to be granted pursuantto the individual compensation plan for nClose.

In connection with an agreement that Wave entered intowith an outside sales representative, in 2003 Wave issued warrants to purchase44,365 shares of Class A Common Stock at prices ranging from $0.95 to$1.45 per share, pursuant to an individual compensation plan with the salesrepresentative. No additional warrants are required to be granted pursuant tothe individual compensation plan for the sales representative. These warrantsare currently exercisable and expire January 1, 2013 through April 30,2013.

In connection with a software development agreementthat Wave entered into with Archon Technologies, Inc. (“Archon”), Waveissued to Archon a warrant to purchase 50,000 shares of Class A CommonStock at $3.48 per share, pursuant to an individual compensation plan withArchon (the “Archon Plan”). The warrant became exercisable on November 9,2002, and expires on November 9, 2007. No additional warrants are requiredto be granted pursuant to the Archon Plan.

As a result of thesuccessful placement of 350 shares of Series B preferred stock, in 1996 aconsultant from Digital Media Group, Inc. (“Digital Media”) was issuedwarrants by Wave to purchase 15,000 shares of Class A Common Stock at aprice of $3.09 per share, pursuant to an individual compensation plan withDigital Media (the “Digital Media Plan”). No additional warrants are requiredto be granted pursuant to the Digital Media Plan. These warrants are currentlyexercisable and expire on March 1, 2006.

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**Item 6.***                       *SelectedFinancial Data

**ConsolidatedStatement of Operations Data**
| ** **                                                                                    | ** ** | **For the year-ended December 31,** | ** **  |
|-----------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|-------------|
| ** **                                                                                    | ** ** | **2004**                                                | ** **  | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| Net Revenues                                                                                  |       | $                                                       | 209,311     |   | $ | 189,363 |   | $ | 446,588 |   | $ | 692,125 |   | $ | 332,522 |   |
| Cost of Sales                                                                                 |       | 151,704                                                 |        | 55,179 |   | 202,208 |   | 369,959 |   | 58,864 |   |
| Gross Profit                                                                                  |       | 57,607                                                  |        | 134,184 |   | 244,380 |   | 322,166 |   | 273,658 |   |
| Operating expenses:                                                                           |       |                                                    |        |   |   |   |   |   |   |   |   |
| Selling, general  and administrative                                                          |       | 12,255,427                                              |        | 12,698,682 |   | 19,188,046 |   | 24,184,317 |   | 26,553,634 |   |
| Research and  development                                                                     |       | 6,852,754                                               |        | 7,384,708 |   | 12,009,713 |   | 17,691,051 |   | 20,866,055 |   |
| Restructuring and  other special  charges                                                     |       | —                                                  |        | — |   | 726,280 |   | — |   | — |   |
| Amortization of  goodwill                                                                     |       | —                                                  |        | — |   | — |   | 1,720,632 |   | 573,544 |   |
| Inventory  provision                                                                          |       | —                                                  |        | 1,114,442 |   | — |   | — |   | — |   |
| Write-off of  goodwill                                                                        |       | —                                                  |        | — |   | — |   | 2,284,570 |   | — |   |
| Write-off of  intangible and other impaired assets                                            |       | 301,366                                                 |        | — |   | 1,571,031 |   | 1,761,917 |   | — |   |
| In- process  research & development                                                  |       | —                                                  |        | — |   | — |   | — |   | 2,176,000 |   |
|                                                                                          |       | 19,409,547                                              |        | 21,197,832 |   | 33,495,070 |   | 47,642,487 |   | 50,169,233 |   |
| Other income (expense):                                                                       |       |                                                    |        |   |   |   |   |   |   |   |   |
| Equity in net  losses of GlobalWave                                                           |       | —                                                  |        | — |   | — |   | (2,332,159 | ) | (3,406,491 | ) |
| Loss on other than  temporary decline in equity securities                                    |       | —                                                  |        | — |   | (11,513,099 | ) | (1,736,682 | ) | — |   |
| Liquidated damages                                                                            |       | —                                                  |        | (155,716 | ) | — |   | — |   | — |   |
| Gain on decrease  in value of warrant liability                                               |       | 498,723                                                 |        | 263,097 |   | — |   | — |   | — |   |
| Gain on  termination of development contract                                                  |       | —                                                  |        | — |   | 1,818,000 |   | — |   | — |   |
| Recovery of  (Provision for loss on) officer note receivable                                  |       | —                                                  |        | 999,518 |   | (999,518 | ) | — |   | — |   |
| Gain on sale of  marketable securities                                                        |       | 4,330,248                                               |        | 234,759 |   | — |   | — |   | 542,457 |   |
| Net interest and  other income   (expense)                                                    |       | 24,931                                                  |        | 127,192 |   | 477,902 |   | 2,688,105 |   | 5,103,716 |   |
| Total Other Income  / (expense)                                                               |       | 4,853,902                                               |        | 1,468,850 |   | (10,216,715) |   | (1,380,736) |   | 2,239,682 |   |
| Net loss                                                                                      |       | (14,498,038)                                            |        | (19,594,798) |   | (43,467,405) |   | (48,701,057) |   | (47,655,893) |   |
| Accrued dividends  on preferred stock (including $5,485,000 of accretion of discount in 2003) |       | —                                                  |        | 5,697,518 |   | — |   | — |   |   |   |
| Net loss to common  stockholders                                                              |       | $                                                       | (14,498,038 | ) | $ | (25,292,316 | ) | $ | (43,467,405 | ) | $ | (48,701,057 | ) | $ | (47,655,893 | ) |
| Weighted average  number of common shares outstanding during the period                       |       | 69,040,661                                              |        | 55,887,384 |   | 51,135,548 |   | 49,949,875 |   | 46,149,587 |   |
| Loss per common  share-basic and   diluted                                                    |       | $                                                       | (0.21       | ) | $ | (0.45 | ) | $ | (0.85 | ) | $ | (0.97 | ) | $ | (1.03 | ) |
| Cash dividends  declared per common share                                                     |       | -0-                                                     |        | -0- |   | -0- |   | -0- |   | -0- |   |

 

See Notes to FinancialStatements

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**ConsolidatedBalance Sheet Data**
| ** **                       | ** ** | **As of December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|
| ** **                       | ** ** | **2004**                              | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| Working capital                  |       | $                                     | 3,549,095  |   | $ | 12,406,861 |   | $ | 8,754,620 |   | $ | 36,963,617 |   | $ | 76,099,347 |   |
| Total assets                     |       | 8,454,582                             |       | 18,160,430 |   | 18,209,372 |   | 60,234,302 |   | 98,084,461 |   |
| Long-term  liabilities           |       | 493,128                               |       | 991,851 |   | — |   | — |   | — |   |
| Total Liabilities                |       | 3,744,382                             |       | 4,145,794 |   | 3,667,533 |   | 6,428,896 |   | 7,870,009 |   |
| Total stockholders’  equity |       | $                                     | 4,710,200  |   | $ | 14,014,636 |   | $ | 14,541,839 |   | $ | 53,805,406 |   | $ | 90,214,452 |   |

 

**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

**Overview**

In  2003 Wave’s management made a shift in itsbusiness focus by devoting less attention and resource to its proprietaryEMBASSY Trust System and more attention to developing and marketingTCG-compliant software products known as it’s EMBASSY Trust Suite andEMBASSY Trust Server Applications. These are products designed and built aroundthe TCG specifications, known as Trusted Platforms,  that are being adopted into the InformationSecurity Services marketplace. Wave devoted a substantial amount of itsactivities and resources during the year ended December 31, 2003 toorganizing its business to capitalize on the opportunities presented by theemergence of the TCG specifications.

In 2004,Wave continued to pursue a strategy of educating the marketplace on thebenefits that trusted computing has to offer, while continuing to develop thebasic software applications designed to enable this emerging technology. Themarket trends and opportunities that management focused the company’sactivities during the year ended December 31, 2004 included the following:

·       Themarket for information security services is growing rapidly—according toindustry analyst, IDC, the U.S. market for information security services isexpected to grow from approximately $4 billion in 2001 to $10.7 billion in 2006representing a compound annual growth rate of 21.7%. The global market forinformation security is expected to reach $23 billion by 2006. (1)

·       Thepersistence of security threats indicates that hardware is needed to providemore robust security than traditional software solutions.

·       Emergenceof TPM-enabled PCs being sold into the marketplace—this emergence iscomplementary to Wave’s business model, which largely relies upon providingservices for Trusted Platforms rather than selling the hardware itself.

·       Businessand security strategies are becoming more closely aligned due to the increasingrate of significant high profile and costly security breaches and theassociated risks presented by this phenomenon.

·       In-housesecurity expertise remains in short supply—Wave seeks to capitalize on itsexpertise as awareness of TPM-enabled solutions increases.

·       Microsofthas required TPM version 1.2 in its draft Longhorn operating system hardwarerequirements specification for logo compliance. Wave believes that asignificant percentage of the approximately 150 million unit PC market willinclude TPMs by May 2006, which is Microsoft’s stated launch date forLonghorn.

Inpursuing these opportunities, we recognize many significant challenges thatmust be overcome, including:

·       Tightenterprise IT budgets—industry data appear to show that, while enterprisesecurity will be a priority, it will be challenged by tight budgets

----

(1)                 IDC,*The Shifting Landscape: U.S. Information SecurityServices*, Jan. 2003, document # 28640.

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·       Longsales cycle due to continued lack of support for enterprise spending onsecurity solutions — information security continues to be viewed as an IT issueversus a business issue

·       Needto educate the marketplace of the advantages of utilizing hardware-basedtrusted platforms as a security solution

·       Limitedavailability of capital resources—Wave continues to rely on financing thedevelopment of its business by issuing new equity (See **Liquidityand capital resources**section for a detailed discussion of financingactivities during 2004).

As more PC and chip OEMs have begun introducing theirTrusted Platform offerings, management has focused on entering into licensingcontracts in which the OEM licenses our applications and bundles them withtheir offering, paying Wave a royalty for each unit shipped. Wave currently hassigned such bundling agreements with three separate OEM partners. For the yearended December 31, 2004, Wave received approximately $308,000 in royaltiesfrom these OEM partners pursuant to its license agreements with them. Revenuerecognized on these contracts through December 31, 2004 totaledapproximately $60,000, while the remaining $248,000 is deferred revenue.  We continue to pursue OEM business under theroyalty model described herein. In addition, we seek to enter into arrangementswith resellers that sell to PC OEMs to distribute our applications as a productoffering that users may choose when purchasing a TPM-equipped computer from thePC OEM. For instance, in February, 2005, Dell Computers Inc began offering Wave’sETS Software as an option for purchase on select models through their websiteat Dell.com. Wave hopes to capitalize on this association with Dell productsand the wider distribution of TPM-equipped personal computers that a Dell TPM offering represents. In addition, wehave sought to develop our products such that they operate on all of the majorPC OEM Trusted Platforms that are currently shipping product in the marketplaceand our applications have been approved to work with the Trusted Platforms ofIBM, HP, Atmel, Infineon and others.

Management is also focused on developing the client andserver-side applications and tools that will enable enterprises to manage an ITinfrastructure that relies on products built using TCG specifications. Wave isdevoting a significant portion of its research and development budget toaddress this opportunity, as this will be a key ingredient for enterprises insuccessfully implementing a Trusted Platform solution. Wave released thesetools and applications in 2004, and has signed a license agreement in the firstquarter of 2005 with an embedded systems manufacturer  to license the Wave TCG-enabled toolkit andKTM ES AD.

With respect to sales and marketing, management isfocused on broadening our distribution strategies to include the directengagement of our channel partners using their resellers and systemsintegrators and has hired regional representation in Japan. We have alsoexpanded our targeted presence selling directly to OEMs. We havespecifically focused our resources towards solution selling in these channels. Wehave reorganized and shifted the focus of our sales force during the year inorder to achieve these objectives.

Management is alsofocused on opportunities for its eTMS product suite to provide digital signingand document management solutions to the financial services and other verticalmarkets in which there is a clear and identifiable value proposition inimplementing these solutions. Although we have met significant implementationchallenges and long sales cycles with this effort, we have also experiencedsignificant interest in these products and we continue to pursue thisopportunity.

Wavexpress is focused on building a sustainablerevenue stream based on establishing partnerships with branded contentproviders to provide paid and advertising supported video entertainmentservices. These services are designed into existing web sites andpresented as extensions to Microsoft Media Center Edition PC’s. Thecompany is extending the technology so that its subscriber management systemcan leverage the added security of a TPM and is preparing back-office systemsfor standalone deployment into 

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enterprise installations. Wavexpress currently hasthree active contracts that are generating revenue going into 2005. It isexpected that these contracts will generate revenue that is in line with therevenue that Wavexpress has generated in the last two fiscal quarters. Managementplans to devote increasing development resources towards building its featureset to meet market demand.

While management isprimarily focused on the emerging TCG Trusted Platform opportunities, itremains committed to pursuing business opportunities that involve itsproprietary EMBASSY Trust System products and services, primarily in thegovernment sector.

*Operating ExpenseTrends*

In addition to the trend of decreasing research anddevelopment expenses shown in Item I—Business; selling, general andadministrative expenses (“S,G&A”) have likewise been trending downward overthe three years ended December 31, 2004. For the years ended December 31,2004, 2003 and 2002 we have incurred approximately $12.3 million, $12.7 millionand $19.2 million, in S,G&A expenses, respectively. The activitiessupported by these expenditures include business development, sales, marketing(including product management), corporate communications and public relations,information technology and management information systems, human resources,accounting, executive management, corporate governance and generaladministrative functions. The downward trend in S,G&A expenses and expensesin general, is indicative of Wave’s strict cost-cutting measures, which beganduring the second half of 2001 and continued through the end of 2003, and havesince flattened into 2004. Much of these cost reductions were the result ofWave’s abandonment of several lines of business that it had previously beenpursuing, including Internet services and consumer e-commerce. In addition,Wave de-emphasized the marketing of its proprietary EMBASSY Trust Systemplatform in 2003 other than to the government security sector. While Waveadjusted its emphasis to focus on the emerging TCG services market segmenttoward the end of 2002 and into 2003, it drastically reduced several areaswithin the selling, general and administrative category including productmanagement, sales and marketing, business development and support areasincluding accounting, human resources, information systems and other corporateoverhead, that had supported the higher level of business activity that has nowbeen reduced. The expense reductions being referred to herein came mostly inthe form of headcount and outside services expenditure reductions. Now thatWave has begun selling an introductory suite of software applications into themarket and has identified and begun developing the next generation of theseproducts that will include key management and infrastructure services, we’vebegun rebuilding our sales force, expanding our distribution channels andimplementing a global sales and marketing strategy.

Although we’ve reduced our expenditures significantly,given the early stage nature of the markets for products that use ourtechnology, we will continue to expend considerable resources in the sales,marketing, business development and support activities referred to above thatwill be necessary for us to be successful in developing salable products andmarkets for our technology. The outlook over the short-term is for sales andmarketing expenditures to remain relatively flat, compared with 2004, withresearch and development remaining at approximately the same level as 2004 aswell. (See **Liquidity and capital resources**)

The following discussionrelated to the consolidated financial statements of Wave should be read inconjunction with the financial statements appearing in Item 8.

**Critical Accounting Policies**

Wave’s discussion and analysis of its financialcondition and results of operations are based on the Company’s consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States of America. The preparationof these financial statements requires management to make estimates andassumptions that affect the reported amounts of 

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assets and liabilities andthe disclosure of contingent assets and liabilities at the date of thefinancial statements, as well as the reported revenues and expenses during thereporting periods. On an ongoing basis, management evaluates its estimates andjudgments, including those related to revenue recognition, accounts receivablereserves, marketable securities, valuation of long-lived and intangible assets,accounting for joint ventures and software development. Management bases itsestimates on historical experience and on various other factors that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying value of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions.

The following accounting policies are deemed criticalto the understanding of the consolidated financial statements included underItem 8—Financial Statements and Supplementary Data.

*Methodof Accounting for Joint Ventures*—Wave accounts for itsinvestments in joint ventures using the equity method of accounting when itsownership interest in the joint venture is less than fifty percent and it isdetermined that Wave has the ability to exercise significant influence over thejoint venture’s operating and financial policies. The financial statements ofjoint ventures in which Wave owns greater than a fifty-percent interest areconsolidated with Wave’s financial statements pursuant to Accounting PrinciplesBoard (“APB”) Opinion No. 18.

*MarketableSecurities*—Investments, which consist solely of equitysecurities, are accounted for under Statement of Financial Accounting Standards(SFAS) No. 115, “Accounting for Certain Investments in Debt and EquitySecurities” issued by the Financial Accounting Standards Board (FASB). Pursuantto the provisions of SFAS No. 115, investments are classified as “trading”,“available-for sale” or “held to maturity”. “Trading” securities are bought andheld principally for the purpose of selling them in the near term and arerecorded at fair value. Fair value is based upon quoted market prices. Unrealizedgains and losses on trading securities are included in the determination of netearnings. “Available-for-sale” securities are being held for an unspecifiedperiod of time and may be used for liquidity or other corporate purposes andare recorded at fair value. Unrealized gains and losses on available-for-salesecurities are reported as a separate component of comprehensive income (loss)in stockholders’ equity. Unrealized losses that are determined to be other thantemporary are recognized as charges against earnings. Factors considered whendetermining if an other than temporary decline has occurred include: whether adecline in market value is related to specific concerns of the issuer of thesecurities as opposed to general market conditions, the length of time of thedecline in market price, the financial condition and near-term prospects of theissuer and other factors that may indicate that the value of the securitieswill not recover. “Held to maturity” securities are debt securities that areintended to be held to maturity and are recorded at amortized cost. As of December 31, 2004, all of Wave’smarketable equity securities are classified as available-for-sale.

*Researchand Development and Software Development Costs*—Researchand development costs are expensed as incurred. Software development costs areaccounted for pursuant to Statement of Financial Accounting Standards No. 86“Accounting for the Costs of Computer Software to be Sold, Leased, or OtherwiseMarketed” (“SFAS No. 86”). SFAS No. 86 specifies that costs incurredinternally in creating a computer software product should be charged to expensewhen incurred as research and development costs until technological feasibilityhas been established for the product. Once technological feasibility is establishedand the product has achieved commercial marketability, all development costsshould be capitalized until the product is available for general release tocustomers. We consider technological feasibility to be established uponcompletion of a detail program design, or in the absence of a detail programdesign, upon completion of a working model of the software as defined in SFAS No. 86.Judgment is required in determining when the technological feasibility of aproduct is established, if the product has achieved commercial marketabilityand in estimating the life of the product for which the capitalized costs willbe amortized.

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*Impairment of Long-LivedAssets and Long-Lived Assets to Be Disposed Of*—Wavereviews the valuation of long-lived assets, including property and equipmentand capitalized software, under the provisions of SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets” and SFAS No. 86. Waveis required to assess the recoverability of long-lived assets and capitalizedsoftware costs whenever events and circumstances indicate that the carryingvalue may not be recoverable. Factors we consider important that could triggeran impairment review include the following:

·       significantunderperformance relative to expected historical or projected future operatingresults;

·       significantchanges in the manner of our use of the acquired assets or the strategy of ouroverall business;

·       significantnegative industry or economic trends; and

·       significantdecline in our stock price for a sustained period.

In accordance with SFAS No. 144, when wedetermine that the carrying value of applicable long-lived assets may not berecoverable based upon the existence of one or more of the above indicators ofimpairment, we evaluate whether the carrying amount of the asset exceeds thesum of the undiscounted cash flows expected to result from the use and eventualdisposition of that asset. If such a circumstance exists, we would measure animpairment loss to the extent the carrying amount of the particular long-livedasset or group exceeds its fair value. We would determine the fair value basedon a projected discounted cash flow method using a discount rate determined byour management to be commensurate with the risk inherent in our current businessmodel. In accordance with SFAS No. 86, when we determine that the carryingvalue of certain other types of long-lived assets may not be recoverable, weevaluate whether the unamortized cost exceeds the expected future netrealizable value of the products. If the unamortized costs exceed the expectedfuture net realizable value of the products, the excess amount is written off. Changesin judgments on any of these factors could impact the value of the asset beingevaluated.

*RevenueRecognition*—Wave’s business model targets revenuesfrom various sources including: licensing of EMBASSY Trust Suite, Wavexpress’broadband media distribution and eTMS software products, sales of hardware anddevelopment contracts. Many of our sales arrangements include multiple-elements,and/or required significant modification or customization of our software.

Wave follows the provisions of statement of position “SOP”97-2, *Software Revenue Recognition* as amendedby SOP 98-9, Modification of SOP 97-2, *Software Revenue Recognition,with Respect to Certain Transactions*. Generally, Wave recognizesrevenue when it is realized or realizable and earned. Wave considers revenuerealized or realizable and earned when persuasive evidence of an arrangementexists, delivery has occurred, the sales price is fixed or determinable andcollectibility is reasonably assured. Wave reduces revenue for estimatedcustomer returns, rotations and sales rebates when such amounts can beestimated. When these amounts cannot be estimated Wave defers revenue until theproduct is sold to the end-user. Revenue from software license agreements thathave significant customizations and modification of the software product isdeferred and recognized in a manner that approximates the percentage ofcompletion method. In addition to the aforementioned general policy, thefollowing are the specific revenue recognition policies for each major categoryof revenue.

PRODUCTS—SOFTWARE AND HARDWARE

Revenue from delivered elements of one-time chargelicensed software is recognized at the inception of the license term, providedWave has vendor-specific objective evidence of the fair value of eachundelivered element, for arrangements that contain multiple elements. Revenueis deferred for undelivered elements for these arrangements. Revenue is alsodeferred for the entire arrangement, if vendor-specific objective evidence doesnot exist for each undelivered contract element. Examples of undeliveredelements in which the timing of delivery is uncertain include contractualelements that give 

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customers rights to anyfuture upgrades at no additional charge or future maintenance that is providedwithin the overall price. The revenue that is deferred for any contract elementis recognized when all of the revenue recognition criteria have been met forthat element.

Prepaid royalty fees received pursuant to distributionsoftware licenses with OEMs in which Wave earns a royalty, based upon unitsshipped by the OEM to end customers, are deferred when received, and recognizedas revenue as units are shipped by the OEM.

Revenue from the sale of hardware components isrecognized when persuasive evidence of an arrangement exists, the product hasbeen shipped to the customer, the sales price is fixed or determinable, andcollectivity is reasonably assured. All of the product is shipped withownership passing to the buyer upon leaving our premises and payment terms aregenerally net 30.

SERVICES

Revenue from time andmaterial service contracts is recognized as the services are provided. Revenuefrom fixed price, long-term service or development contracts is recognized overthe contract term based on the percentage of services that are provided duringthe period compared with the total estimated services to be provided over theentire contract. Losses on fixed price contracts are recognized during theperiod in which the loss first becomes apparent. Payment terms vary bycontract.

**Comparisonof the years ended December 31, 2004 and 2003**

*Results ofOperations*

Forthe twelve months ended December 31, 2004 and December 31, 2003,revenues were $209,311 and $189,363, respectively. The increase in revenue isattributable to increases in product, and licensing revenue offset by adecrease in service revenues, as set forth in the following table:
| ** **           | ** ** | **2004** | ** ** | **2003** | ** ** | **Increase/(Decrease)** | ** ** | **%** Change | ** ** |
|----------------------|------------|----------|------------|----------|------------|-------------------------|------------|-------------------|------------|
| Product              |       | $        | 7,160      |     | $          | 3,350                   |       |              | $          | 3,810 |   |   |   | 113.7 | % |   |
| Services             |       | 18,833   |       | 65,343   |       |                    | (46,510    | )                 |       |   | (71.2 | %) |   |
| Licensing and  Other |       | 183,318  |       | 120,670  |       |                    | 62,648     |              |       |   | 51.9 | % |   |
| Total Net Revenues   |       | $        | 209,311    |     | $          | 189,363                 |       |              | $          | 19,948 |   |   |   | 10.5 | % |   |

 

Cost of sales for the year ended December 31,2004, was $151,704 compared with $55,179 for the same period in 2003. Grossprofit was $57,607 representing a gross profit margin of 28% for the year endedDecember 31, 2004 while $134,184 represented a gross profit margin of 71%for the year ended December 31, 2003. The decrease in gross profit marginwas the result of the higher margins on service contracts in 2003 versus 2004,and higher costs of license revenues in 2004 versus 2003 resulting from the amortizationexpense of capitalized software costs.

Research and development expenses for the twelvemonths ended December 31, 2004 were $6,852,754 as compared to $7,384,708for the comparable period of 2003. This 7% decrease in research and developmentexpenses was primarily attributable to headcount reductions of employees andconsultants, which decreased expenses by a total of $640,928 including salaryand consultant compensation. Wavexpress’ research and development expenses were$1,657,376 for the year ended December 31, 2004 versus $1,873,463, for areduction of 12%. The amounts set forth for Wavexpress are included in theconsolidated amounts referred to above. Also, the reasons for the reduction inexpenditures set forth above pertain to both Wave as a whole and Wavexpress.

S,G&A expenses for the twelve months ended December 31,2004 were $12,255,427 as compared to $12,698,682 for the comparable period of2003. The 3% decrease in selling, general and administrative expenses wasattributable primarily to headcount reductions at both Wave and Wavexpress. Wavexpress

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incurred S,G&Aexpenses of $1,789,997 in 2004, compared to $2,014,828 for 2003, for a decreaseof 11%. The reasons set forth above encompass Wavexpress, as well as Wave as awhole.

For the year ended December 31, 2004, Wave took acharge of approximately $301,000 to write-off developed software that had beencapitalized. The software that was written off was developed for a distributionagreement that was entered into with NSC, whereby NSC was to distribute it withtheir trusted platform module chip. The write-off was the result of thetermination of the agreement and because the version of the software that waswritten off has been discontinued and superseded by a new version. Consequently,the value of the software became impaired because it had no alternative uses.No such impairment charges were incurred in the year ended December 31,2003. Wave continues to maintain a license agreement with NSC, whereby Wave ispaid royalties based on Wave technology that is included in NSC’s chip design.

For the year ended December 31,2003, Wave recorded a write down of approximately $1,114,000, representing thevalue of its EMBASSY 2100 chips held in inventory. This charge was takenbecause of the amount of time that continued to elapse without any substantialsales of this inventory coupled with the emergence within the trusted computingmarket towards TCG-compliant chips that have less functionality than theEMBASSY 2100 chips, but for which the marketplace is more readily accepting atthis stage in the development of the trusted computing market.

*Other Income andExpenses*

Interest income for the year ended December 31,2004 was $24,931 versus December 31, 2003 of $74,822 for a decrease of 67%.The decrease in interest income is primarily attributable to interest incomehaving been recognized on the officer loan recovery referred to below for theyear ended Deceember 31, 2003, and from a decrease in interest-bearing assetsduring 2004.

Wave sold 2,507,300 shares of its holdings of SSPSolutions, Inc., common stock and 966,300 shares of Saflink Corporationcommon stock during the year ended December 31, 2004, for total proceedsof $6,759,748, recording a realized gain of $4,330,248 on the sales. In August,2004, SSP Solutions, Inc. merged with and became a wholly-owned subsidiaryof Saflink Corporation. For the year ended December 31, 2003, Wave sold332,500 shares of SSP for proceeds of $430,934, realizing an aggregate gainfrom the sales of $234,759.

During the fourth quarter of 2003, Wave incurred $155,716 in liquidateddamages in connection with the issuance of 3,725,263 shares of its Class ACommon Stock at a price of $1.90 per share and warrants to purchase 931,309shares of Class A Common Stock at an exercise price of $2.62 per share ina private placement to a group of accredited investors for proceeds ofapproximately $6,562,000, net of issuance costs of approximately $516,000. Theshares were issued pursuant to a securities purchase agreement dated November 18,2003 between Wave and certain purchasers. Pursuant to a related registrationrights agreement, if Wave did not file a registration statement for the shareswithin 30 days from the date of the closing of the securities purchaseagreement, Wave would be required to pay liquidated damages to each purchaserequal to 2% of each purchaser’s subscription amount, for each month elapsedbeyond the 30 day deadline. Because Wave was not able to file the registrationstatement until one month and three days after the 30 day deadline, Waveincurred an aggregate of $155,716 in liquidated damages in the fourth quarterof 2003. No such charges were incurred in 2004.

For the year ended December 31, 2004, Waverecorded income of $498,723 representing the decrease in the value of theliability for outstanding warrants containing net cash settlement features. Thesewarrants were granted in connection with a private placement of Class ACommon Stock completed on November 18, 2003. The liability, calculatedusing the Black Scholes option pricing model, was valued at $991,851 as December 31,2003, versus $493,128 as of December 31, 2004. The decrease was the resultof the decrease in the quoted closing price on the Nasdaq National Exchange ofWave’s Class A Common 

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Stock from December 31,2003 to December 31, 2004. Because the price of Wave’s Class A CommonStock declined, the fair value of the warrants declined as well resulting inthe gain. A gain of $263,097 was recognized for the year ended December 31,2003 due to the decrease in the fair market value of the warrant from theinception of the warrant through December 31, 2003.

Wave reversed the reserve previously established withrespect to notes receivable from Peter J. Sprague, Wave’s former Chairman ofthe Board, of $999,518 during the year ended December 31, 2003, becausethe notes were collected in the third quarter of 2003. These loans werepreviously reserved for during the fourth quarter of 2002, because at the timethere was substantial doubt about the ability of the borrower to repay theseloans. In the third quarter of 2003, Mr. Sprague sold 500,000 shares ofWave Class A Common Stock, and was therefore able to repay the loans andall accrued interest thereon with the proceeds from such sales of Wave’s Class ACommon Stock. Mr. Sprague resigned as Chairman of the Board of Wave as of March 31,2003. Mr. Sprague was subsequently appointed Chairman of the Board andChief Executive Officer of Wavexpress. No such charges were incurred in 2004. Consistentwith the provisions of the Sarbanes-Oxley Act of 2002, Wave has adopted awritten policy prohibiting future loans to officers and directors.

For the year ended December 31, 2003, Wavereceived other income of $52,370, primarily from the settlement of a disputewith a former vendor. No such other income was received for the year ended December 31,2004

For the year ended December 31,2003, Wave recorded accrued dividends on its Series H Stock in the amountof $212,518 plus accretion of discount on such preferred stock of $5,485,000for total dividends on preferred stock of $5,697,518. There was no preferredstock outstanding in 2004, therefore, no preferred stock dividend expense wasrecorded in 2004. (See Note 8 to the Financial Statements).

**Comparisonof the years ended December 31, 2003 and 2002**

*Results ofOperations*

For the twelve months ended December 31, 2003 andDecember 31, 2002, revenues were $189,363 and $446,588, respectively. Thedecrease in revenue is attributable to decreases in Product and Services andoff set by an increase in Licensing and Other revenues, as set forth in thefollowing table:
| ** **           | ** ** | **2003** | ** ** | **2002** | ** ** | **Increase/(Decrease)** | ** ** | **%** Change | ** ** |
|----------------------|------------|----------|------------|----------|------------|-------------------------|------------|-------------------|------------|
| Product              |       | $        | 3,350      |     | $          | 121,974                 |       |              | $          | (118,624 | ) |   |   | (97 | %) |   |
| Services             |       | 65,343   |       | 310,573  |       |                    | (245,230   | )                 |       |   | (79 | %) |   |
| Licensing and  Other |       | 120,670  |       | 14,041   |       |                    | 106,629    |              |       |   | 759 | % |   |
| Total Net Revenues   |       | $        | 189,363    |     | $          | 446,588                 |       |              | $          | (257,225 | ) |   |   | (58 | %) |   |

 

The decrease in product revenue was the result of lessdemand and thus fewer shipments of hardware products in 2003 versus 2002. Thistrend is also indicative of management’s shift in focus, as discussed in the **Overview**section above, away from its proprietary EMBASSYTrust System hardware to becoming a provider of security software applicationsthat are compatible with various chip OEMs’ security hardware, or TPMs. Theservice contract revenue for the year ended December 31, 2002 was derivedin large part from a development contract with SSP Solutions, a formershareholder of Wave. (Wave also owned 16.5% of SSP Solutions as of December 31,2003). The service contract revenue derived from this development contract forthe year ended December 31, 2002 was $197,965, or 64% of the total servicecontract revenue for that year. Revenue on the contract was recognized on apercentage of completion basis limited to cash received and milestonesaccomplished. Work under this contract was suspended during the first quarterof 2002, and the contract was formally terminated pursuant to a settlementreached on September 30, 2002, in which Wave was issued 1,600,000 additionalshares of SSP common stock and a convertible note with a face value of $270,000that was converted into 200,000 additional common shares of SSP (See Item 8, 

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Financial Statements, Note11). Services revenue recognized in 2003 was for a number of smaller contractswith various customers. The increase in Licensing and Other revenues was due inlarge part to a licensing contract between Wavexpress and a customer whichgenerated approximately $80,000 in revenue. The remainder of this Licenserevenue was derived from contracts for Wave’s eTMS software applications andOEM license contracts for Wave’s EMBASSY Trust Suite of products.

Cost of sales for the year ended December 31,2003, was $55,179 compared with $202,208 for the same period in 2002. Gross profitwas $134,184 representing a gross profit margin of 71% for the year ended December 31,2003 versus gross profit of $244,380 representing a gross profit margin of 55%for the year ended December 31, 2002. The $110,196 decrease in grossprofit was primarily the result of the overall decrease in sales, offset inpart with a higher gross profit margin for the year ended December 31,2003, due to higher margins realized on licensing revenues in 2003 versushardware and development services in 2002.

Revenue and gross margins during the year ended December 31,2003 versus the same period in 2002 is indicative of a downward trend, withneither period showing significant revenues. The amount of revenues in bothyears has not reached a level that would contribute significantly to Wave’soperations and has been sporadic. (For a forward looking discussion onrevenues, See **Liquidity and capital resources**, *Revenue outlook*.)

Research and development expenses for the twelvemonths ended December 31, 2003 were $7,384,708 as compared to $12,009,713for the comparable period of 2002. This 39% decrease in research anddevelopment expenses was primarily attributable to headcount reductions ofemployees and consultants, which decreased expenses by a total of $3,175,000including salary and consultant compensation, fringe cost and all otherheadcount related expense associated with these headcount reductions. Thirtyfour positions were eliminated in 2003, due to an overall reduction in designand development activities in 2003. In addition, Wave reduced rent and otherinfrastructure related costs by $740,000 and depreciation expense was reducedby $343,000, due to assets becoming fully depreciated. Wavexpress’ research anddevelopment expenses were $1,873,463 for the year ended December 31, 2003versus $2,331,080 for the year ended December 31, 2002, for a reduction of20%. The amounts set forth for Wavexpress are included in the consolidatedamounts referred to above. Also, the reasons for the reduction in expendituresset forth above pertain to both Wave as a whole and Wavexpress.

S,G&A expenses for the twelve months ended December 31,2003 were $12,698,682 as compared to $19,188,046 for the comparable period of2002. The 34% decrease in selling, general and administrative expenses wasattributable to several factors. Wave reduced employee compensation, fringeexpenses and other employee related expenses by approximately $2,833,000 byreducing its selling, general and administrative headcount by twenty-two (22)positions in 2003, in addition to the thirty-three (33) position decrease inthe prior year. The headcount reductions were primarily in the areas of productmarketing, business development and sales. Wave also reduced headcount inadministrative and support areas within the company where it was possible toconsolidate and restructure certain functions. Much of the cost savings werefor reductions made during 2002, the cost reductions for which, carried into2003 because the expenses were incurred for part of the year in 2002. Thesepositions supported products and/or lines of business that Wave hadde-emphasized in the prior year including our internet related businesses:MyPublish.com, a service that allows individual publishers to offer digitalcontent for sale via the MyPublish.com website; CharityWave.com, an onlinecharitable donation service; Wave Direct, a website offering digital contentthat could be consumed using a Wave hardware device; and iShopHere.com, aninternet shopping portal. In addition, during 2003, as Wave shifted the focusof its business more towards developing Trusted Platform software applicationsand less towards business development for its proprietary EMBASSY Trust System,management eliminated much of the product marketing, business development andsales positions that had previously been devoted toward supporting theseproducts. Later in the year, management began re-building much of its salesorganization to focus on the emerging trusted 

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computing softwareapplication opportunity. Included in S,G&A expense were bonuses ofapproximately $986,000 and $831,000 paid to employees for the years ended December 31,2003 and 2002, respectively. Additional cost reductions for the year ended December 31,2003 versus 2002 consisted of reductions in legal costs of $605,000 as a resultof fewer legal matters during 2003 versus 2002, reductions in trade showexpenses of approximately $388,000 and public relations and marketing expenseswere reduced by approximately $951,000. In addition, Wave reduced office rent andother infrastructure expense by approximately $376,000 by consolidating somelocations and other cost cutting measures. Wave also reduced software licenseand maintenance agreement costs by $446,000, depreciation expense by $416,000and franchise tax expenses by $118,000. Also, accrued litigation lossesdecreased by $488,000 due primarily to a charge for this amount that wasrecorded in the quarter ended March 31, 2002, related to a demand forarbitration brought by a former supplier against Wave. The arbitration aroseout of a claim that Wave had breached a contract with the supplier to purchasecomputer components to be incorporated into an Internet security deviceproduced by Wave. Wavexpress incurred S,G&A expenses of $2,014,828 in 2003,compared to $2,506,768 for 2002, for a decrease of 20%. The reasons set forthabove encompass Wavexpress as well as Wave as a whole.

For the year ended December 31, 2003, Waverecorded a write down of approximately $1,114,000, representing the value ofits EMBASSY 2100 chips held in inventory. This charge was taken because of theamount of time that continued to elapse without any substantial sales of thisinventory coupled with the emergence within the trusted computing markettowards TCG compliant chips that have less functionality than the EMBASSY 2100chips, but for which the marketplace is more readily accepting at this stage inthe development of the trusted computing market.

Restructuring charges andcharges for write-off of intangibles and other impaired assets decreased by$726,280 and $1,571,031 for the year ended December 31, 2003 versus 2002. Thiswas due to a restructuring and cost reduction program during the year ended December 31,2002 which Wave undertook to prioritize its initiatives, reduce expenses andimprove efficiency. This program included a workforce reduction, the relocationof its Wavexpress office and restructuring of certain business functions. As aresult of this program, Wave recorded restructuring costs and other charges of$726,280 consisting of $229,000 in severance benefits associated with theworkforce reduction, $426,000 for lease termination fees and brokerage fees and$71,000 for moving expenses related to the Wavexpress office relocation. Inaddition, Wave recorded impairment charges of $905,390 for abandoned leaseholdimprovements and other tangible fixed assets that were disposed of or removedfrom operations. In the third quarter of 2002, Wave recorded an additionalimpairment charge which was associated with a license that was acquired inconnection with its purchase of 60% of GlobalWave Group plc of $665,641. As aresult of these two impairment events, total asset impairment charges for thetwelve months ended December 31, 2002 were $1,571,031. No such chargeswere taken in the year ended December 31, 2003.

*Other Income andExpenses*

Interest and other income for the year ended December 31,2003 was $127,192 versus $477,902 for the year ended December 31, 2002,for a decrease of 73%. This decrease resulted from a decrease in interestbearing assets during 2003 and lower rates earned on those interest-bearingassets.

For the year ended December 31, 2002, Wave took acharge for an “other than temporary decline” in the value of its investment inSSP of $11,513,099. This charge was taken because it was determined that another than temporary decline in SSP’s share price had occurred due to concernsabout SSP’s financial condition and near-term prospects. The amount wascalculated as the difference between the previously adjusted cost basis of Wave’s4,883,083 shares of SSP, 3,083,083 of which were acquired in February 2001and 1,800,000 which were acquired as settlement for termination of adevelopment agreement (discussed below), versus the fair value of the sharesbased on the closing price of SSP as of December 31, 2002 on the NasdaqNational Exchange, or $0.59 per share. Also, during 2002, Wave was issued1,800,000 shares of 

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SSP in connection with thetermination of a development contract between Wave and SSP. These shares wererecorded as a gain on the termination of $1,818,000 of the contract for theyear ended December 31, 2002. Wave sold 332,500 of its holdings of4,883,083 shares of SSP during the year-ended December 31, 2003 for totalproceeds of $430,934, recording a realized gain of $234,759. The 4,550,583remaining shares of SSP are presented on the December 31, 2003 balancesheets at $6,325,310 versus $2,881,016 for the 4,883,083 shares held at December 31,2002, respectively, which represents the closing value of the shares on theNasdaq National Exchange on these dates. The increase in the value of theadjusted cost basis of the remaining shares as of December 31, 2003 of$3,640,469 is presented as an unrealized gain on marketable securities as aseparate component of stockholders’ equity as of December 31, 2003.

For the year ended December 31, 2003, Waverecorded income representing the decrease in the value of the liability foroutstanding warrants containing net cash settlement features. These warrantswere granted in connection with a private placement of Class A CommonStock completed on November 18, 2003. The liability, calculated using theBlack Scholes option pricing model, was valued at $1,254,948 as of the closingdate of the private placement. As of December 31, 2003, the fair value ofthe liability was $991,851. The decrease was primarily the result of thedecrease in the quoted closing price on the Nasdaq National Exchange of Wave’s Class ACommon Stock from November 18, 2003 to December 31, 2003. Because theprice of Wave’s Class A Common Stock declined, the fair value of thewarrants declined as well resulting in the gain. No such gains were realizedfor the year ended December 31, 2002.

Wave reversed the reserve previously established withrespect to notes receivable from Peter J. Sprague, Wave’s former Chairman ofthe Board, of $999,518 during the year ended December 31, 2003, becausethe notes were collected in the third quarter of 2003. These loans werepreviously reserved for during the fourth quarter of 2002, because at the timethere was substantial doubt about the ability of the borrower to repay theseloans. In the third quarter of 2003, Mr. Sprague sold 500,000 shares ofWave Class A Common Stock, and was therefore able to repay the loans andall accrued interest thereon with the proceeds from such sales of Wave’s Class ACommon Stock. Mr. Sprague resigned as Chairman of the Board of Wave as of March 31,2003. Mr. Sprague was subsequently appointed Chairman of the Board andChief Executive Officer of Wavexpress. Consistent with the provisions of theSarbanes-Oxley Act of 2002, Wave has adopted a written policy prohibitingfuture loans to officers and directors.

During the fourth quarter of 2003, Wave incurred $155,716 in liquidateddamages in connection with the issuance of 3,725,263 shares of its Class ACommon Stock at a price of $1.90 per share and warrants to purchase 931,309shares of Class A Common Stock at an exercise price of $2.62 per share ina private placement to a group of accredited investors for proceeds ofapproximately $6,562,000, net of issuance costs of approximately $516,000. Theshares were issued pursuant to a securities purchase agreement dated November 18,2003 between Wave and certain purchasers. Pursuant to a related registrationrights agreement, if Wave did not file a registration statement for the shareswithin 30 days from the date of the closing of the securities purchaseagreement, Wave would be required to pay liquidated damages to each purchaserequal to 2% of each purchaser’s subscription amount, for each month elapsedbeyond the 30 day deadline. Because Wave was not able to file the registrationstatement until one month and three days after the 30 day deadline, Waveincurred an aggregate of $155,716 in liquidated damages in the fourth quarterof 2003.

For the year ended December 31, 2003, Waverecorded accrued dividends on its Series H Stock in the amount of $212,518plus accretion of discount on such preferred stock of $5,485,000 for totaldividends on preferred stock of $5,697,518. (See Note 8 to the FinancialStatements).

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**Liquidity and capital resources**

We have experienced netlosses and negative cash flow from operations since our inception and, as of December 31,2004, had a deficit accumulated during the development stage of $267,184,364.Total stockholders’ equity as of December 31, 2004 was $4,710,200. We havefinanced our operations since inception principally through the issuance of Class Aand B Common Stock and various series of preferred stock, for total proceedssince inception of approximately $233,135,490.

*Sources and Uses ofCash*

At December 31, 2004, we had $5,805,912 in cashand cash equivalents versus $8,818,305 as of December 31, 2003, resultingin a net decrease in cash of $3,012,393 for the year ended December 31,2004.  The table below shows theyear-to-year comparison of the significant elements of cash used in operating,investing and financing activities and a reconciliation of each year’soperating results reported in the statement of operations to the total decreasein cash in each of the three years ended December 31, 2004.

As shown below, the totalnet decrease in cash over the last three years has changed significantly from anet cash decrease for the year ended December 31, 2002 of $30,215,995 to anet cash decrease for the year ended December 31, 2003 of $1,402,819 to anet cash decrease for the year ended December 31, 2004 of $3,012,393.

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**ConsolidatedStatement of Cash Flow Data**
| ** **                                                                                  | ** ** | **For the years ended December 31,** | ** **  |
|---------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                                                  | ** ** | **2004**                                                      | ** **  | **2003** | ** ** | **2002** | ** ** |
| Cash used in operating  activities:                                                         |       |                                                          |        |   |   |   |   |
| Net loss                                                                                    |       | $                                                             | (14,498,038 | ) | $ | (19,594,798 | ) | $ | (43,467,405 | ) |
| (Recovery of)  provision for note receivable from officers                                  |       | —                                                        |        | (999,518 | ) | 999,518 |   |
| Realized gain  from the sale of marketable securities                                       |       | (4,330,248                                                    | )           | (234,759 | ) | — |   |
| Unrealized (gain)  loss on marketable securities                                            |       | —                                                        |        | — |   | 11,513,099 |   |
| Gain on decrease  in value of warrant liability                                             |       | (498,723                                                      | )           | (263,097 | ) | — |   |
| Write off  intangible and other assets that became impaired                                 |       | 301,366                                                       |        | — |   | 1,571,031 |   |
| Provision for  obsolete inventory                                                           |       | —                                                        |        | 1,114,442 |   | — |   |
| Gain on  termination of development contract                                                |       | —                                                        |        | — |   | (1,818,000 | ) |
| Depreciation and  amortization                                                              |       | 854,629                                                       |        | 1,241,035 |   | 2,000,705 |   |
| Compensation paid  in the form of stock options & warrants                    |       | 80,609                                                        |        | 189,565 |   | 510,747 |   |
| Total adjustments  to reconcile net loss to cash used in operating activities               |       | (3,592,367                                                    | )           | 1,047,668 |   | 14,777,100 |   |
| Proceeds from  liquidation of other assets                                                  |       | 93,570                                                        |        | 50,688 |   | 1,026,365 |   |
| Reduction in  inventory                                                                     |       | —                                                        |        | — |   | (530,906 | ) |
| (Increase)  decrease in prepaid expenses and receivables                                    |       | (67,085                                                       | )           | 368,844 |   | 50,219 |   |
| (Reduction)  increase in deferred revenue                                                   |       | 276,968                                                       |        | 74,222 |   | (197,965 | ) |
| (Reduction)  increase in accrued expenses                                                   |       | 63,540                                                        |        | (567,833 | ) | (655,264 | ) |
| Changes in  assets & liabilities                                                   |       | 366,993                                                       |        | (74,079 | ) | (307,551 | ) |
| Other accrual to  cash adjustments, net                                                     |       | (31,480                                                       | )           | 144,773 |   | (99,048 | ) |
| Cash used in  operating activities                                                          |       | (17,754,892                                                   | )           | (18,476,436 | ) | (29,096,904 | ) |
| Cash flows from  investing activities:                                                      |       |                                                          |        |   |   |   |   |
| Disbursements for capital expenditures                                                      |       | (304,172                                                      | )           | (985,146 | ) | (1,148,723 | ) |
| Net disbursement related to GlobalWave joint venture                                        |       | —                                                        |        | — |   | (178,786 | ) |
| Proceeds provided by sales of marketable equity  securities                                 |       | 6,759,751                                                     |        | 430,934 |   | — |   |
| Net cash provided by (used in) investing activities                                         |       | 6,455,579                                                     |        | (554,212 | ) | (1,327,509 | ) |
| Cash flows from  financing activities:                                                      |       |                                                          |        |   |   |   |   |
| Proceeds from sale of Common Stock in private  placements                                   |       | 8,286,920                                                     |        | 6,562,180 |   | — |   |
| Proceeds from sale and conversion of preferred stock                                        |       | —                                                        |        | 4,780,540 |   | — |   |
| Proceeds from exercise of employee stock options                                            |       | —                                                        |        | 2,868,916 |   | 44,099 |   |
| Proceeds from the exercise of warrants granted in  connection with sales of preferred stock |       | —                                                        |        | 2,493,390 |   | — |   |
| Total proceeds  from issuance of newly issued equity                                        |       | 8,286,920                                                     |        | 16,705,026 |   | 44,099 |   |
| Proceeds from  repayment (issuance) of officer notes receivable                             |       | —                                                        |        | 1,135,320 |   | 164,319 |   |
| Payment of  dividends on preferred stock                                                    |       | —                                                        |        | (212,517 | ) | — |   |
| Total cash  provided by financing activities                                                |       | —                                                        |        | 17,627,829 |   | 208,418 |   |
| Net decrease in cash                                                                        |       | $                                                             | (3,012,393  | ) | $ | (1,402,819 | ) | $ | (30,215,995 | ) |

 

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*Cash used inoperations*

The amount of cash used inoperations decreased to $17,754,890 for the year ended December 31, 2004from $18,476,436 used for the year ended December 31, 2003, whichdecreased significantly from $29,096,904 used for the year ended December 31,2002. The decease in cash used in operations was, in large part, the result ofthe reduction in the Net Losses reported by Wave over the three year period asshown above, and as discussed in the previous *Results ofOperations* section. In addition, the table above shows thesignificant items that were added back or subtracted from the net loss, asreported, that are either non-cash elements of the net losses oroperating-related cash receipts and disbursements that are not reported in theConsolidated Statement of Operations, to arrive at the amount of cash used byoperating activities.

*Adjustments toreconcile net loss to cash used in operating activities*

These amounts representitems reported in Wave’s Consolidated Statement of Operations, that do notrepresent an outlay or receipt of cash in the year that they are reported undergenerally accepted accounting principals. These items, and their fluctuationsfrom year to year, are described in the *Results of Operations*section above. These items in the aggregate make up a significant portion ofthe differences between the reductions in Wave’s reported Net Losses year overyear, versus the differences in the amount of cash used by Wave’s operationsover each of the periods. These items resulted in a net subtraction fromreported net income of $3,592,567 for the year-ended December 31, 2004 andadd-backs of $1,047,668 and $14,777,100 for the years ended December 31,2003 and 2002, respectively, to the reported net losses, due to large lossitems included in the reported net loss that did not involve the outlay of cashin the periods. In addition, there were changes in asset and liability accountsand other adjustments, primarily for the pay down of accounts payable andaccrued expenses and purchases of inventory as detailed above which representadditional uses of cash in each of the three years, and the receipt of$1,026,365 for the liquidation of other assets (this was primarily for thereturn of security deposits in connection with expired leases) in 2002. Accordingly,while the overall net loss decreased by $5,096,760 (from $19,594,798 to$14,498,038) for the year ended December 31, 2004  versus the year ended December 31, 2003,cash used in operating activities decreased by the lesser amount of $730,546(from $17,745,890 versus $18,476,436.) This was due in large part to the gain realized on the sales ofavailable-for sale-securities of $4,330,248 in 2004 versus $234,759 in 2003. Thegain is subtracted from the reported net loss to arrive at cash used byoperating activities because sales of marketable securities are  an investing activity, therefore the grossproceeds from these sales are shown in Cash Flows from Investing Activities. Similarly,while the overall Net Loss decreased  by$23,872,607 (from $43,467,405 to $19,594,798) for the year ended December 31,2003 versus the year ended December 31, 2002, cash used in operatingactivities decreased by the lesser amount of $10,620,468 (from $29,096,904 to$18,476,436.)  This difference was dueprimarily to the unrealized loss from other than temporary declines in value ofmarketable securities recognized in the year ended December 31, 2002,which is an add-back to net loss in arriving at cash used in operations,because it is a non-cash item.

*Cash Flows frominvesting activities*

As displayed in the table above, cash used ininvesting activities consisted of funds used to acquire and develop capitalassets totaling $304,171, $985,146 and $1,148,723 for the years ended December 31,2004, 2003 and 2002, respectively. Such amounts included the cost of internallydeveloped capitalized software in the amount of $73,000, $580,543, and $770,468for each of the three years ended December 31, 2004, 2003 and 2002,respectively. Wave expects to continue to acquire fixed assets primarily toreplace computer equipment to be used internally and to develop softwareproducts to be licensed to customers. These expenditures are expected tocontinue at approximately the same level as the 2004 expenditures.

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During the year ended December 31,2004, Wave sold 2,507,300 shares of SSP, in a series of separate sales and966,300 shares of Saflink, for total proceeds of $6,759,751. For the year endedDecember 31, 2003, Wave sold 332,500 shares of the common stock of SSP fortotal proceeds of $430,934. The cash generated from the sale of marketablesecurities was a significant source of cash for Wave in 2004. Wave holds259,670 shares of Saflink valued at $721,880 as of December 31, 2004.

*Cash Flows fromfinancing activities*

Because Wave did not havesufficient cash on hand, nor did it generate sufficient revenues to fund theamount of cash used for operations and acquisition and development of capitalassets for the years ended December 31, 2004 and 2003, we needed tofinance much of our operations through the sale of newly issued common stock asdescribed below. In addition, during 2003, Wave received funds from therepayment of notes receivable with an officer and a former officer of Wave thattotaled $1,135,320, including $281,000 that was repaid with the proceeds of abonus that was awarded to the officer to repay his loan.

*Proceeds fromIssuance of Newly Issued Equity Securities*

*Sales of CommonStock*

On December 16, 2004, Wave entered into asecurities purchase agreement, pursuant to which Wave sold and issued 5,484,790shares of Class A Common Stock, par value $.01 per share (the “CommonShares”), to certain purchasers who are parties to the Purchase Agreement (the “Purchasers”)for an aggregate purchase price of $5,759,030. The Common Shares were priced at$1.05. Corpfin Inc. (the “Placement Agent”), had entered into a placementagency agreement with Wave in which they agreed to act as placement agent inconnection with the offering. Wave paid the Placement Agent a fee equal to 4.0%of the gross proceeds of this offering. Wave realized net proceeds of$5,474,728 after deducting placement agent and other fees associated with theissuance of these securities. The Common Shares were drawn-down off of a shelfregistration statement which was filed by Wave on April 15, 2004 anddeclared effective by the Securities and Exchange Commission (the “SEC”) on May 10,2004.

On July 30, 2004, Wave entered into a securitiespurchase agreement, pursuant to which Wave sold and issued 3,529,412 shares of Class ACommon Stock, par value $.01 per share for an aggregate purchase price of$3,000,000. The shares of Class A Common Stock were priced at $0.85. Waverealized net proceeds of $2,777,897 after deducting placement agent and otherfees associated with the issuance of these securities. These shares weredrawn-down off of a shelf registration statement, which was filed by Wave on April 15,2004, and declared effective by the Securities and Exchange Commission on May 10,2004. In addition, a total of 3,529,412 shares were offered in connection withthis sale and issuance of these shares, in the form of an additional investmentright with an exercise price of $1.00 per share and warrants for 4,411,765shares at exercise prices currently ranging from $1.1428 to $1.2820 per share. Theadditional investment right expired on November 2, 2004. The warrants areexercisable during the period January 30, 2005 through January 30,2006, and if exercised in their entirety, may yield approximately $5.0 millionin proceeds, net of offering expenses.

Total net proceeds received from sales of common stockwere $8,286,920 for the year ended December 31, 2004, most of whichconsisted of the two sales referred to above which totaled $8,252,625. Theremaining proceeds of $34,295 were from the exercise of employee stock options.

On November 18, 2003,Wave issued 3,725,263 shares of its Class A Common Stock at a price of$1.90 per share and granted warrants to purchase 931,309 shares of Class ACommon Stock at a an exercise price of $2.62 per share in a private placementto a group of accredited investors for proceeds of approximately $6,562,000,net of issuance costs of approximately $516,000. The warrants have a three (3) yearterm.  In addition, in connection withthe transaction, Wave incurred commissions of $218,000 for the fair market 

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value ofwarrants granted to placement agents to purchase approximately 161,595 sharesof Wave’s Class A Common Stock. The warrants granted to the placementagents are also exercisable at a price of $2.62 per share and have a three- (3) yearlife as well. If exercised in full, the warrants granted in connection withthis financing will generate up to an additional $2,864,000, at the exerciseprice. Pursuant to a registration rights agreement entered into with theaccredited investors for the sales of these shares, Wave agreed to file aregistration statement with the Securities and Exchange Commission covering theresale of the Class A Common Shares sold and those underlying thewarrants, and bear all expenses therefrom. Wave filed the registrationstatement on Form S-3 covering the resale of the shares on January 20,2004. On February 12, 2004 the registration statement was declaredeffective by the Commission.

*Series HPreferred Stock and Warrant*

On April 30, 2003, Wave completed a privateplacement of 548.5 shares of its Series H Convertible Preferred Stock (the“Series H Stock”) and warrants to purchase Wave’s Class A CommonStock for an aggregate purchase price of $5,485,000, with a group of institutionaland accredited investors. Wave realized aggregate proceeds of $4,780,540 net ofcommissions and other cash fees of $704,460, in connection with the transaction. In addition, Wave incurred commissionsof $315,969 for the fair market value of warrants granted to placement agentsto purchase 322,270 shares of Wave’s Class A Common Stock at $0.01. All ofthe warrants granted to the placement agents have been exercised as of December 31,2003 for proceeds of $3,223. As of December 31, 2003 all 548.5 shares of Series HStock were converted at a conversion price of $0.76 into 7,217,105 shares of Class ACommon Stock. In addition, 2,632,311 shares of Class A Common Stock wereissued in connection with the exercise of Series H Warrants for netproceeds of $2,490,167. Series H Warrants to acquire 65,789 shares of Class ACommon Stock remain outstanding as of March 1, 2004.

The Series H Warrantswere initially exercisable for a total of 3,608,556 shares of Class ACommon Stock on the trading day following the date of Wave’s 2003 annualmeeting of stockholders, had an initial exercise price of $1.13 per share and afive-(5) year life. During September 2003 the terms of the Series HPurchase Agreement and other documents governing the Series H Stock andthe Series H Warrants were modified, pursuant to a letter agreement andwaiver (collectively the “Waiver”) whereby, each holder that executed theWaiver was required to convert their Series H Stock on the effective dateof the Waiver and agreed to allow Wave to reduce their Series H Warrantshares by the holders’ proportion of a 900,000 reduction in the total number ofSeries H Warrant shares. Also, pursuant to the Waiver, the exercise priceof the Series H Warrants was reduced from $1.13 to $1.00 for the holders thatsigned the Waiver. Dividends on the Series H Stock accrued on the initialliquidation preference amount of each share ($10,000) at an annual rate of 10%,and would have increased to 12% on April 30, 2004. Dividends were payableout of any assets legally available to pay dividends when and if declared bythe board of Directors of Wave, upon liquidation of the Series H Stock orupon conversion of the Series H Stock. Dividends paid for the year ended December 31,2003 totaled $212,517.

*Exercise of employeestock options*

During 2003, employeesexercised stock options resulting in the issuance of 1,340,739 shares of Wave Class ACommon Stock for proceeds of $2,868,916, at an average price per share of $2.14.

*Proceeds fromrepayment of officer notes receivable*

Prior to the enactment of the Sarbanes-Oxley Act of2002, Wave had made loans to certain of its officers. Some of the loans wereextended beyond their original terms by one year. These loans and theextensions thereon, were granted to the officers, prior to the enactment of theSarbanes-Oxley Act of 2002, to allow them to satisfy certain personal financialobligations that would otherwise have required them to liquidate some of theirholdings of Wave shares. The loans were granted as a means to mitigate apotential 

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unfavorable impact to Wave’sshare price as a result of the officers selling large blocks of shares. Allloans to officers were paid in full as of December 31, 2003. Loansreceivable from officers were $1,277,860 with a reserve of $999,518 for a netbalance of $278,342 as of December 31, 2002. Details with respect to theofficer loans are as follows:

On March 26, 2001 Wave made a personal loan to Mr. GerardT. Feeney, Senior Vice President, Chief Financial Officer and Secretary of Waveas evidenced by a demand note for $250,000, which sum was due and payable toWave on March 26, 2002 and bore interest at a rate per annum equal to 1%over the prime interest rate. Interest on the loan accrued monthly and waspayable at maturity. The terms of the loan were substantially equivalent tomarket terms at that time. The due date of the demand note was subsequently extendeduntil March 26, 2003. As of March 26, 2003 the loan balance,including accrued interest thereon was $281,399. On March 27, 2003, theCompensation Committee approved a bonus in an amount equal to Mr. Feeney’sobligations with respect to such loan and accrued interest. Proceeds of thisbonus were used to repay the loan and all interest accrued on such loan. Thebonus was granted during the year so that Mr. Feeney could repay his loan,rather than at fiscal year end when bonuses are usually awarded. The factorsused in granting this bonus were the amount of the loan, the ability of Mr. Feeneyto repay the loan and the impact that non-repayment of the loan would have hadon Mr. Feeney’s abilities to fulfill his duties for Wave. Wave no longerintends to award bonuses to executive officers or directors in order for themto repay outstanding loans because there are no outstanding loans to anycurrent executive officers or directors and the Sarbanes-Oxley Act of 2002prohibits any future such loans. The largest aggregate amount outstanding withrespect to indebtedness of Mr. Feeney during the year ended December 31,2003 was $281,399. Wave intends to take this bonus into account whenconsidering future bonus awards to Mr. Feeney.

Also during 2001, Wave made personal loans to Mr. PeterJ. Sprague, former Chairman of Wave evidenced by demand notes for $713,320dated February 27, 2001, $184,500 dated July 25, 2001 and $164,000dated September 5, 2001 for a total of $1,062,000. These demand notescarried terms of one year and bore interest at a rate per annum equal to 1%over the prime rate of interest. Interest on the loans accrued monthly and waspayable at maturity. The terms of the loans were substantially equivalent tomarket terms at that time. Two of the loans in the amount of $713,320 and$184,500 plus accrued interest came due on February 27, 2002 and July 25,2002, respectively and were extended for an additional year beyond theiroriginal due dates, prior to the enactment of the Sarbanes-Oxley Act of 2002. Theremaining loan that had an original face value of $164,319, the balance ofwhich was $174,391 including accrued interest, came due in September 2002.On November 12, 2002, the Compensation Committee approved the payment of abonus that Mr. Sprague used to repay the $164,319 balance of the note plusaccrued interest of $10,072. This bonus was granted during the year so that Mr. Spraguecould repay his loan, rather than at fiscal year end when bonuses are usuallyawarded. This bonus was awarded based on the same factors as the bonus awardedto Mr. Feeney.  Wave had recorded areserve for uncollectibility for 100% of the loans that were outstanding as of December 31,2002, which totaled $999,518, because the Company had determined that there wassubstantial doubt as to Mr. Sprague’s ability to repay the loans.Mr. Sprague resigned as Chairman of Wave as of March 31, 2003 and wasappointed Chairman and Chief Executive Officer of Wavexpress. As of August 14,2003, Mr. Sprague repaid the entire balance outstanding as of that date of$1,028,087, consisting of $897,820 in original principal and $130,267 ininterest from origination through the date of repayment. Accordingly, Wavereversed the reserve previously established in the amount of $999,518 andrecorded interest income of $28,569 in its Statement of Operations for the yearended December 31, 2003.

Consistent with theprovisions of the Sarbanes-Oxley Act of 2002, Wave has adopted a written policyprohibiting future loans to officers and directors.

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*Summary analysis ofhistorical cash flows and future outlook*

It is evident from thetable above that Wave’s use of cash to fund operations has decreasedsignificantly over the three-year period presented. The detailed discussion ofthis trend is presented in the analysis of the results of operations above. Inaddition, Wave needed to raise a significant amount of additional fundsprimarily from issuing new shares of common stock as detailed in the abovediscussion of cash flows from financing activities.

*Liquidity Requirementsand Future Sources of Capital*

Wave estimates that its total expenditures to fundoperations for the year ending December 31, 2005 will be approximately$19,400,000, including research and development (including capitalized productdevelopment), acquisition of capital assets, sales and marketing, generalcorporate expenses and overhead.

Expected sources ofcapital include the following:

·       cashon hand of $5,805,912 as of December 31, 2004

·       salesof marketable securities valued at approximately $721,880 as of December 31,2004

·       grossmargin contribution from sales and licensing of products

·       additionalfinancings

Given Wave’s capital requirements for the year ending December 31,2005 as indicated above, the cash on hand of $5,805,912 as of December 31, 2004, by itself will not besufficient to fund its operations for the full year ending December 31,2005.

It is likely that Wave will seek to obtain additionalfunding from further sales of newly issued shares of its Class A CommonStock.  Wave filed a shelf registrationstatement on April 15, 2004 that was declared effective by the Securitiesand Exchange Commission (the “SEC”) on May 10, 2004. We intend to continueto utilize this shelf registration to issue and sell additional shares of our Class ACommon Stock to the extent necessary to fund our operations for the foreseeablefuture.  Presently, after subtracting the$8,252,625 in actual proceeds referred to above and the potential proceeds fromthe outstanding warrants described above, there remains approximately $11million in available proceeds, less offering expenses, under this shelfregistration.

An additional source ofcash to fund operations for 2005 will likely come from the sales of itsmarketable securities valued as of December 31, 2004 at approximately$721,000, which consist of 259,670 shares of Saflink’s common stock. Wave maysell some or all of its holdings in Saflink, as needed to fund its operationsduring 2005.

*Revenue outlook*

During 2003, Wave began licensing its EMBASSY Trust Suite softwarethrough bundling arrangements with OEMs with whom it signed contracts withduring the year. In addition, Wave received revenues from software developmentand other services. Total cash received from all revenue sources in 2004 wasapproximately $355,000 versus approximately $227,000 for 2003.

Because of the early stageof Wave’s market and other factors, a high level of uncertainty exists withrespect to the ability to forecast future revenues. Wave continues to work withits current partners and customers to introduce and promote its existingsoftware products and new software products which are under development in aneffort to expand the market for TPM-based secure computing and thereby increaseits market share and revenues. However, because TCG hardware security is stilla new, developing category within the computer security market, the ultimatesize of this market and the timeframe for its 

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developmentare unknown and difficult to predict. Wave will also continue to pursuehardware sales and licensing of its proprietary EMBASSY Trust System, primarilyin government-related security markets.

As stated previously,Wavexpress currently has three active contracts with customers for itsbroadband media distribution services. Under these contracts Wavexpress sharessubscription and/or advertising revenue generated by the client’s website inaddition to bandwidth fees. Given that this is a new type of service, it isdifficult to predict the subscription levels and therefore the revenue thatwill be generated from these contracts. In addition, Wavexpress has a number ofadditional customer prospects with whom it may close business in 2005; however,it is also difficult to predict the number of contracts that it will enter intoduring the year.

*Known Trends and Uncertainties affecting future cashflows*

Wave’s cash and marketablesecurities on hand will not, on their own, be sufficient to fund operations forthe full year ending December 31, 2005. Furthermore, given theuncertainties described above with respect to Wave’s revenue outlook for 2005,there exists a reasonably high likelihood that additional funding will need tobe generated. Alternatively, Wave may be required to reduce expenses which maysignificantly impede its ability to meet its sales, marketing and developmentobjectives. The amount of any such financing is unknown at this time. However,in the event that revenues do not grow substantially and given the availablecash and marketable securities currently on hand, it is likely that Wave willbe required to generate at least $13,000,000 in additional funding to continuein business through the end of 2005. It should also be noted that the marketprice of Saflink’s common stock is and has historically been volatile, andthere is not certainty that such market price will not decrease therebyreducing the amount of capital available from this investment.

*Other uncertainties that may impact the futurebusiness outlook*

Uncertainty exists withrespect to the legal matters that are currently pending including the formalSEC investigation and several class action securities and derivativeshareholder lawsuits that have been served on Wave. There is uncertainty as tothe amount of legal costs that Wave may incur in addressing these matters. Inaddition, the extent of any impact due to negative publicity or perceivednegative publicity is not known.

Because the informationsecurity services market and the TCG hardware security category in particularare in early stages of development, customer requirements may change or newcompetitive pressures can emerge which could require a shift in productdevelopment and/or market strategy. Should such shifts occur, it may requiredevelopment, marketing and sales strategies to re-start or expand which wouldlikely increase operating costs, requiring additional capital. Such shifts haveoccurred several times throughout Wave’s history, requiring significant changesin strategy and business plan.

Furthermore, theachievement of sufficient revenue is dependent upon continued significantexpenditures both in terms of the amount which will likely be required forresearch and development and sales and marketing to increase market awareness,beyond 2005. Therefore, if Wave is not able to begin to generate significantrevenues during 2005 to cover its operating costs, it will need to generatecapital from other sources, and the likelihood is Wave will need to raise fundsthrough either issuing additional common stock, preferred stock and/or debt tofund its operations during 2005.

*Commitments*

Wavehas no significant long-term contractual obligations other than with respect tooperating leases for its facilities, which are listed below: 
| ** **                    | ** ** | **Within one year** | ** ** | **Years two and three** | ** ** | **Years four and five** | ** ** | **Total** | ** ** |
|-------------------------------|------------|-------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|-----------|------------|
| Operating leases  commitments |       |                          | $          | 848,000                                |       |                                   |       | $         | 1,110,000  |   |   |   | $ | 55,000 |   |   | $ | 2,013,000 |   |
|                               |            |                               |            |                                        |            |                                        |            |           |            |  |  |  |  |  |  |  |  |  |  |

 

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*Net Operating andCapital Loss Carryforwards*

As of December 31,2004, Wave had available net operating and capital loss carryforwards forFederal income tax purposes of approximately $232 million, which expirebeginning in 2005 through 2024. Because of the “change in ownership” provisionsof the Tax Reform Act of 1986, our net operating and capital loss carryforwardsmay be subject to an annual limitation on the utilization of thesecarryforwards against taxable income in future periods if a cumulative changein ownership of more than 50 percent of Wave occurs within any three-yearperiod. We have made no determination concerning whether there have beensuch  cumulative changes in ownership orthe impact on the utilization of the loss carryforwards if such changes haveoccurred. However, in considering Section 382 of the Internal RevenueCode, we believe that it is likely that such a change in ownership occurredprior to or following the completion of our initial public offering in September 1994and, potentially, in periods following. As a result, all of the utilization ofour net operating losses is likely to be subject to annual limitations.

*Going ConcernOpinion*

Wave’s consolidatedfinancial statements as of December 31, 2004 have been prepared under theassumption that we will continue as a going concern. Wave’s independentauditors, KPMG LLP, have issued a report dated March 15, 2005, thatincludes an explanatory paragraph referring to our significant operating lossesand substantial doubt of our ability to continue as a going concern. (See Note2 to Wave’s consolidated financial statements.)

**Recent Accounting Pronouncements**

In December 2004, theFinancial Accounting Standard Board (FASB) issued a revision to Statement ofFinancial Accounting Standard No. 123, “Accounting for Stock-BasedCompensation” (SFAS 123R). SFAS 123R eliminates our ability to use theintrinsic value method of accounting under APB Opinion 25, “Accounting forStock Issued to Employees,” and generally requires a public entity to reflecton its income statement, instead of pro forma disclosures in its financialfootnotes, the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value of the award. Thegrant-date fair value will be estimated using option-pricing models adjustedfor the unique characteristics of those equity instruments. Among other things,SFAS 123R also requires entities to estimate the number of instruments forwhich the requisite service is expected to be rendered and, if the terms orconditions of an equity award are modified after the grant date, to recognizeincremental compensation cost for such a modification by comparing the fairvalue of the modified award with the fair value of the award immediately beforethe modification. In addition, SFAS 123R amends FASB Statement No. 95, “Statementof Cash Flows,” to require that excess tax benefits be reported as a financingcash inflow rather than as a reduction of taxes paid. SFAS 123R is effectivegenerally for public companies as of the beginning of the first interim orannual reporting period that begins after June 15, 2005. SFAS 123R appliesto all awards granted after the required effective date and to awards modified,repurchased, or cancelled after that date. As of the required effective date,all public entities that used the fair-value-based method for eitherrecognition or disclosure under the original Statement 123 will apply thisrevised statement using a modified version of prospective application. Under thattransition method, compensation cost is recognized on or after the requiredeffective date for the portion of outstanding awards for which the requisiteservice has not yet been rendered, based on the grant-date fair value of thoseawards calculated under the original Statement 123 for either recognition orpro forma disclosures. For periods before the required effective date, thoseentities may elect to apply a modified version of retrospective applicationunder which financial statements for prior periods are adjusted on a basisconsistent with the pro forma disclosures required for those periods by theoriginal Statement 123. We are currently evaluating the requirements of SFAS123R and will adopt this statement at the effective date. 

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Althoughwe cannot estimate the exact amount at this time, we expect that the adoptionof this statement will have a material effect on our financial statements.

**Item7A.   Quantitative and Qualitative Disclosure about Market Risk**

Wave’sinvestment portfolio consists of a minority equity investment in SaflinkCorporation, a publicly traded company. As of December 31, 2004, we held259,670 shares of Saflink’s common stock. These securities are classified asavailable-for-sale and, consequently, are recorded on the balance sheet at fairvalue with unrealized gains and losses reported as a separate component ofstockholders’ equity. This investment is inherently risky because the marketsfor the technologies or products that Saflink has under development aretypically in the early stages and may never become profitable. In addition, thevalue of this investment is subject to significant price volatility, andtherefore, our investment in these shares is subject to potentially significantdeclines in value. For example, during the period that Wave has held shares ofSaflink, its closing price has fluctuated from a low closing price of $1.94 toa high closing price of $2.97. The following table presents the change in fairvalues of Wave’s investments in marketable equity securities of publicly tradedentities using the high and low closing prices of the securities from August 9,2004, which was the first trading day that Wave owned Safllink’s common stockthrough February 18, 2005:
| ** **                                                 | ** ** | **Fair Market Value (“FMV”)  at the lowest closing price  from August 9, 2004  through February 18, 2005** | ** ** | **FMV as of  December 31, 2004** | ** ** | **FMV at the highest  closing price from  August 9, 2004 through  February 18, 2005** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|
| Corporate  Equities                                        |       |                                                                                                                                                                                  | $          | 503,758                                              |       |                                                                                                                                    |       | $ | 721,880 |   |   |   | $ | 771,217 |   |   |
| Percentage  decrease from highest closing price            |       |                                                                                                                                                                                  | 35         | %                                                    |       |                                                                                                                                    | 6          | % |   |   | — |   |   |
| Percentage decrease from  FMV as of December 31, 2004 |       |                                                                                                                                                                                  | 30         | %                                                    |       |                                                                                                                                    | —     |   |   |   | — |   |   |

 

Assuming hypothetical future changes in the marketprices of these investments based on the historical data presented above, thepotential loss in future values resulting from such changes could range frombetween 6% and 35% of the fair market value of these investments as of December 31,2004. The amount of such hypothetical future losses in fair market value wouldbe equal to $43,313, $216,564 and $252,658, using hypothetical losses of 6%,30% and 35%, respectively.

The exposure to marketrisk associated with interest rate-sensitive instruments is not material. Wave’scash and cash equivalents consist primarily of money market funds that meethigh credit quality standards and the amount of credit exposure to any oneissue is limited.

**Item8.   Financial Statements and Supplementary Data**

The consolidated financialstatements, the notes thereto, and the independent auditors’ report thereon arepresented beginning at page F-1 of this Form 10-K and are herebyincorporated by reference into this Item 8. The quarterly financialinformation required by this Item 8 is included in the Notes to ConsolidatedFinancial Statements.

**Item9.*  *Changes in and Disagreements withAccountant on Accounting and Financial Disclosure**

Not Applicable.

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**Item 9A.   Controls and Procedures**

*Evaluation ofdisclosure controls and procedures*

Our CEO and CFO haveevaluated the effectiveness of our disclosure controls and procedures as of December 31,2004.  Based on their evaluation, our CEOand CFO have concluded, as of the date of such evaluation, that our disclosurecontrols and procedures are effective.

*Management’s reporton Internal Control Over Financial Reporting*

Wave’smanagement is responsible for establishing and maintaining adequate internalcontrol over financial reporting, as defined in Rule 13a-15(f) promulgatedunder the Exchange Act. Wave’s internal control system was designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. Wave’s management assessed theeffectiveness of its internal control over financial reporting as of December 31,2004. In making its assessment, Wave’s management used the criteria set forthby the Committee of Sponsoring Organizations of the Treadway Commission in “InternalControl Integrated Framework”. Based on this assessment, Wave’s managementconcluded that, as of December 31, 2004, its internal control overfinancial reporting is effective based on those criteria.  Wave’s Independent Registered PublicAccounting Firm, KPMG LLP, has issued an attestation report on management’sassessment of Wave’s internal control over financial reporting, which isincluded following this report.
| Dated: March 15, 2005 |
|----------------------------|
| WAVE SYSTEMS CORP.         |
| By:                        | /s/ STEVEN K. SPRAGUE |   | By: | /s/ GERARD T. FEENEY |
| Name:                      | Steven K. Sprague |   | Name: | Gerard T. Feeney |
| Title:                     | *President and Chief Executive Office* |   | Title: | *Senior Vice President of Finance and  Administration, Chief Financial Officer* |
|                            |  |  |  |  |  |  |

 

**Report of theIndependent Registered Public Accounting Firm**

The Board of Directors andStockholdersWave Systems Corp.:

We have audited management’s assessment, included inthe accompanying ***Management’s report on Internal Control OverFinancial Reporting,*****thatWave Systems Corp. and subsidiaries (a development stage corporation)maintained effective internal control over financial reporting as of December 31,2004, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO)*.*The Company’s managementis responsible for maintaining effective internal control over financialreporting and for its assessment of the effectiveness of internal control overfinancial reporting. Our responsibility is to express an opinion on management’sassessment and an opinion on the effectiveness of the Company’s internalcontrol over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operating 

38

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effectiveness of internalcontrol, and performing such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment that WaveSystems Corp. maintained effective internal control over financial reporting asof December 31, 2004, is fairly stated, in all material respects, based oncriteria established in Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO)*.*Also, in our opinion, Wave Systems Corp.maintained, in all material respects, effective internal control over financialreporting as of December 31, 2004, based criteriaestablished in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO).

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheets ofWave Systems Corp and subsidiaries (a development stage corporation) as of December 31,2004 and 2003, and the related consolidated statements of operations,stockholders’ equity (deficiency) and comprehensive income (loss), and cashflows for each of the years in the three-year period ended December 31,2004, and our report dated March 15, 2005 expressed an unqualified opinionon those consolidated financial statements. Our report dated March 15,2005 contains an explanatory paragraph that states that the Company hassuffered recurring losses from operations and has an accumulated deficit thatraise substantial doubt about its ability to continue as a going concern. Theconsolidated financial statements do not include any adjustments that mightresult from the outcome of that uncertainty.
| KPMG LLP              |
|-----------------------|
| Boston, Massachusetts |
| March 15, 2005   |

 

*Changes in internalcontrols*

There have been no changesin Wave’s internal controls over financial reporting that occurred during Wave’sfourth fiscal quarter that have materially affected, or are reasonably likelyto effect, Wave’s internal control over financial reporting.

**Item 9B.*  *OtherInformation**

Not Applicable.

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**PART III**

**Item10.   Directors and Executive Officers of the Registrant**

Information concerning Wave’s directors and executiveofficers will appear in Wave’s Proxy Statement for the 2005 Annual Meeting ofStockholders, to be filed pursuant to Regulation 14A on or before April 30,2005, under the caption “Election of Directors.” Such information is incorporatedherein by reference.

Information concerning compliance with Section 16(a) ofthe Securities Exchange Act will appear in Wave’s Proxy Statement for the 2005Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A on orbefore April 30, 2005, under the caption “Compliance with Section 16(a) ofthe Exchange Act.” Such information is incorporated herein by reference.

Information concerning Wave’s Audit Committee willappear in Wave’s Proxy Statement for the 2005 Annual Meeting of Stockholders,to be filed pursuant to Regulation 14A on or before April 30, 2005, underthe caption “The Board of Directors and its Committees” Such information isincorporated herein by reference.

Wave’s Board of Directorshas adopted a code of ethics that applies to its Chief Executive Officer andChief Financial Officer (the “Code of Ethics”). The Code of Ethics has beenposted on Wave’s Internet website at www.wave.com. Wave intends to satisfy thedisclosure requirements under Item 10 of Form 8-K regarding an amendmentto, or waiver from, a provision of the Code of Ethics that relates to asubstantive amendment or material departure from a provision of the Code ofEthics by posting such information on its internet website at www.wave.com.

**Item 11.   Executive Compensation**

Information regardingexecutive compensation will appear in Wave’s Proxy Statement for the 2005Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A on orbefore April 30, 2005, under the caption “Executive Compensation.”  Such information is incorporated herein byreference.

**Item12.   Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters**

Information regardingsecurity ownership of certain beneficial owners and management and relatedstockholder matters will appear in Wave’s Proxy Statement for the 2005 AnnualMeeting of Stockholders, to be filed pursuant to Regulation 14A on or before April 30,2005, under the caption “Security Ownership of Certain Beneficial Owners andManagement.”  Such information isincorporated herein by reference.

**Item13.   Certain Relationships and Related Transactions**

Information regardingcertain relationships and related transactions will appear in Wave’s ProxyStatement for the 2005 Annual Meeting of Stockholders, to be filed pursuant toRegulation 14A on or before April 30, 2005, under the caption “CertainRelationships and Related Transactions.” Such information is incorporated herein by reference.

**Item 14.   Principal Accountant’s Fees**

Information regarding Wave’sprinciple accountant’s fees will appear in Wave’s Proxy Statement for the 2005Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A on orbefore April 30, 2005, under the caption “Certain Relationships andRelated Transactions.”  Such informationis incorporated herein by reference.

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**PART IV**

**Item15.   Exhibits, Financial Statement Schedules, and Reports on Form 8-K**

(a) (1)      FinancialStatements:
|                                                                                                                                                                                                                                                                         | ** ** | **Page(s)** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|
| Index to  Consolidated Financial Statements                                                                                                                                                                                                                             |       |        | F-1 |   |
| Report  of Independent Registered Public Accounting Firm                                                                                                                                                                                                                |       |        | F-2 |   |
| Consolidated  Balance Sheets as of December 31, 2004 and 2003                                                                                                                                                                                                      |       |        | F-3 |   |
| Consolidated  Statements of Operations for each of the  years ended December 31, 2004, 2003 and 2002 and for the period from  February 12, 1988 (inception) through December 31, 2004                                                                    |       |        | F-4 |   |
| Consolidated  Statements of Stockholders’ Equity (Deficiency) and Other Comprehensive  Income (Loss) for each of the years ended  December 31, 2004, 2003 and 2002 and for the period from  February 12, 1988 (inception) through December 31, 2004 |       |        | F-5 |   |
| Consolidated  Statements of Cash Flows for each of the  years ended December 31, 2004, 2003 and 2002 and for the period from  February 12, 1988 (inception) through December 31, 2004                                                                    |       |        | F-12 |   |
| Notes to Consolidated  Financial Statements                                                                                                                                                                                                                             |       |        | F-14 |   |

 

(a) (2)      Financial Statement Schedules:

All schedules have been omitted since they are eithernot required or not applicable.

(a) (3)      Exhibits:
| Exhibit No. | ** ** | ** ** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                               |
|------------------|------------|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1*             |       | —     |       | Restated Certificate of  Incorporation of Wave (incorporated by reference to Exhibit 3.1 of  Wave’s Registration Statement on Form S-1, File No. 33-75286)                                                                                                                           |
| 3.2*             |       | —     |       | Bylaws of Wave  (incorporated by reference to Exhibit 3.2 of Wave’s Registration  Statement on Form S-1, File No. 33-75286)                                                                                                                                                          |
| 4.1*             |       | —     |       | Form of Stock Certificate  of Class A Common Stock (incorporated by reference to Exhibit 4.1  of Wave’s Registration Statement on Form S-1, File No. 33-75286)                                                                                                             |
| 4.2*             |       | —     |       | Form of  Representative’s Warrant Agreement, including the form of Representative’s  Warrant (incorporated by reference to Exhibit 4.2 of Wave’s Registration  Statement on Form S-1, File No. 33-75286).                                                             |
| 4.3*             |       | —     |       | Certificate of  Designation of Series B Preferred Stock of Wave as filed with the  Delaware Secretary of State on May 24, 1996 (incorporated by reference  to Exhibit 3.1 of Wave’s Current Report on Form 8-K, filed on  June 6, 1996, File No. 0-24752)             |
| 4.4*             |       | —     |       | Certificate of  Designation of Series C Convertible Preferred Stock as filed with the  Delaware Secretary of State on December 27, 1996 (incorporated by reference  to Exhibit 3.1 of Wave’s Current Report on Form 8-K, filed on  January 8, 1997, File No. 0-24752) |
| 4.5*             |       | —     |       | Certificate of  Designation of Series D Convertible Preferred Stock as filed with the  Delaware Secretary of State on December 27, 1996 (incorporated by  reference to Exhibit 3.1 of Wave’s Current Report on Form 8-K,  filed on June 3, 1997, File No. 0-24752)    |

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| 4.6*         |   | — |   | Certificate of  Designation of Series F Convertible Preferred Stock of Wave as filed  with the Delaware Secretary of State on October 9, 1997 (incorporated by  reference to Exhibit 3.1 of Wave’s Current Report on Form 8-K,  filed on October 15, 1997, File No. 0-24752) |
|--------------|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.7*         |   | — |   | Certificate of  Designation of Series G Convertible Preferred Stock of Wave as filed  with the Delaware Secretary of State on March 5, 1998 (incorporated by  reference to Exhibit 3.1 of Wave’s Current Report on Form 8-K,  filed on March 19, 1998, File No. 0-24752)     |
| 4.8*         |   | — |   | Certificate of  Designation of Series H Convertible Preferred Stock of Wave as filed  with the Delaware Secretary of State on April 30, 2003 (incorporated by  reference to Exhibit 4.1 of Wave’s Current Report on Form 8-K,  filed on May 5, 2003, File No. 0-24752)       |
| +10.1*       |   | — |   | Joint Technology  Development Agreement, dated as of May 1, 1992, between The Titan Corporation  and Cryptologics International, Inc. (incorporated by reference to  Exhibit 10.2 of Wave’s Registration Statement on Form S-1,  File No. 33-75286)                               |
| +10.2*       |   | — |   | License and Cross-License  Agreement, dated as of May 1, 1992, between The Titan Corporation and  Cryptologics International, Inc. (incorporated by reference to  Exhibit 10.3 of Wave’s Registration Statement on Form S-1,  File No. 33-75286)                                  |
| 10.3*        |   | — |   | Amendment to License and  Cross-License Agreement, dated as of August 27, 1993, between The  Titan Corporation and Wave (incorporated by reference to Exhibit 10.4 of  Wave’s Registration Statement on Form S-1, File No. 33-75286)                                                   |
| 10.4*        |   | — |   | Amended and Restated  License Agreement, dated February 14, 1994, by and among Wave , Peter  J. Sprague and John R. Michener (incorporated by reference to  Exhibit 10.5 of Wave’s Registration Statement on Form S-1,  File No. 33-75286)                                   |
| †10.5*  |   | — |   | Wave’s Amended and  Restated 1994 Stock Option Plan (incorporated by reference to Wave’s Notice  of Special Meeting of Stockholders on Schedule 14A filed on October 16,  2003, File No. 33-75286)                                                                                          |
| †10.6*  |   | — |   | Wave Non-Employee  Directors Stock Option Plan (incorporated by reference to Exhibit 10.7  of Wave’s Registration Statement on Form S-1, File No. 33-75286)                                                                                                                                 |
| †10.7*  |   | — |   | Wave 1996 Performance  Stock Option Plan (incorporated by reference to Exhibit 10.12 of Wave’s  Annual Report on Form 10-K, filed on April 1, 2002, File #0-24752)                                                                                                                          |
| 10.8*        |   | — |   | Addendum  to License and Cross-License Agreement, dated February 28, 1997,  between The Titan Corporation and Wave (incorporated by reference to  Exhibit 10.10 of Wave’s Annual Report on Form 10-K, filed on  March 24, 1997, File No. 0-24752).                                |
| †10.9*  |   | — |   | Employment  Contract, dated June 8, 1998, between Gerard T. Feeney and Wave (incorporated  by reference to Exhibit 10.18 of Wave’s Annual Report on Form 10-K,  filed on April 1, 1999, File No. 0-24752).                                                                        |
| †10.10* |   | — |   | Employment  Contract, dated November 10, 1998, between Steven Sprague and Wave (incorporated  by reference to Exhibit 10.19 of Wave’s Annual Report on Form 10-K,  filed on April 1, 1999, File No. 0-24752).                                                                     |
| 10.11*       |   | — |   | Asset Purchase Agreement  dated August 13, 2000, by and among Wave and Indigo Networks, LLC  (incorporated by reference to Exhibit 99.1 of Wave’s Current Report on  Form 8-K, filed on September 15, 2000, File #0-24752)                                                        |

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| 10.12* |   | — |   | Office Building  Lease dated October 20, 2002 between Stevens Creek Investors, LLC and  Wave (incorporated by reference to Exhibit 10.13 of Wave’s Annual Report  on Form 10-K, filed on March 31, 2003, File #0-24752)                                                                                            |
|--------|--------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13* |   | — |   | Form of Asset  Purchase Agreement dated October 4, 2001, by and between Wave and  SignOnLine (incorporated by reference to Exhibit 10.15 of Wave’s Annual  Report on Form 10-K, filed on April 1, 2002, File #0-24752)                                                                                        |
| 10.14* |   | — |   | First Amendment to Asset  Purchase Agreement dated October 4, 2001, by and between Wave and  SignOnLine (incorporated by reference to Exhibit 10.16 of Wave’s Annual  Report on Form 10-K, filed on April 1, 2002, File #0-24752)                                                                                  |
| 10.15* |   | — |   | Termination Agreement and Mutual Release between Wave  Systems Corp. and SSP Solutions, Inc. date September 30, 2002  (Incorporated herein by referenced to Exhibit 10.1 of Wave’s Quarterly  Report on Form 10-Q for the quarter ended September 30, 2002,  filed on November 14, 2002,  File #0-24752) |
| 10.16* |   | — |   | Subordinated Convertible  Promissory Note between Wave Systems Corp. and SSP Solutions, Inc. dated September 30,  2002 (Incorporated herein by referenced to Exhibit 10.2 of Wave’s  Quarterly Report on Form 10-Q for the quarter ended  September 30, 2002, filed on November 14, 2002, File #0-24752) |
| 10.17* |   | — |   | Share Purchase Agreement  between Redwave plc, GlobalWave Group plc and Wave Systems Corp. dated  June 19, 2002 (Incorporated  herein by referenced to Exhibit 10.3 of Wave’s Quarterly Report on  Form 10-Q/A for the quarter ended September 30, 2002, filed  on March 19, 2003, File #0-24752)             |
| 10.18* |   | — |   | GlobalWave Group plc  Notice of Extraordinary General Meeting dated June 20, 2002 (Incorporated herein by  referenced to Exhibit 10.4 of Wave’s Quarterly Report on Form 10-Q/A  for the quarter ended September 30, 2002, filed on March 19, 2003, File #0-24752)                                            |
| 10.19* |   | — |   | Joint Venture Agreement  dated October 15, 1999 between Wave, Wavexpress and Sarnoff.  (incorporated by reference to Exhibit 10.20 of Wave’s Annual Report on  Form 10-K/A, filed on June 27, 2003, File #0-24752)                                                                                                 |
| 10.20* |   | — |   | Stockholder Agreement  dated October 15, 1999 between Wave, Wavexpress and Sarnoff.  (incorporated by reference to Exhibit 10.21 of Wave’s Annual Report on  Form 10-K/A, filed on June 27, 2003, File #0-24752)                                                                                                   |
| 10.21* |   | — |   | Securities Purchase  Agreement dated as of July 30, 2004 among Purchasers and Wave  (incorporated by reference to Exhibit 10.1 of Wave’s Current Report on  Form 8-K, filed on August 3, 2004, File #0-24752)                                                                                                      |
| 10.22* |   | — |   | Additional Investment  Right to Purchase 3,529,412 Shares of Common Stock of Wave Systems Corp.  (incorporated by reference to Exhibit 10.2 of Wave’s Current Report on  Form 8-K, filed on August 3, 2004, File #0-24752)                                                                                              |
| 10.23* |   | — |   | Series A Common  Stock Purchase Warrant to Purchase 3,529,412 Shares of Class A Common  Stock of Wave Systems Corp. (incorporated by reference to Exhibit 10.3  of Wave’s Current Report on Form 8-K, filed on August 3,  2004, File #0-24752)                                                                |
| 10.24* |   | — |   | Series B Common  Stock Purchase Warrant to Purchase 882,353 Shares of Class A Common  Stock of Wave Systems Corp. (incorporated by reference to Exhibit 10.4  of Wave’s Current Report on Form 8-K, filed on August 3,  2004, File #0-24752)                                                                  |
| 10.25* |   | — |   | Placement Agency  Agreement between Corpfin Inc. and Wave (incorporated by reference to  Exhibit 10.5 of Wave’s Current Report on Form 8-K, filed on  August 3, 2004, File #0-24752)                                                                                                                                    |

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| 10.26* |   | — |   | Securities Purchase  Agreement dated as of December 16, 2004 among Purchasers and Wave  (incorporated by reference to Exhibit 10.1 of Wave’s Current Report on  Form 8-K, filed on December 17, 2004, File #0-24752)                                                                                        |
|--------|--------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.27  |   | — |   | Form of Addendum  No. 1 to Authorized Distributor Agreement between Wave and Envoy Data  Inc. dated December 14, 2004                                                                                                                                                                                                 |
| 21.1*  |   | — |   | Subsidiaries of  Registrant (incorporated by reference to Exhibit 10.12 of Wave’s Annual  Report on Form 10-K, filed on April 1, 2002, File #0-24752)                                                                                                                                                            |
| 23.1   |   | — |   | Consent of Independent  Auditors—KPMG LLP                                                                                                                                                                                                                                                                                       |
| 31.1   |   | — |   | Section 302  Certification by Steven K. Sprague, President and Chief Executive Officer                                                                                                                                                                                                                                          |
| 31.2   |   | — |   | Section 302  Certification by Gerard T. Feeney, Chief Financial Officer                                                                                                                                                                                                                                                         |
| 32.1   |   | — |   | Section 906  Certification                                                                                                                                                                                                                                                                                                      |
| 99.1*  |   | — |   | Form of  Series H Convertible Preferred Stock Purchase Agreement, dated as of  April 30, 2003 (the “First Purchase Agreement”), by and among Wave and  the purchasers of the Series H Convertible Preferred Stock (Incorporated  by reference to Wave’s Form 8-K filed on May 5, 2003). |
| 99.2*  |   | — |   | Form of  Series H Convertible Preferred Stock Purchase Agreement, dated as of  April 30, 2003 (the “Second Purchase Agreement”), by and between Wave  and an individual purchaser (Incorporated by reference to Wave’s Form 8-K  filed on May 5, 2003).                                      |
| 99.3*  |   | — |   | Form of  Registration Rights Agreement by and among Wave and the purchasers of the  Series H Convertible Preferred Stock, dated as of April 30, 2003  (Incorporated by reference to Wave’s Form 8-K filed on May 5,  2003).                                                                            |
| 99.4*  |   | — |   | Form of Warrant  issued by Wave pursuant to the First Purchase Agreement to each of the  purchasers of the Series H Convertible Preferred Stock, dated as of  April 30, 2003 (Incorporated by reference to Wave’s Form 8-K  filed on May 5, 2003).                                                     |
| 99.5*  |   | — |   | Form of Warrant  issued by Wave pursuant to the Second Purchase Agreement to the individual  purchaser, dated as of April 30, 2003 (Incorporated by reference to  Wave’s Form 8-K filed on May 5, 2003).                                                                                                    |
| 99.6*  |   | — |   | Form of Warrant  issued by Wave to the placement agent and sub-placement agents, dated  as of April 30, 2003 (Incorporated by reference to Wave’s Form S-3  filed on May 14, 2003 (Registration No. 333-99469)).                                                                                       |
| 99.7*  |   | __     |   | Letter Amendment to  First Purchase Agreement and Second Purchase Agreement effected on  August 11, 2003 (Incorporated by reference to Wave’s Form 8-K  filed on August 12, 2003).                                                                                                                               |
| 99.8*  |   | __     |   | Form of Letter  Agreement to the Series H Convertible Preferred Stock Purchase  Agreements dated September 4, 2003, effected on September 15, 2003  (Incorporated by reference to Wave’s Form 8-K filed on  September 16, 2003).                                                                  |
| 99.9*  |   | __     |   | Form of Waiver to  the Series H Preferred Stock Purchase Agreements dated September 4,  2003, effected on September 15, 2003 (Incorporated by reference to  Wave’s Form 8-K filed on September 16, 2003).                                                                                         |
| 99.10* |   | __     |   | Securities Purchase  Agreement, dated as of November 18, 2003, by and among Wave and purchasers  of the Class A common stock. (Incorporated by reference to Wave’s  registration statement filed on Form S-3/A filed on  February 12, 2004. (Registration No. 333-112017.))                            |

44

----

 
| 99.11* |   | __     |   | Form of  Warrant issued by Wave to each of the purchasers of the Class A Common  Stock and the placement agents, dated as of November 18, 2003 with the  schedule of holders attached thereto. (Incorporated by reference to Wave’s  Form 8-K/A filed on February 13, 2004). |
|--------|--------|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 99.12* |   | __     |   | Registration Rights  Agreement by and among Wave and the purchasers of the Class A Common  Stock, dated as of November 18, 2003. (Incorporated by reference to  Wave’s Form 8-K/A filed on February 13, 2004).                                                                    |
| 99.13* |   | — |   | Demand Note, dated  March 26, 2001 between Gerard T. Feeney and Wave (incorporated by reference  to Exhibit 99.1 of Wave’s Annual Report on Form 10-K, filed  on April 1, 2002, File #0-24752)                                                                                    |
| 99.14* |   | — |   | Demand Note, dated  February 27, 2001 between Peter J. Sprague and Wave (incorporated by  reference to Exhibit 99.2 of Wave’s Annual Report on Form 10-K,  filed on April 1, 2002, File #0-24752)                                                                                 |
| 99.15* |   | — |   | Demand Note,  dated July 25, 2001 between Peter J. Sprague and Wave (incorporated by  reference to Exhibit 99.3 of Wave’s Annual Report on Form 10-K,  filed on April 1, 2002, File #0-24752)                                                                                     |
| 99.16* |   | — |   | Demand Note, dated  September 5, 2001 between Peter J. Sprague and Wave (incorporated by  reference to Exhibit 99.4 of Wave’s Annual Report on Form 10-K,  filed on April 1, 2002, File #0-24752)                                                                                 |
| 99.17* |   | — |   | Allonge to Demand  Promissory Note, dated March 26, 2002 between Gerard T. Feeney and Wave  (incorporated by reference to Exhibit 99.6 of Wave’s Annual Report on  Form 10-K/A, filed on June 30, 2003, File #0-24752)                                                            |
| 99.18* |   | — |   | Allonge to Demand  Promissory Note, dated February 27, 2002 between Peter J. Sprague and  Wave (incorporated by reference to Exhibit 99.7 of Wave’s Annual Report  on Form 10-K/A, filed on June 30, 2003, File #0-24752)                                                         |
| 99.19* |   | — |   | Allonge to Demand  Promissory Note, dated July 25, 2002 between Peter J. Sprague and Wave  (incorporated by reference to Exhibit 99.8 of Wave’s Annual Report on  Form 10-K/A, filed on June 30, 2003, File #0-24752)                                                             |

----

*                    Incorporatedherein by reference

+                Confidentialtreatment has been granted as to portions of this exhibit.

†                    Managementcontract or compensatory plan.

(b)         Reports on Form 8-K

45

----

 

**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.
| Dated: March 16, 2005 |                                           |
|----------------------------|------------------------------------------------|
|                       | WAVE SYSTEMS CORP.                             |
|                       | By:                                            | /s/  STEVEN K SPRAGUE |
|                       | Name: Steven K.  Sprague                       |
|                       | Title: *President and Chief Executive Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.
|                                    | **Signature** | ** **                             | ** **           | ** ** | **Title** | ** ** | ** ** | **Date** | ** ** |
|------------------------------------|---------------|----------------------------------------|----------------------|------------|-----------|------------|------------|----------|------------|
| /s/  STEVEN K. SPRAGUE             |          | President,  Chief Executive Officer    | March 16,  2005 |
| Steven K. Sprague                  |          | and Director                           |                 |
| /s/  JOHN E. BAGALAY, JR.     |          | Chairman                               | March 16,  2005 |
| John E.  Bagalay, Jr.         |          |                                   |                 |
| /s/  GEORGE GILDER                 |          | Director                               | March 16,  2005 |
| George Gilder                      |          |                                   |                 |
| /s/  JOHN E. MCCONNAUGHY, JR. |          | Director                               | March 16,  2005 |
| John E.  McConnaughy, Jr.     |          |                                   |                 |
| /s/  NOLAN BUSHNELL                |          | Director                               | March 16,  2005 |
| Nolan Bushnell                     |          |                                   |                 |
|                               |          | Senior  Vice President, Finance        |                 |
| /s/ GERARD T. FEENEY               |          | and  Administration, Chief Financial   |                 |
| Gerard T. Feeney                   |          | Officer and  Secretary (Principal      | March 16,  2005 |
|                               |          | Financial Officer  and Duly Authorized |                 |
|                               |          | Officer of the  Registrant)            |                 |

 

46

----

 

**Indexto Consolidated Financial Statements**
|                                                                                                                                                                                                                                                                         | ** ** | ** ** | **Page(s)** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|-------------|------------|
| Report  of Independent Registered Public Accounting Firm                                                                                                                                                                                                                |       | F-2        |
| Consolidated  Balance Sheets as of December 31, 2004 and 2003                                                                                                                                                                                                      |       | F-3        |
| Consolidated  Statements of Operations for each of the years ended December 31, 2004,  2003 and 2002 and for the period from February 12, 1988 (inception)  through  December 31, 2004                                                                   |       | F-4        |
| Consolidated  Statements of Stockholders’ Equity (Deficiency) and Other Comprehensive  Income (Loss) for each of the years ended December 31, 2004, 2003 and  2002 and for the period from February 12, 1988 (inception) through  December 31, 2004 |       | F-5        |
| Consolidated  Statements of Cash Flows for each of the years ended December 31, 2004,  2003 and 2002 and for the period from February 12, 1988 (inception)  through  December 31, 2004                                                                   |       | F-12       |
| Notes to Consolidated  Financial Statements                                                                                                                                                                                                                             |       | F-14       |

 

F-1

----

 

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors andStockholdersWave Systems Corp.:

We have audited the accompanying consolidated balancesheets of Wave Systems Corp. and subsidiaries (a development stage corporation)as of December 31, 2004 and 2003, and the related statements ofoperations, stockholders’ equity, and cash flows for each of the years in thethree-year period ended December 31, 2004. These consolidated financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, 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 statementsreferred to above present fairly, in all material respects, the financialposition of Wave Systems Corp. and subsidiaries as of December 31, 2004and 2003, and the results of their operations and their cash flows for each ofthe years in the three-year period ended December 31, 2004 and for theperiod from February 12, 1988 (date of inception) to December 31,2004 in conformity with accounting principles generally accepted in the UnitedStates of America.

The accompanying consolidated financial statementshave been prepared assuming that the Company will continue as a going concern. Asdiscussed in Note 2 to the consolidated financial statements, the Company hassuffered recurring losses from operations and has an accumulated deficit thatraises substantial doubt about its ability to continue as a going concern. Management’splans in regard to these matters are also described in Note 2. The financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.

We also have audited, inaccordance with standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Wave Systems Corp. internal control overfinancial reporting as of December 31, 2004, based on criteria establishedin Internal Control-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO) and our report dated March 15,2005, expressed an unqualified opinion on management’s assessment of, and theeffective operation of internal control over financial reporting.
|                       | KPMG LLP |
|-----------------------|----------|
| Boston, Massachusetts |
| March 15, 2005   |

 

F-2

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES(a development stage corporation)**

**Consolidated Balance SheetsDecember 31, 2004 and 2003**
| ** **                                                                                                                                             | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|------------|--------------|------------|
| **Assets**                                                                                                                                             |       |         |       |         |       |
| Current assets:                                                                                                                                        |       |         |       |         |       |
| Cash and cash equivalents                                                                                                                              |       | $            | 5,805,912  |         | $          | 8,818,305 |   |
| Cash collected on behalf of charities                                                                                                                  |       | —       |       | 211,717      |       |
| Marketable securities                                                                                                                                  |       | 721,880      |       | 6,325,310    |       |
| Prepaid expenses and other receivables                                                                                                                 |       | 272,557      |       | 205,472      |       |
| Total current assets                                                                                                                                   |       | 6,800,349    |       | 15,560,804   |       |
| Property and equipment, net                                                                                                                            |       | 1,435,053    |       | 2,286,876    |       |
| Other assets                                                                                                                                           |       | 219,180      |       | 312,750      |       |
| Total Assets                                                                                                                                           |       | 8,454,582    |       | 18,160,430   |       |
| **Liabilities  and Stockholders’ equity**                                                                                                         |       |         |       |         |       |
| Current liabilities:                                                                                                                                   |       |         |       |         |       |
| Accounts payable and accrued expenses                                                                                                                  |       | 2,900,064    |       | 2,836,524    |       |
| Due to charities                                                                                                                                       |       | —       |       | 243,197      |       |
| Deferred revenue                                                                                                                                       |       | 351,190      |       | 74,222       |       |
| Total current liabilities                                                                                                                              |       | 3,251,254    |       | 3,153,943    |       |
| Liability  for warrants containing cash settlement provisions                                                                                          |       | 493,128      |       | 991,851      |       |
| Total  liabilities                                                                                                                                     |       | 3,744,382    |       | 4,145,794    |       |
| Stockholders’ Equity:                                                                                                                             |       |         |       |         |       |
| Common Stock,  $.01 par value. Authorized 120,000,000 shares as Class A; 76,177,617  shares issued and outstanding in 2004 and 67,128,106 in 2003 |       | 761,776      |       | 671,281      |       |
| Common Stock,  $.01 par value. Authorized 13,000,000 shares as Class B; 205,725 shares  issued and outstanding in 2004 and 2003                   |       | 2,057        |       | 2,057        |       |
| Capital in excess  of par value                                                                                                                        |       | 270,664,189  |       | 262,387,155  |       |
| Deficit  accumulated during the development stage                                                                                                      |       | (267,184,364 | )          | (252,686,326 | )          |
| Accumulated other  comprehensive income—unrealized gain on marketable securities                                                                  |       | 466,542      |       | 3,640,469    |       |
| Total stockholders’ equity                                                                                                                        |       | 4,710,200    |       | 14,014,636   |       |
| Total Liabilities and  Stockholders’ Equity                                                                                                       |       | $            | 8,454,582  |         | $          | 18,160,430 |   |

 

See accompanying notes to consolidated financial statements.

F-3

----

**WAVE SYSTEMS CORP. ANDSUBSIDIARIES(a development stage corporation)**

**Consolidated Statements of Operations**

**Years endedDecember 31, 2004, 2003, 2002 and theperiod from February 12, 1988 (date of inception)through December 31, 2004**
| ** **                                                                                    | ** ** | **2004**    | ** ** | **2003**    | ** **  | **2002**    | ** ** | **Period from  February 12, 1988  through  December 31,  2004** | ** **   |
|-----------------------------------------------------------------------------------------------|------------|-------------|------------|-------------|-------------|-------------|------------|-------------------------------------------------------------------------------------|--------------|
| Net Revenues:                                                                                 |       |        |       |        |        |        |       |                                                                                |         |   |   |
| Product                                                                                       |       | $           | 7,160      |        | $           | 3,350       |       | $                                                                                   | 121,974      |   |   | $ | 496,624 |   |   |
| Services                                                                                      |       | 18,833      |       | 65,343      |        | 310,573     |       |                                                                                | 825,473      |   |   |
| Licensing and  Other                                                                          |       | 183,318     |       | 120,670     |        | 14,041      |       |                                                                                | 809,887      |   |   |
| Total Net Revenues                                                                            |       | 209,311     |       | 189,363     |        | 446,588     |       |                                                                                | 2,131,984    |   |   |
| Cost of sales:                                                                                |       |        |       |        |        |        |       |                                                                                |         |   |   |
| Product                                                                                       |       | 4,647       |       | 2,870       |        | 64,769      |       |                                                                                | 288,572      |   |   |
| Services                                                                                      |       | 13,589      |       | 12,948      |        | 132,582     |       |                                                                                | 386,243      |   |   |
| Licensing and  Other                                                                          |       | 133,468     |       | 39,361      |        | 4,857       |       |                                                                                | 308,466      |   |   |
| Total Cost of  Sales                                                                          |       | 151,704     |       | 55,179      |        | 202,208     |       |                                                                                | 983,281      |   |   |
| Gross profit                                                                                  |       | 57,607      |       | 134,184     |        | 244,380     |       |                                                                                | 1,148,703    |   |   |
| Operating expenses:                                                                           |       |        |       |        |        |        |       |                                                                                |         |   |   |
| Selling, general  and administrative                                                          |       | 12,255,427  |       | 12,698,682  |        | 19,188,046  |       |                                                                                | 152,614,068  |   |   |
| Research and  development                                                                     |       | 6,852,754   |       | 7,384,708   |        | 12,009,713  |       |                                                                                | 98,200,151   |   |   |
| Inventory provision                                                                           |       | —      |       | 1,114,442   |        | —      |       |                                                                                | 1,114,442    |   |   |
| Amortization of  goodwill                                                                     |       | —      |       | —      |        | —      |       |                                                                                | 2,294,176    |   |   |
| Write-off of  intangibles and other impaired assets                                           |       | 301,366     |       | —      |        | 1,571,031   |       |                                                                                | 3,634,314    |   |   |
| Restructuring  costs and other special charges                                                |       | —      |       | —      |        | 726,280     |       |                                                                                | 726,280      |   |   |
| Write-off of  goodwill                                                                        |       | —      |       | —      |        | —      |       |                                                                                | 3,054,456    |   |   |
| In-process  research and development expense                                                  |       | —      |       | —      |        | —      |       |                                                                                | 2,176,000    |   |   |
| Acquisition costs                                                                             |       | —      |       | —      |        | —      |       |                                                                                | 1,494,000    |   |   |
| Aladdin license  expense                                                                      |       | —      |       | —      |        | —      |       |                                                                                | 3,889,000    |   |   |
|                                                                                          |       | 19,409,547  |       | 21,197,832  |        | 33,495,070  |       |                                                                                | 269,196,887  |   |   |
| Other income (expense):                                                                       |       |        |       |        |        |        |       |                                                                                |         |   |   |
| Interest income                                                                               |       | 24,931      |       | 74,822      |        | 477,902     |       |                                                                                | 10,291,054   |   |   |
| Interest expense                                                                              |       | —      |       | —      |        | —      |       |                                                                                | (1,695,461   | ) |   |
| Equity in net  losses of GlobalWave                                                           |       | —      |       | —      |        | —      |       |                                                                                | (5,738,650   | ) |   |
| Loss on other than  temporary decline in marketable equity securities                         |       | —      |       | —      |        | (11,513,099 | )          |                                                                                | (13,249,781  | ) |   |
| Gain on sale of  marketable securities                                                        |       | 4,330,248   |       | 234,759     |        | —      |       |                                                                                | 5,107,464    |   |   |
| Gain on  termination of development contract                                             |       | —      |       | —      |        | 1,818,000   |       |                                                                                | 1,818,000    |   |   |
| Liquidated damages                                                                            |       | —      |       | (155,716    | )           | —      |       |                                                                                | (155,716     | ) |   |
| Unrealized gain on  decrease in value of warrant liability                                    |       | 498,723     |       | 263,097     |        | —      |       |                                                                                | 761,820      |   |   |
| Recovery of  (provision for loss on) officer note receivable                                  |       | —      |       | 999,518     |        | (999,518    | )          |                                                                                | —       |   |   |
| License fee                                                                                   |       | —      |       | —      |        | —      |       |                                                                                | 5,000,000    |   |   |
| License warrant  cost                                                                         |       | —      |       | —      |        | —      |       |                                                                                | (1,100,000   | ) |   |
| Other income  (expense)                                                                       |       | —      |       | 52,370      |        | —      |       |                                                                                | (174,910     | ) |   |
|                                                                                          |       | 4,853,902   |       | 1,468,850   |        | (10,216,715 | )          |                                                                                | 863,820      |   |   |
| Net loss                                                                                      |       | (14,498,038 | )          | (19,594,798 | )           | (43,467,405 | )          |                                                                                | (267,184,364 | ) |   |
| Accrued dividends  on preferred Stock (including $5,485,000 of accretion of discount in 2003) |       | —      |       | 5,697,518   |        | —      |       |                                                                                | 10,048,115   |   |   |
| Net loss to common  stockholders                                                              |       | (14,498,038 | )          | $           | (25,292,316 | )           | $          | (43,467,405                                                                         | )            |   | $ | (277,232,479 | ) |   |
| Loss per common  share—basic and diluted                                                 |       | $           | (0.21      | )           | $           | (.45        | )          | $                                                                                   | (0.85        | ) |   | $ | (10.61 | ) |   |
| Weighted average  number of common shares Outstanding during the period                       |       | 69,040,661  |       | 55,887,384  |        | 51,135,548  |       |                                                                                | 26,136,284   |   |   |

See accompanying notes to consolidated financial statements.

F-4

----

**WAVE SYSTEMS CORP. ANDSUBSIDIARIES(a development stage corporation) (Continued)**

**ConsolidatedStatements of Stockholders’ Equity (Deficiency) And Comprehensive Income (Loss)**
| ** **                                                                                                              | ** ** | ** **            | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **          | ** ** | ** **         | ** ** | **Deficit**     | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|----------------------------|------------|---------------------|------------|--------------------|------------|-----------------|------------|------------------|------------|-----------------|------------|------------|------------|
| ** **                                                                                                              | ** ** | ** **            | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **          | ** ** | ** **         | ** ** | **accumulated** | ** ** | ** **       | ** ** | **Note**        | ** ** | ** ** | ** ** |
| ** **                                                                                                              | ** ** | **Class A**      | ** ** | **Class B**      | ** ** | **Capital**                | ** ** | **during the** | ** ** | ** **         | ** ** | **receivable**  | ** ** | ** **       | ** ** |
| ** **                                                                                                              | ** ** | **Common Stock** | ** ** | **Common Stock** | ** ** | **in excess of** | ** ** | **development**     | ** ** | **Deferred**       | ** ** | **from**        | ** ** | ** **       | ** ** |
| ** **                                                                                                              | ** ** | **Shares**            | ** ** | **Amount**            | ** ** | **Shares**                 | ** ** | **Amount**          | ** ** | **par value** | ** ** | **stage**       | ** ** | **compensation** | ** ** | **stockholder** | ** ** | **Total**  | ** ** |
| Shares issued to founders at $.003 per share                                                                            |       |                  | —     |                  |       |                       | $          | —              |       |               | 4,680,000  |            | $          | 46,800           |       | $               | (31,200    | )          | $          | — |   |   | $ | — |   |   |   | $ | — |   |   | $ | 15,600 |   |
| Shares issued at $1.25 per share, net of expenses of  $36,574 from September through November 1988            |       |                  | —     |                  |       |                       | —     |                |       | 300,000            |       | 3,000           |       | 335,426          |       | —          |       |       | —     |   |   |   | — |   |   | 338,426 |   |
| Net loss for period ended December 31, 1988                                                                        |       |                  | —     |                  |       |                       | —     |                |       | —             |       | —          |       | —           |       | (326,832        | )          |       | —     |   |   |   | — |   |   | (326,832 | ) |
| Balance at December 31, 1988                                                                                       |       |                  | —     |                  |       |                       | —     |                |       | 4,980,000          |       | 49,800          |       | 304,226          |       | (326,832        | )          |       | —     |   |   |   | — |   |   | 27,194 |   |
| Shares issued at $1.25 per share, net of expenses of  $68,750, from January through December 1989             |       |                  | —     |                  |       |                       | —     |                |       | 270,000            |       | 2,700           |       | 266,050          |       | —          |       |       | —     |   |   |   | — |   |   | 268,750 |   |
| Shares issued at $1.25 per share in July 1989 as  compensation for services rendered                               |       |                  | —     |                  |       |                       | —     |                |       | 1,920              |       | 19              |       | 2,381            |       | —          |       |       | —     |   |   |   | — |   |   | 2,400 |   |
| Shares issued by principal stockholders at $1.25 per  share in December 1989 as compensation for services rendered |       |                  | —     |                  |       |                       | —     |                |       | —             |       | —          |       | 374,000          |       | —          |       |       | —     |   |   |   | — |   |   | 374,000 |   |
| Net loss for year ended December 31, 1989                                                                          |       |                  | —     |                  |       |                       | —     |                |       | —             |       | —          |       | —           |       | (982,186        | )          |       | —     |   |   |   | — |   |   | (982,186 | ) |
| Balance at December 31, 1989                                                                                       |       |                  | —     |                  |       |                       | —     |                |       | 5,251,920          |       | 52,519          |       | 946,657          |       | (1,309,018      | )          |       | —     |   |   |   | — |   |   | (309,842 | ) |
| Shares issued by principal stockholder at $1.25 per  share in March 1990 as compensation for services rendered     |       |                  | —     |                  |       |                       | —     |                |       | —             |       | —          |       | 56,250           |       | —          |       |       | —     |   |   |   | — |   |   | 56,250 |   |
| Shares issued by principal stockholder at$.50 per  share in March 1990 as compensation for services rendered       |       |                  | —     |                  |       |                       | —     |                |       | —             |       | —          |       | 60,000           |       | —          |       |       | —     |   |   |   | — |   |   | 60,000 |   |
| Shares issued at $1.67 per share in May 1990 as  compensation for services rendered                                |       |                  | —     |                  |       |                       | —     |                |       | 6,000              |       | 60              |       | 9,940            |       | —          |       |       | —     |   |   |   | — |   |   | 10,000 |   |
| Shares issued at $1.67 per share, net of expenses of  $5,000 in March, April, November and December 1990      |       |                  | —     |                  |       |                       | —     |                |       | 390,000            |       | 3,900           |       | 641,100          |       | —          |       |       | —     |   |   |   | — |   |   | 645,000 |   |
| Net loss for year ended December 31, 1990                                                                          |       |                  | —     |                  |       |                       | —     |                |       | —             |       | —          |       | —           |       | (1,178,129      | )          |       | —     |   |   |   | — |   |   | (1,178,129 | ) |
| Balance at December 31, 1990                                                                                       |       |                  | —     |                  |       |                       | —     |                |       | 5,647,920          |       | 56,479          |       | 1,713,947        |       | (2,487,147      | )          |       | —     |   |   |   | — |   |   | (716,721 | ) |
| Shares issued at $1.67 per share from March through  November 1991                                                 |       |                  | —     |                  |       |                       | —     |                |       | 315,000            |       | 3,150           |       | 521,850          |       | —          |       |       | —     |   |   |   | — |   |   | 525,000 |   |
| Shares issued at $1.67 per share in November 1991 as compensation  for services rendered                                |       |                  | —     |                  |       |                       | —     |                |       | 19,800             |       | 198             |       | 32,802           |       | —          |       |       | —     |   |   |   | — |   |   | 33,000 |   |
| Net loss for year ended December 31, 1991                                                                          |       |                  | —     |                  |       |                       | —     |                |       | —             |       | —          |       | —           |       | (1,009,368      | )          |       | —     |   |   |   | — |   |   | (1,009,368 | ) |
| Balance at  December 31, 1991                                                                                      |       |                  | —     |                  |       |                       | —     |                |       | 5,982,720          |       | 59,827          |       | 2,268,599        |       | (3,496,515      | )          |       | —     |   |   |   | — |   |   | (1,168,089 | ) |
|                                                                                                                         |            |                       |            |                       |            |                            |            |                     |            |                    |            |                 |            |                  |            |                 |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to consolidated financial statements.

F-5

 

----

 

**WAVE SYSTEMS CORP. ANDSUBSIDIARIES(a development stage corporation)**

**Consolidated Statements of Stockholders’ Equity(Deficiency) And Comprehensive Income (Loss)––(Continued)**
| ** **                                                                                                                                                                                      | ** ** | ** **            | ** **   | ** **            | ** ** | ** **                 | ** **   | ** **          | ** ** | ** **         | ** ** | **Deficit**     | ** ** | ** **       | ** ** | ** **      | ** ** | ** **   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|--------------|-----------------------|------------|----------------------------|--------------|---------------------|------------|--------------------|------------|-----------------|------------|------------------|------------|-----------------|------------|--------------|------------|
| ** **                                                                                                                                                                                      | ** ** | ** **            | ** **   | ** **            | ** ** | ** **                 | ** **   | ** **          | ** ** | ** **         | ** ** | **accumulated** | ** ** | ** **       | ** ** | **Note**        | ** ** | ** **   | ** ** |
| ** **                                                                                                                                                                                      | ** ** | **Class A**      | ** **   | **Class B**      | ** ** | **Capital**                | ** **   | **during the** | ** ** | ** **         | ** ** | **receivable**  | ** ** | ** **       | ** ** |
| ** **                                                                                                                                                                                      | ** ** | **Common Stock** | ** **   | **Common Stock** | ** ** | **in excess of** | ** **   | **development**     | ** ** | **Deferred**       | ** ** | **from**        | ** ** | ** **       | ** ** |
| ** **                                                                                                                                                                                      | ** ** | **Shares**            | ** **   | **Amount**            | ** ** | **Shares**                 | ** **   | **Amount**          | ** ** | **par value** | ** ** | **stage**       | ** ** | **compensation** | ** ** | **stockholder** | ** ** | **Total**    | ** ** |
| Balance at December 31, 1991                                                                                                                                                               |       |                  | —       |                  |       |                       | —       |                |       | 5,982,720          |       |            | 59,827     |             |       | 2,268,599       |       | (3,496,515   | )          |   | — |   |   |   | — |   |   | (1,168,089 | ) |
| Shares issued at $1.67 per share from  January through October 1992                                                                                                                   |       |                  | —       |                  |       |                       | —       |                |       | 708,000            |       |            | 7,080      |             |       | 1,172,920       |       | —       |       |   | — |   |   |   | — |   |   | 1,180,000 |   |
| Shares issued at $1.67 per share in May 1992 in  connection with License and Cross-License Agreement                                                                                       |       |                  | —       |                  |       |                       | —       |                |       | 674,976            |       |            | 6,750      |             |       | 1,118,210       |       | —       |       |   | — |   |   |   | — |   |   | 1,124,960 |   |
| Shares issued at $1.67 per share in May 1992 as compensation  for services rendered                                                                                                        |       |                  | —       |                  |       |                       | —       |                |       | 18,000             |       |            | 180        |             |       | 29,820          |       | —       |       |   | — |   |   |   | — |   |   | 30,000 |   |
| Shares issued at $2.50 per share in May and  November 1992 as compensation for services rendered                                                                                           |       |                  | —       |                  |       |                       | —       |                |       | 771,000            |       |            | 7,710      |             |       | 1,919,790       |       | —       |       |   | — |   |   |   | — |   |   | 1,927,500 |   |
| Shares issued at $2.50 per share, net of expenses of  $7,500, in November and December 1992                                                                                           |       |                  | —       |                  |       |                       | —       |                |       | 323,001            |       |            | 3,230      |             |       | 796,773         |       | —       |       |   | — |   |   |   | — |   |   | 800,003 |   |
| Shares issued by principal stockholder in December 1992  at $2.50 per share as compensation for services rendered                                                                          |       |                  | —       |                  |       |                       | —       |                |       | —             |       |            | —     |             |       | 75,000          |       | —       |       |   | — |   |   |   | — |   |   | 75,000 |   |
| Shares canceled in October and  December 1992                                                                                                                                         |       |                  | —       |                  |       |                       | —       |                |       | (75,000            | )          |            | (750       | )                |       | 750             |       | —       |       |   | — |   |   |   | — |   |   | — |   |
| Issuance of stock options at $.003 exercise price per  share in June 1992                                                                                                                  |       |                  | —       |                  |       |                       | —       |                |       | —             |       |            | —     |             |       | 798,400         |       | —       |       |   | (398,660 | ) |   |   | — |   |   | 399,740 |   |
| Amortization of deferred compensation                                                                                                                                                           |       |                  | —       |                  |       |                       | —       |                |       | —             |       |            | —     |             |       | —          |       | —       |       |   | 155,455 |   |   |   | — |   |   | 155,455 |   |
| Accrued dividends on preferred stock                                                                                                                                                            |       |                  | —       |                  |       |                       | —       |                |       | —             |       |            | —     |             |       | (6,383          | )          | —       |       |   | — |   |   |   | — |   |   | (6,383 | ) |
| Note receivable and accrued interest from stockholder                                                                                                                                           |       |                  | —       |                  |       |                       | —       |                |       | —             |       |            | —     |             |       | —          |       | —       |       |   | — |   |   |   | (152,974 | ) |   | (152,974 | ) |
| Net loss for the year ended December 31, 1992                                                                                                                                              |       |                  | —       |                  |       |                       | —       |                |       | —             |       |            | —     |             |       | —          |       | (4,182,638   | )          |   | — |   |   |   | — |   |   | (4,182,638 | ) |
| Balance at December 31, 1992                                                                                                                                                               |       |                  | —       |                  |       |                       | —       |                |       | 8,402,697          |       |            | 84,027     |             |       | 8,173,879       |       | (7,679,153   | )          |   | (243,205 | ) |   |   | (152,974 | ) |   | 182,574 |   |
| Shares issued at $1.67 per share in  February 1993                                                                                                                                         |       |                  | —       |                  |       |                       | —       |                |       | 30,000             |       |            | 300        |             |       | 49,800          |       | —       |       |   | — |   |   |   | — |   |   | 50,100 |   |
| Shares issued at $3.50 per share, net of expenses of $82,427,  from April through December 1993                                                                                       |       |                  | —       |                  |       |                       | —       |                |       | 550,359            |       |            | 5,504      |             |       | 1,838,294       |       | —       |       |   | — |   |   |   | — |   |   | 1,843,798 |   |
| Shares issued at $3.50 per share from May to  December 1993 as compensation for services rendered, for the acquisition of property  and equipment and as additional interest on borrowings |       |                  | —  |                  |       |                       | —  |                |       | 73,319        |       |            | 733   |             |       | 255,884    |       | —  |       |   | —  |   |   |   | —  |   |   | 256,617  |   |
| Issuance of warrants to purchase Class B Common  Stock from September to December 1993 in conjunction with the  issuance of convertible debt                                     |       |                  | —       |                  |       |                       | —       |                |       | —             |       |            | —     |             |       | 72,893          |       | —       |       |   | — |   |   |   | — |   |   | 72,893 |   |
| Amortization of deferred compensation—                                                                                                                                                     |       |                  | —       |                  |       |                       | —       |                |       | —             |       |            | —     |             |       | —          |       | —       |       |   | 243,205 |   |   |   | — |   |   | 243,205 |   |
| Accrued dividends on preferred stock                                                                                                                                                            |       |                  | —       |                  |       |                       | —       |                |       | —             |       |            | —     |             |       | (38,467         | )          | —       |       |   | — |   |   |   | — |   |   | (38,467 | ) |
| Note receivable and accrued interest from stockholder                                                                                                                                           |       |                  | —       |                  |       |                       | —       |                |       | —             |       |            | —     |             |       | —          |       | —       |       |   | — |   |   |   | (39,783 | ) |   | (39,783 | ) |
| Net loss for year ended December 31, 1993                                                                                                                                                  |       |                  | —       |                  |       |                       | —       |                |       | —             |       |            | —     |             |       | —          |       | (3,959,334   | )          |   | — |   |   |   | — |   |   | (3,959,334 | ) |
| Balance at  December 31, 1993                                                                                                                                                              |       |                  | —       |                  |       |                       | —       |                |       | 9,056,375          |       |            | 90,564     |             |       | 10,352,283      |       | (11,638,487  | )          |   | — |   |   |   | (192,757 | ) |   | (1,388,397 | ) |

See accompanyingnotes to consolidated financial statements.

F-6

 

----

 

**WAVE SYSTEMS CORP. ANDSUBSIDIARIES(a development stage corporation)**

**Consolidated Statements ofStockholders’ Equity (Deficiency) And Comprehensive Income (Loss)––(Continued)**
| ** **                                                                                                                                                             | ** ** | ** **            | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **          | ** ** | ** **         | ** ** | **Deficit**     | ** ** | ** **       | ** **   | ** **      | ** ** | ** ** | ** **   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|----------------------------|------------|---------------------|------------|--------------------|------------|-----------------|------------|------------------|--------------|-----------------|------------|------------|--------------|
| ** **                                                                                                                                                             | ** ** | ** **            | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **          | ** ** | ** **         | ** ** | **accumulated** | ** ** | ** **       | ** **   | **Note**        | ** ** | ** ** | ** **   |
| ** **                                                                                                                                                             | ** ** | **Class A**      | ** ** | **Class B**      | ** ** | **Capital**                | ** ** | **during the** | ** ** | ** **         | ** ** | **receivable**  | ** ** | ** **       | ** **   |
| ** **                                                                                                                                                             | ** ** | **Common stock** | ** ** | **Common stock** | ** ** | **in excess of** | ** ** | **development**     | ** ** | **Deferred**       | ** ** | **from**        | ** ** | ** **       | ** **   |
| ** **                                                                                                                                                             | ** ** | **Shares**            | ** ** | **Amount**            | ** ** | **Shares**                 | ** ** | **Amount**          | ** ** | **par value** | ** ** | **stage**       | ** ** | **compensation** | ** **   | **stockholder** | ** ** | **Total**  | ** **   |
| Balance at  December 31, 1993                                                                                                                                     |       | —                |       | —                |       | 9,056,375                  |       | 90,564              |       | 10,352,283         |       | (11,638,487     | )          |             | —       |            |       |       | (192,757     | ) |   | (1,388,397 | ) |
| Shares issued at  $3.50 per share in January and February 1994                                                                                               |       | —                |       | —                |       | 95,715                     |       | 957                 |       | 334,046            |       | —          |       |             | —       |            |       |       | —       |   |   | 335,003 |   |
| Shares issued at  $3.50 per share in February 1994 as additional interest on borrowings                                                                           |       | —                |       | —                |       | 5,700                      |       | 57                  |       | 19,893             |       | —          |       |             | —       |            |       |       | —       |   |   | 19,950 |   |
| Issuance of  warrants to purchase Class B Common Stock in January and  February 1994 in conjunction with the issuance of convertible  debt    |       | —                |       | —                |       | —                     |       | —              |       | 115,234            |       | —          |       |             | —       |            |       |       | —       |   |   | 115,234 |   |
| Accrued dividends  on preferred stock                                                                                                                                  |       | —                |       | —                |       | —                     |       | —              |       | (39,484            | )          | —          |       |             | —       |            |       |       | —       |   |   | (39,484 | ) |
| Accrual of  interest on note receivable from stockholder                                                                                                               |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —          |       |             | —       |            |       |       | (17,315      | ) |   | (17,315 | ) |
| Sale of warrants  to underwriter in September 1994                                                                                                                |       | —                |       | —                |       | —                     |       | —              |       | 4                  |       | —          |       |             | —       |            |       |       | —       |   |   | 4 |   |
| Conversion of  notes payable                                                                                                                                           |       | —                |       | —                |       | 599,507                    |       | 5,995               |       | 2,079,131          |       | —          |       |             | —       |            |       |       | —       |   |   | 2,085,126 |   |
| Shares issued at  $5.00 per share in initial public offering in September 1994, net of  expenses of $2,929,835                                                    |       | 3,728,200             |       | 37,282                |       | —                     |       | —              |       | 15,673,883         |       | —          |       |             | —       |            |       |       | —       |   |   | 15,711,165 |   |
| Net loss for year  ended December 31, 1994                                                                                                                        |       | —                |       | —                |       | —                     |       | —              |       | —             |       | (4,271,501      | )          |             | —       |            |       |       | —       |   |   | (4,271,501 | ) |
| Balance at  December 31, 1994                                                                                                                                     |       | 3,728,200             |       | 37,282                |       | 9,757,297                  |       | 97,573              |       | 28,534,990         |       | (15,909,988     | )          |             | —       |            |       |       | (210,072     | ) |   | 12,549,785 |   |
| Shares issued at  prices ranging from $1.00 per share to $3.13 per share as compensation  for services rendered                                                   |       | 31,559                |       | 315                   |       | —                     |       | —              |       | 57,184             |       | —          |       |             | —       |            |       |       | —       |   |   | 57,499 |   |
| Exercise of  options to purchase Class B Common Stock                                                                                                             |       | —                |       | —                |       | 681,700                    |       | 6,817               |       | 429,413            |       | —          |       |             | —       |            |       |       | —       |   |   | 436,230 |   |
| Accrued dividends  on preferred stock                                                                                                                                  |       | —                |       | —                |       | —                     |       | —              |       | (40,600            | )          | —          |       |             | —       |            |       |       | —       |   |   | (40,600 | ) |
| Accrual of  interest on note receivable from stockholder                                                                                                               |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —          |       |             | —       |            |       |       | (17,318      | ) |   | (17,318 | ) |
| Exchange of  Class B Common Stock for Class A Common Stock                                                                                              |       | 2,855,859             |       | 28,559                |       | (2,855,859                 | )          | (28,559             | )          | —             |       | —          |       |             | —       |            |       |       | —       |   |   | — |   |
| Net loss for the  year ended December 31, 1995                                                                                                                    |       | ––          |       | ––          |       | ––               |       | ––        |       | ––       |       | (6,832,866      | )          |             | –– |            |       |       | –– |   |   | (6,832,866 | ) |
| Balance at  December 31, 1995                                                                                                                                     |       | 6,615,618             |       | 66,156                |       | 7,583,138                  |       | 75,831              |       | 28,980,987         |       | (22,742,854     | )          |             | —       |            |       |       | (227,390     | ) |   | 6,152,730 |   |
| Exercise of  options to purchase Class A Common Stock                                                                                                             |       | 214,091               |       | 2,141                 |       | —                     |       | —              |       | 420,366            |       | —          |       |             | —       |            |       |       | —       |   |   | 422,507 |   |
| Shares issued at  prices ranging from $2.06 per share to $3.44 per share as compensation  for services rendered                                                   |       | 42,077                |       | 421                   |       | —                     |       | —              |       | 123,029            |       | —          |       |             | —       |            |       |       | —       |   |   | 123,450 |   |
| Issuance of  unregistered Class B Common Stock to acquire Wave  Interactive  Network valued at approximately $.98 per share                                  |       | —                |       | —                |       | 375,000                    |       | 3,750               |       | 364,688            |       | —          |       |             | —       |            |       |       | —       |   |   | 368,438 |   |
| Issuance of  warrants to purchase unregistered shares of Class A Common Stock in  conjunction with the issuance of convertible debt and preferred stock |       | —                |       | —                |       | —                     |       | —              |       | 283,455            |       | —          |       |             | —       |            |       |       | —       |   |   | 283,455 |   |
| Conversion of  Class B Preferred Stock                                                                                                                            |       | 2,960,303             |       | 29,603                |       | —                     |       | —              |       | 3,078,921          |       | —          |       |             | —       |            |       |       | —       |   |   | 3,108,524 |   |
| Accrual of  interest on note receivable                                                                                                                                |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —          |       |             | —       |            |       |       | (17,315      | ) |   | (17,315 | ) |
| Accrued dividends  on preferred stock                                                                                                                                  |       | —                |       | —                |       | —                     |       | —              |       | (199,014           | )          | —          |       |             | —       |            |       |       | —       |   |   | (199,014 | ) |
| Exchange of  Class B Common Stock for Class A Common Stock                                                                                              |       | 1,749,997             |       | 17,500                |       | (1,749,997                 | )          | (17,500             | )          | —             |       | —          |       |             | —       |            |       |       | —       |   |   | — |   |
| N*ABLE APIC in  connection with the issuance of Class A Common Stock due to merger                                                                                |       | 873,317               |       | 8,733                 |       | —                     |       | —              |       | 1,296,241          |       | —          |       |             | —       |            |       |       | —       |   |   | 1,304,974 |   |
| Net loss for the  year ended December 31, 1996                                                                                                                    |       | —                |       | —                |       | —                     |       | —              |       | —             |       | (10,126,546     | )          |             | —       |            |       |       | —       |   |   | (10,126,546 | ) |
| Balance at  December 31, 1996                                                                                                                                     |       | 12,455,403            |       | 124,554               |       | 6,208,141                  |       | 62,081              |       | 34,348,673         |       | (32,869,400     | )          |             | —       |            |       |       | (244,705     | ) |   | 1,421,203 |   |

 

See accompanying notes to consolidated financial statements.

F-7

 

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES(a development stage corporation)Consolidated Statements of Stockholders’ Equity (Deficiency) And ComprehensiveIncome (Loss)—(Continued)**
| ** **                                                                                                                                     | ** ** | ** **            | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **          | ** ** | ** **         | ** ** | **Deficit**     | ** ** | ** **        | ** **  | ** **      | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|----------------------------|------------|---------------------|------------|--------------------|------------|-----------------|------------|-------------------|-------------|-----------------|------------|------------|------------|
| ** **                                                                                                                                     | ** ** | ** **            | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **          | ** ** | ** **         | ** ** | **Accumulated** | ** ** | **Series G** | ** **  | **Note**        | ** ** | ** ** | ** ** |
| ** **                                                                                                                                     | ** ** | **Class A**      | ** ** | **Class B**      | ** ** | **Capital**                | ** ** | **during the** | ** ** | **Convertible**    | ** ** | **receivable**  | ** ** | ** **        | ** **  |
| ** **                                                                                                                                     | ** ** | **Common stock** | ** ** | **Common stock** | ** ** | **in excess of** | ** ** | **development**     | ** ** | **Preferred**      | ** ** | **from**        | ** ** | ** **        | ** **  |
| ** **                                                                                                                                     | ** ** | **Shares**            | ** ** | **Amount**            | ** ** | **Shares**                 | ** ** | **Amount**          | ** ** | **par value** | ** ** | **stage**       | ** ** | **Stock**         | ** **  | **stockholder** | ** ** | **Total**  | ** ** |
| Balance at  December 31, 1996                                                                                                             |       | 12,455,403            |       | 124,554               |       | 6,208,141                  |       | 62,081              |       | 34,348,673         |       | (32,869,400     | )          | —            |        |            | (244,705   | )          |       | 1,421,203 |   |
| Exercise of  options to purchase Class A and B Common Stock                                                                               |       | 70,326                |       | 703                   |       | 10,330                     |       | 104                 |       | 139,081            |       | —          |       | —            |        |            | —     |       |       | 139,888 |   |
| Shares issued at  prices ranging from $1.00 per share to $3.00 per share as compensation for  services rendered                                |       | 126,885               |       | 1,269                 |       | —                     |       | —              |       | 304,227            |       | —          |       | —            |        |            | —     |       |       | 305,496 |   |
| Conversion of  preferred stock into Common Stock                                                                                               |       | 7,998,860             |       | 79,989                |       | —                     |       | —              |       | 6,703,028          |       | —          |       | —            |        |            | —     |       |       | 6,783,017 |   |
| Issuance of Class A  Common Stock and warrants to purchase Class A Common Stock to Aladdin                                           |       | 500,000               |       | 5,000                 |       | —                     |       | —              |       | 3,834,000          |       | —          |       | —            |        |            | —     |       |       | 3,839,000 |   |
| Issuance of  Class A Common Stock and warrants to purchase Class A Common Stock                                                      |       | 799,964               |       | 8,000                 |       | —                     |       | —              |       | 792,000            |       | —          |       | —            |        |            | —     |       |       | 800,000 |   |
| Reduction in note  receivable                                                                                                                  |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —          |       | —            |        |            | 50,000     |       |       | 50,000 |   |
| Accrual of  interest on note receivable                                                                                                        |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —          |       | —            |        |            | (17,319    | )          |       | (17,319 | ) |
| Issuance of  warrants to purchase Class A Common Stock in conjunction with the  issuance of preferred stock                               |       | —                |       | —                |       | —                     |       | —              |       | 386,462            |       | —          |       | —            |        |            | —     |       |       | 386,462 |   |
| Accrued dividend  on preferred stock including accretion of assured incremental yield                                                          |       | —                |       | —                |       | —                     |       | —              |       | (1,372,984         | )          | —          |       | —            |        |            | —     |       |       | (1,372,984 | ) |
| Assured  incremental yield on issuance of Series F convertible preferred stock  and debt                                                  |       | —                |       | —                |       | —                     |       | —              |       | 682,000            |       | —          |       | —            |        |            | —     |       |       | 682,000 |   |
| N*ABLE APIC in  connection with the issuance of Class A Common Stock due to merger                                                        |       | 1,404,723             |       | 14,047                |       | —                     |       | —              |       | 10,133,497         |       | —          |       | —            |        |            | —     |       |       | 10,147,544 |   |
| Net loss                                                                                                                                       |       | —                |       | —                |       | —                     |       | —              |       | —             |       | (18,012,635     | )          | —            |        |            | —     |       |       | (18,012,635 | ) |
| Exchange of  Class B Common Stock for Class A Common Stock                                                                           |       | 1,796,518             |       | 17,965                |       | (1,796,518                 | )          | (17,965             | )          | —             |       | —          |       | —            |        |            | —     |       |       | — |   |
| Balance at  December 31, 1997                                                                                                             |       | 25,152,679            |       | $251,527              |       | 4,421,953                  |       | $                   | 44,220     |               | $          | 55,949,984      |       | $                 | (50,882,035 | )               | $          | —     |       |   | $ | (212,024 | ) |   | $ | 5,151,672 |   |
| Exercise of  options to purchase Class A Common Stock                                                                                     |       | 77,558                |       | 775                   |       | —                     |       | —              |       | 151,180            |       | —          |       | —            |        |            | —     |       |       | 151,955 |   |
| Options issued to  employees below fair market-value                                                                                           |       | —                |       | —                |       | —                     |       | —              |       | 234,723            |       | —          |       | —            |        |            | —     |       |       | 234,723 |   |
| Exercise of  warrants to purchase Class A Common Stock                                                                                    |       | 1,652,770             |       | 16,528                |       | —                     |       | —              |       | 3,945,740          |       | —          |       | —            |        |            | —     |       |       | 3,962,268 |   |
| Warrants to  purchase Class A Common Stock to be issued as part of technology  licensing agreement and issued to consultants for services |       | —                |       | —                |       | —                     |       | —              |       | 1,546,824          |       | —          |       | —            |        |            | —     |       |       | 1,546,824 |   |
| Shares issued at  prices ranging from $1.00 per share to $5.00 per share as compensation for  services rendered                                |       | 121,400               |       | 1,214                 |       | —                     |       | —              |       | 647,274            |       | —          |       | —            |        |            | —     |       |       | 648,488 |   |
| Reduction in note  receivable                                                                                                                  |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —          |       | —            |        |            | 75,000     |       |       | 75,000 |   |
| Issuance of  Series G Convertible Preferred stock and Common Stock warrants, net of  issuance costs of $222,500                           |       | —                |       | —                |       | —                     |       | —              |       | 218,250            |       | —          |       | 1,809,250         |        |            | —     |       |       | 2,027,500 |   |
| Assured  incremental yield on issuance of Series G convertible preferred stock  and debt                                                  |       | —                |       | —                |       | —                     |       | —              |       | 750,000            |       | —          |       | —            |        |            | —     |       |       | 750,000 |   |
| Accrual of  interest on note receivable                                                                                                        |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —          |       | —            |        |            | (12,318    | )          |       | (12,318 | ) |
| Accrued dividend  on preferred stock including accretion of assured incremental yield                                                          |       | —                |       | —                |       | —                     |       | —              |       | (858,863           | )          | —          |       | 837,263           |        |            | —     |       |       | (21,600 | ) |
| Conversion of  Series G Preferred Stock                                                                                                   |       | 2,394,494             |       | 23,945                |       | —                     |       | —              |       | 2,274,756          |       | —          |       | (2,298,701        | )           |            | —     |       |       | — |   |
| N*ABLE’s APIC in  connection with the issuance of Class A Common Stock due to the merger                                             |       | 2,781                 |       | 28                    |       | —                     |       | —              |       | 59,182             |       | —          |       | —            |        |            | —     |       |       | 59,210 |   |
| Net loss                                                                                                                                       |       | —                |       | —                |       | —                     |       | —              |       | —             |       | (16,586,027     | )          | —            |        |            | —     |       |       | (16,586,027 | ) |
| Adjustment for net  loss of N*ABLE for the six months ended June 30, 1998                                                                 |       | —                |       | —                |       | —                     |       | —              |       | —             |       | 2,253,461       |       | —            |        |            | —     |       |       | 2,253,461 |   |
| Exchange of  Class B Common Stock for Class A Common Stock                                                                           |       | 1,281,288             |       | 12,813                |       | (1,281,288                 | )          | (12,813             | )          | —             |       | —          |       | —            |        |            | —     |       |       | — |   |
| Balance at  December 31, 1998                                                                                                             |       | 30,682,970            |       | $306,830              |       | 3,140,665                  |       | $                   | 31,407     |               | $          | 64,919,050      |       | $                 | (65,214,601 | )               | $          | 347,812    |       |   | $ | (149,342 | ) |   | $ | 241,156 |   |

 

See accompanying notes to consolidated financial statements.

F-8

 

----

**WAVE SYSTEMS CORP. ANDSUBSIDIARIES(a development stage corporation)**

**Consolidated Statements ofStockholders’ Equity (Deficiency) And Comprehensive Income (Loss)—(Continued)**
| ** **                                                                                                  | ** ** | ** **            | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **          | ** ** | ** **         | ** ** | **Deficit**       | ** **  | ** **        | ** ** | ** **      | ** ** | ** **      | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|----------------------------|------------|---------------------|------------|--------------------|------------|-------------------|-------------|-------------------|------------|-----------------|------------|-----------------|------------|------------|------------|
| ** **                                                                                                  | ** ** | ** **            | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **          | ** ** | ** **         | ** ** | **accumulated**   | ** **  | **Series G** | ** ** | **Accumulated** | ** ** | **Note**        | ** ** | ** ** | ** ** |
| ** **                                                                                                  | ** ** | **Class A**      | ** ** | **Class B**      | ** ** | **Capital**                | ** ** | **during the** | ** ** | **Convertible**    | ** ** | **Other**         | ** **  | **receivable**    | ** ** | ** **      | ** ** |
| ** **                                                                                                  | ** ** | **Common Stock** | ** ** | **Common Stock** | ** ** | **in excess of** | ** ** | **development**     | ** ** | **Preferred**      | ** ** | **Comprehensive** | ** **  | **from**          | ** ** | ** **      | ** ** |
| ** **                                                                                                  | ** ** | **Shares**            | ** ** | **Amount**            | ** ** | **Shares**                 | ** ** | **Amount**          | ** ** | **par value** | ** ** | **stage**         | ** **  | **Stock**         | ** ** | **Income**      | ** ** | **stockholder** | ** ** | **Total**  | ** ** |
| Balance at  December 31, 1998                                                                          |       | 30,682,970            |       | $                     | 306,830    |                       | 3,140,665  |                | $          | 31,407             |       | $                 | 64,919,050  |              | $          | (65,214,601     | )          |            | $          | 347,812    |       |   |   | — |   |   |   | $ | (149,342 | ) |   | $ | 241,156 |   |
| Net loss                                                                                                    |       | —                |       | —                |       | —                     |       | —              |       | —             |       | (28,052,572       | )           |              | —     |            |       |            | —     |       |       |   | — |   |   | (28,052,572 | ) |
| Unrealized gain on  Marketable Securities                                                                   |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —            |        |              | —     |            |       |            | 2,860,500  |       |       |   | — |   |   | 2,860,500 |   |
| Comprehensive loss                                                                                          |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | (25,192,072 | ) |
| Exercise of  options to purchase Class A Common Stock                                             |       | 964,000               |       | 9,640                 |       | —                     |       | —              |       | 1,622,431          |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 1,632,071 |   |
| Warrants exercised  to purchase Class A Common Stock                                              |       | 3,370,238             |       | 33,702                |       | —                     |       | —              |       | 6,708,057          |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 6,741,759 |   |
| Shares Issued at  $11.00 per share, net of issuance costs                                                   |       | 2,090,405             |       | 20,904                |       | —                     |       | —              |       | 21,481,665         |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 21,502,569 |   |
| Conversion of  Bridge to Loan to purchase Class A Common Stock                                         |       | 787,349               |       | 7,874                 |       | —                     |       | —              |       | 2,567,380          |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 2,575,254 |   |
| Warrants to  Purchase Class A Common Stock For services rendered                                       |       | —                |       | —                |       | —                     |       | —              |       | 1,075,240          |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 1,075,240 |   |
| Shares issued as  compensation for services rendered                                                        |       | 83,461                |       | 834                   |       | —                     |       | —              |       | 1,149,486          |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 1,150,320 |   |
| Accrual of  interest on note receivable                                                                     |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —            |        |              | —     |            |       |            | —     |       |       |   | (4,818 | ) |   | (4,818 | ) |
| Conversion of  Series G Preferred Stock                                                                |       | 377,102               |       | 3,771                 |       | —                     |       | —              |       | 344,041            |       | —            |        |              | (347,812   | )               |       |            | —     |       |       |   | — |   |   | — |   |
| Accrued dividend  on preferred stock                                                                        |       | —                |       | —                |       | —                     |       | —              |       | (13,239            | )          | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | (13,239 | ) |
| Exchange of  Class B Common Stock for Class A stock                                               |       | 1,090,158             |       | 10,902                |       | (1,090,158                 | )          | (10,902             | )          | —             |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | — |   |
| Balance at  December 31, 1999                                                                          |       | 39,445,683            |       | $                     | 394,457    |                       | 2,050,507  |                | $          | 20,505             |       | $                 | 99,854,111  |              | $          | (93,267,173     | )          |            | $          | 0          |       |   |   | $ | 2,860,500 |   |   |   | $ | (154,160 | ) |   | $ | 9,708,240 |   |
| Net loss                                                                                                    |       | —                |       | —                |       | —                     |       | —              |       | —             |       | (47,655,893       | )           |              | —     |            |       |            | —     |       |       |   | — |   |   | (47,655,893 | ) |
| Unrealized gain  (loss) on marketable securities                                                            |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —            |        |              | —     |            |       |            | (937,196   | )          |       |   | — |   |   | (937,196 | ) |
| Comprehensive loss                                                                                          |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | (48,593,089 | ) |
| Shares issued at  $34.00 per share, net of issuance costs                                                   |       | 3,600,800             |       | 36,008                |       | —                     |       | —              |       | 114,941,407        |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 114,977,415 |   |
| Shares issued in  exchange for substantially all of the assets of Indigo Networks, LLC at  $19.30 per share |       | 374,889               |       | 3749                  |       | —                     |       | —              |       | 7,231,609          |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 7,235,358 |   |
| Shares issued as  compensation for services at $13.75 per share                                             |       | 7,879                 |       | 79                    |       | —                     |       | —              |       | 108,254            |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 108,333 |   |
| Exercise of  warrants to purchase Class A Common Stock                                            |       | 319,692               |       | 3,197                 |       | —                     |       | —              |       | 1,331,048          |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 1,334,245 |   |
| Exercise of  Options to purchase Class A Common Stock                                             |       | 2,030,958             |       | 20,309                |       | —                     |       | —              |       | 4,950,872          |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 4,971,181 |   |
| Compensation on  Employee Options issued                                                                    |       | —                |       | —                |       | —                     |       | —              |       | 318,609            |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 318,609 |   |
| Exchange of  Class B Common Stock for Class A Common Stock                                        |       | 1,271,296             |       | 12,713                |       | (1,271,296                 | )          | (12,713             | )          | —             |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | — |   |
| Repayment of note  receivable from stockholder                                                              |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —            |        |              | —     |            |       |            | —     |       |       |   | 154,160 |   |   | 154,160 |   |
| Balance at  December 31, 2000                                                                          |       | 47,051,197            |       | $                     | 470,512    |                       | 779,211    |                | $          | 7,792              |       | $                 | 228,735,910 |              | $          | (140,923,066    | )          |            | $          | 0          |       |   |   | $ | 1,923,304 |   |   |   | $ | 0 |   |   | $ | 90,214,452 |   |
| Net loss                                                                                                    |       | —                |       | —                |       | —                     |       | —              |       | —             |       | (48,701,057       | )           |              | —     |            |       |            | —     |       |       |   | — |   |   | (48,701,057 | ) |
| Investment Loss on  Marketable Securities                                                                   |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —            |        |              | —     |            |       |            | (3,328,296 | )          |       |   | — |   |   | (3,328,296 | ) |
| Comprehensive loss                                                                                          |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | (52,029,353 | ) |
| Shares issued in  exchange for 3,600,000 shares of BIZ Interactive Zone, Inc. at $7.16 per  share      |       | 2,000,000             |       | 20,000                |       | —                     |       | —              |       | 14,292,800         |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 14,312,800 |   |
| Exercise of  Options                                                                                        |       | 523,181               |       | 5,232                 |       | —                     |       | —              |       | 749,721            |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 754,953 |   |
| Compensation on  Employee Options Issued                                                                    |       | —                |       | —                |       | —                     |       | —              |       | 552,554            |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | 552,554 |   |
| Exchange of  Class B Common Stock for Class A Common Stock                                        |       | 422,128               |       | 4,221                 |       | (422,128                   | )          | (4,221              | )          | —             |       | —            |        |              | —     |            |       |            | —     |       |       |   | — |   |   | — |   |
| Balance at  December 31, 2001                                                                          |       | 49,996,506            |       | $                     | 499,965    |                       | 357,083    |                | $          | 3,571              |       | $                 | 244,330,985 |              | $          | (189,624,123    | )          |            | $          | 0          |       |   |   | $ | (1,404,992 | ) |   |   | $ | 0 |   |   | $ | 53,805,406 |   |

See accompanying notes to consolidated financial statements.

F-9

 

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Consolidated Statements of Stockholders’ Equity (Deficiency) And Comprehensive Income (Loss)—(Continued)**
| ** **                                                                                                                                                                           | ** ** | ** **            | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **          | ** ** | ** **         | ** ** | **Deficit**     | ** **  | ** **      | ** ** | ** **   | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|----------------------------|------------|---------------------|------------|--------------------|------------|-----------------|-------------|-----------------|------------|--------------|------------|
| ** **                                                                                                                                                                           | ** ** | ** **            | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **          | ** ** | ** **         | ** ** | **accumulated** | ** **  | **Accumulated** | ** ** | ** **   | ** ** |
| ** **                                                                                                                                                                           | ** ** | **Class A**      | ** ** | **Class B**      | ** ** | **Capital**                | ** ** | **during the** | ** ** | **Other**          | ** ** | ** **      | ** **  |
| ** **                                                                                                                                                                           | ** ** | **Common Stock** | ** ** | **Common Stock** | ** ** | **in excess of** | ** ** | **development**     | ** ** | **Comprehensive**  | ** ** | ** **      | ** **  |
| ** **                                                                                                                                                                           | ** ** | **Shares**            | ** ** | **Amount**            | ** ** | **Shares**                 | ** ** | **Amount**          | ** ** | **par value** | ** ** | **stage**       | ** **  | **Income**      | ** ** | **Total**    | ** ** |
| Balance at  December 31, 2001                                                                                                                                                   |       | 49,996,506            |       | $                     | 499,965    |                       | 357,083    |                | $          | 3,571              |       | $               | 244,330,985 |            | $          | (189,624,123 | )          |   | $ | (1,404,992 | ) |   | $ | 53,805,406 |   |
| Net loss                                                                                                                                                                             |       | —                |       | —                |       | —                     |       | —              |       | —             |       | (43,467,405     | )           |            | —     |         |       | (43,467,405 | ) |
| Investment Loss on  Marketable Securities                                                                                                                                            |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —          |        |            | 1,404,992  |         |       | 1,404,992 |   |
| Comprehensive loss                                                                                                                                                                   |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —          |        |            | —     |         |       | (42,062,413 | ) |
| Issuance of  Class A Common Stock to acquire 60% of the remaining assets of  GlobalWave, Ltd                                                                                    |       | 1,700,000             |       | 17,000                |       | —                     |       | —              |       | 2,227,000          |       | —          |        |            | —     |         |       | 2,244,000 |   |
| Exercise of Options                                                                                                                                                                  |       | 42,554                |       | 426                   |       | —                     |       | —              |       | 43,673             |       | —          |        |            | —     |         |       | 44,099 |   |
| Issuance of  warrants to purchase Class A Common Stock                                                                                                                          |       | 143,500               |       | 143,500               |       |                       |       |                |       |               |       |            |        |            |       |         |       |   |   |
| Compensation on  Expense Employee Options Issued                                                                                                                                     |       | —                |       | —                |       | —                     |       | —              |       | 367,247            |       | —          |        |            | —     |         |       | 367,247 |   |
| Exchange of  Class B Common Stock for Class A Common Stock                                                                                                                 |       | 32,858                |       | 329                   |       | (32,858                    | )          | (329                | )          | —             |       | —          |        |            | —     |         |       | — |   |
| Balance at  December 31, 2002                                                                                                                                                   |       | 51,771,918            |       | $                     | 517,720    |                       | 324,225    |                | $          | 3,242              |       | $               | 247,112,405 |            | $          | (233,091,528 | )          |   | $ | 0 |   |   | $ | 14,541,839 |   |
| Net loss                                                                                                                                                                             |       | —                |       | —                |       | —                     |       | —              |       | —             |       | (19,594,798     | )           |            | —     |         |       | (19,594,798 | ) |
| Investment Loss on  Marketable Securities                                                                                                                                            |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —          |        |            | 3,640,469  |         |       | 3,640,469 |   |
| Comprehensive loss                                                                                                                                                                   |       | —                |       | —                |       | —                     |       | —              |       | —             |       | —          |        |            | —     |         |       | (15,954,329 | ) |
| Issuance of  Class A Common Stock at $1.90 per share in a private placement, net of  issuance costs of $515,820                                                                 |       | 3,725,263             |       | 37,253                |       |                       |       |                |       | 6,524,927          |       | —          |        |            | —     |         |       | 6,562,180 |   |
| Issuance of  Class A Common Stock upon Exercise of Series H Warrants, net of  issuance costs of $180,635                                                                   |       | 2,632,311             |       | 26,323                |       |                       |       |                |       | 2,463,844          |       | —          |        |            | —     |         |       | 2,490,167 |   |
| Issuance of  Class A Common Stock upon exercise of warrants granted to placement  agents in connection with the issuance of Series H Convertible Preferred  Stock.         |       | 322,270               |       | 3,223                 |       | —                     |       | —              |       | —             |       | —          |        |            | —     |         |       | 3,223 |   |
| Conversion of  548.5 shares of Series H Convertible Preferred Stock into Class A  Common Stock at a conversion price of $0.76 per share, net of issuance costs  of $75,000 |       | 7,217,105             |       | 72,171                |       | —                     |       |                |       | 5,412,829          |       | —          |        |            | —     |         |       | 5,485,000 |   |
| Issuance of  Class A Common Stock upon exercise of employee stock options                                                                                                       |       | 1,340,739             |       | 13,406                |       | —                     |       | —              |       | 2,855,509          |       | —          |        |            | —     |         |       | 2,868,915 |   |
| Issuance of  Series H Convertible Preferred Stock and Warrants to Purchase  Class A Common Stock                                                                           |       | —                |       | —                |       | —                     |       | —              |       | 4,464,571          |       | —          |        |            | —     |         |       | 4,464,571 |   |
| Dividends on  Series H Convertible Preferred, including non-cash accretion of  $5,485,000                                                                                       |       | —                |       | —                |       | —                     |       |                |       | (5,697,518         | )          | —          |        |            | —     |         |       | (5,697,518 | ) |
| Issuance of  warrants to purchase Class A Common Stock                                                                                                                          |       |                  |       |                  |       |                       |       |                |       | 315,971            |       | —          |        |            | —     |         |       | 315,971 |   |
| Fair market value  of warrants issued in connection with private placement of Class A  Common Stock                                                                             |       | —                |       | —                |       | —                     |       | —              |       | (1,254,948         | )          | —          |        |            | —     |         |       | (1,254,948 | ) |
| Issuance of  warrants to purchase Class A Common Stock for services                                                                                                             |       | —                |       | —                |       | —                     |       | —              |       | 43,176             |       | —          |        |            | —     |         |       | 43,176 |   |
| Compensation  expense on employee stock options issued                                                                                                                               |       | —                |       | —                |       | —                     |       | —              |       | 146,389            |       | —          |        |            | —     |         |       | 146,389 |   |
| Exchange of  Class B Common Stock for Class A Common Stock                                                                                                                 |       | 118,500               |       | 1,185                 |       | (118,500                   | )          | (1,185              | )          | —             |       | —          |        |            | —     |         |       | — |   |
| Balance at  December 31, 2003                                                                                                                                                   |       | 67,128,106            |       | $                     | 671,281    |                       | 205,725    |                | $          | 2,057              |       | $               | 262,387,155 |            | $          | (252,686,326 | )          |   | $ | 3,640,469 |   |   | $ | 14,014,636 |   |

See accompanying notes to consolidated financial statements.

F-10

 

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Consolidated Statements of Stockholders’ Equity (Deficiency) And Comprehensive Income (Loss)—(Continued)**
| ** **                                                                                   | ** ** | ** **             | ** ** | ** **             | ** ** | ** **          | ** ** | ** **          | ** ** | ** **               | ** ** | **Deficit**     | ** ** | ** **                                                                                                 | ** **  | ** ** | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|---------------------|------------|---------------------|------------|--------------------------|------------|-----------------|------------|------------------------------------------------------------------------------------------------------------|-------------|------------|------------|
| ** **                                                                                   | ** ** | ** **             | ** ** | ** **             | ** ** | ** **          | ** ** | ** **          | ** ** | ** **               | ** ** | **Accumulated** | ** ** | **Accumulated**                                                                                            | ** **  | ** ** | ** ** |
| ** **                                                                                   | ** ** | **Class A ** | ** ** | **Class B ** | ** ** | **Capital in** | ** ** | **During the** | ** ** | **Other **          | ** ** | ** **      | ** ** |
| ** **                                                                                   | ** ** | **Common Stock**  | ** ** | **Common Stock**  | ** ** | **Excess of**  | ** ** | **Development**     | ** ** | **Comprehensive **  | ** ** | ** **      | ** ** |
| ** **                                                                                   | ** ** | **Shares**             | ** ** | **Amount**             | ** ** | **Shares**          | ** ** | **Amount**          | ** ** | ** Par Value** | ** ** | **Stage**       | ** ** | **        Income        ** | ** **  | **Total**  | ** ** |
| Balance at December 31, 2003                                                            |       | 67,128,106             |       | $                      | 671,281    |                | 205,725    |                |       | $                        | 2,057      |            |       | $                                                                                                          | 262,387,155 |       | $          | (252,686,326 | ) |   | $ | 3,640,469 |   |   | $ | 14,014,636 |   |
| Net loss                                                                                     |       | —                 |       | —                 |       | —              |       |                | —     |                     |       | —          |       | (14,498,038                                                                                                | )           |       | —     |   |   | (14,498,038 | ) |
| Unrealized Gain on  Marketable Securities:                                                   |       |                   |       |                   |       |                |       |                |       |                     |       |            |       |                                                                                                       |        |       |       |   |   |   |   |
| Unrealized holding gains during the period                                                   |       | —                 |       | —                 |       | —              |       |                | —     |                     |       | —          |       | —                                                                                                     |        |       | 1,156,321  |   |   | — |   |
| Less: reclassification adjustment for gain included  in net income                           |       | —                 |       | —                 |       | —              |       |                | —     |                     |       | —          |       | —                                                                                                     |        |       | (4,330,248 | ) |   | (3,173,927 | ) |
| Comprehensive loss                                                                           |       | —                 |       | —                 |       | —              |       |                | —     |                     |       | —          |       | —                                                                                                     |        |       | —     |   |   | (17,671,965 | ) |
| Issuance of Class A Common Stock at $0.85 per  share, net of issuance costs of $222,101 |       | 3,529,412              |       | 35,294                 |       | —              |       |                | —     |                     |       | 2,742,603       |       | —                                                                                                     |        |       | —     |   |   | 2,777,897 |   |
| Issuance of Class A Common Stock at $1.05 per  share, net of issuance costs of $284,300 |       | 5,484,790              |       | 54,848                 |       | —              |       |                | —     |                     |       | 5,419,880       |       | —                                                                                                     |        |       | —     |   |   | 5,474,728 |   |
| Issuance of Class A Common Stock upon exercise  of employee stock options               |       | 35,309                 |       | 353                    |       | —              |       |                | —     |                     |       | 33,942          |       | —                                                                                                     |        |       | —     |   |   | 34,295 |   |
| Issuance of warrants to purchase Class A Common  Stock for services                     |       | —                 |       | —                 |       | —              |       |                | —     |                     |       | 80,609          |       | —                                                                                                     |        |       | —     |   |   | 80,609 |   |
| Balance as of  December 31, 2004                                                        |       | 76,177,617             |       | $                      | 761,776    |                | 205,725    |                |       | $                        | 2,057      |            |       | $                                                                                                          | 270,664,189 |       | $          | (267,184,364 | ) |   | $ | 466,542 |   |   | $ | 4,710,200 |   |

See accompanying notes to consolidated financial statements.

F-11

 

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Consolidated Statements of Cash Flows**

**Years ended December 31, 2004, 2003, 2002, and the Period From February 12, 1988 (Date of Inception) through December 31, 2004**
| ** **                                                                            | ** ** | ** **   | ** ** | ** **  | ** **  | ** **  | ** ** | **Period from**              | ** **   |
|---------------------------------------------------------------------------------------|------------|--------------|------------|-------------|-------------|-------------|------------|-----------------------------------|--------------|
| ** **                                                                            | ** ** | ** **   | ** ** | ** **  | ** **  | ** **  | ** ** | **February 12, 1988**   | ** **   |
| ** **                                                                            | ** ** | ** **   | ** ** | ** **  | ** **  | ** **  | ** ** | **(date of inception)** | ** **   |
| ** **                                                                            | ** ** | ** **   | ** ** | ** **  | ** **  | ** **  | ** ** | **through**                       | ** **   |
| ** **                                                                            | ** ** | ** **   | ** ** | ** **  | ** **  | ** **  | ** ** | **December 31,**             | ** **   |
| ** **                                                                            | ** ** | **2004**     | ** ** | **2003**    | ** **  | **2002**    | ** ** | **2004**                          | ** **   |
| Cash flows from operating  activities:                                                |       |         |       |        |        |        |       |                              |         |   |   |
| Net loss                                                                              |       | $(14,498,038 | )          | $           | (19,594,798 | )           | $          | (43,467,405                       | )            |   | $ | (267,184,364 | ) |   |
| Adjustments to reconcile  net loss to net cash used in operating activities:          |       |         |       |        |        |        |       |                              |         |   |   |
| Write-off of  goodwill                                                                |       | —       |       | —      |        | —      |       |                              | 3,054,456    |   |   |
| Goodwill  amortization                                                                |       | —       |       | —      |        | —      |       |                              | 2,294,176    |   |   |
| Depreciation and  amortization                                                        |       | 854,629      |       | 1,241,035   |        | 2,000,705   |       |                              | 11,727,795   |   |   |
| Reserve for note  from affiliate                                                      |       | —       |       | —      |        | —      |       |                              | 1,672,934    |   |   |
| Provision for loss  on officer note receivable                                        |       | —       |       | (999,518    | )           | 999,518     |       |                              | —       |   |   |
| Non-cash expenses:                                                                    |       |         |       |        |        |        |       |                              |         |   |   |
| Accretion of assured  incremental yield on convertible debt                           |       | —       |       | —      |        | —      |       |                              | 119,000      |   |   |
| Common stock issued in  connection with license agreement                        |       | —       |       | —      |        | —      |       |                              | 1,124,960    |   |   |
| Realized gain on  marketable securities                                               |       | (4,330,248   | )          | (234,759    | )           | —      |       |                              | (5,107,464   | ) |   |
| Net losses realized on  GlobalWave investment                                         |       | —       |       | —      |        | —      |       |                              | 5,738,650    |   |   |
| Common stock issued for  services rendered and additional interest on borrowings |       | —       |       | —      |        | —      |       |                              | 3,600,199    |   |   |
| Warrants issued as  compensation for services                                         |       | 80,609       |       | 43,176      |        | 143,500     |       |                              | 3,018,880    |   |   |
| Issuance of warrants to  Aladdin                                                      |       | —       |       | —      |        | —      |       |                              | 2,939,000    |   |   |
| Accrued interest on note  payable                                                     |       | —       |       | —      |        | —      |       |                              | 121,219      |   |   |
| In-process research and  development                                                  |       | —       |       | —      |        | —      |       |                              | 2,176,000    |   |   |
| Write-off of impaired  assets                                                         |       | 301,366      |       | —      |        | 1,571,031   |       |                              | 3,634,314    |   |   |
| Loss on other than  temporary decline in marketable equity                            |       |         |       |        |        |        |       |                              |         |   |   |
| securities                                                                            |       | —       |       | —      |        | 11,513,099  |       |                              | 13,249,781   |   |   |
| Gain on termination of  development contract with SSP                                 |       | —       |       | —      |        | (1,818,000  | )          |                              | (1,818,000   | ) |   |
| Gain on decrease in value  of warrant liability                                       |       | (498,723     | )          | (263,097    | )           | —      |       |                              | (761,820     | ) |   |
| Preferred stock issued  for services rendered                                         |       | —       |       | —      |        | —      |       |                              | 265,600      |   |   |
| Compensation associated  with issuance of stock options                               |       | —       |       | 146,389     |        | 367,247     |       |                              | 2,019,263    |   |   |
| Amortization of deferred  compensation                                                |       | —       |       | —      |        | —      |       |                              | 398,660      |   |   |
| Amortization of discount  on notes payable                                            |       | —       |       | —      |        | —      |       |                              | 166,253      |   |   |
| Common stock issued by  principal stockholder for services                       |       | —       |       | —      |        | —      |       |                              | 565,250      |   |   |
| Changes in assets and  liabilities:                                                   |       |         |       |        |        |        |       |                              |         |   |   |
| Increase (decrease) in  deferred revenue                                              |       | 276,968      |       | 74,222      |        | (197,965    | )          |                              | 351,190      |   |   |
| (Increase) decrease in  accrued interest on note receivable                           |       | —       |       | 142,540     |        | (62,129     | )          |                              | —       |   |   |
| (Increase) decrease in  inventories                                                   |       | —       |       | 1,112,818   |        | (530,906    | )          |                              | —       |   |   |
| (Increase) decrease in  prepaid expenses and other receivables                        |       | (67,085      | )          | 368,844     |        | 50,219      |       |                              | (242,239     | ) |   |
| (Increase) decrease in  other assets                                                  |       | 93,570       |       | 50,688      |        | 1,026,365   |       |                              | (234,095     | ) |   |
| Increase (decrease) in  accounts payable and accrued expenses                         |       | 63,540       |       | (567,853    | )           | (655,264    | )          |                              | 3,289,166    |   |   |
| Increase (decrease) in  amounts due to charities                                      |       | (243,197     | )          | (19,959     | )           | (159,897    | )          |                              | —       |   |   |
| (Increase) decrease in  cash collected on behalf of charities                         |       | 211,717      |       | 23,836      |        | 122,978     |       |                              | —       |   |   |
| Net cash used in operating activities                                                 |       | (17,754,892  | )          | (18,476,436 | )           | (29,096,904 | )          |                              | (213,821,236 | ) |   |
|                                                                                       |            |              |            |             |             |             |            |                                   |              |  |  |  |  |  |

 

See Accompanying notes to consolidated financial statements.

F-12

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Consolidated Statements of Cash Flows (Continued)**

**Years ended December 31, 2004, 2003, 2002, and the Period From February 12, 1988 (Date of Inception) through December 31, 2004**

 
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | **Period from**              | ** **  |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|-------------|------------|-----------------------------------|-------------|
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | **February 12, 1988**   | ** **  |
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | **(date of inception)** | ** **  |
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | **through**                       | ** **  |
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | **December 31,**             | ** **  |
| ** **                                                   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**    | ** ** | **2004**                          | ** **  |
| Cash flows from investing activities:                        |       |       |       |       |       |        |       |                              |        |   |   |
| Acquisition of property  and equipment                       |       | (304,172   | )          | (985,146   | )          | (1,148,723  | )          |                              | (12,732,794 | ) |   |
| Investment in GlobalWave  joint venture                      |       | —     |       | —     |       | (1,559,250  | )          |                              | (5,701,250  | ) |   |
| Cash received in  GlobalWave acquisition                     |       | —     |       | —     |       | 1,380,464   |       |                              | 1,380,464   |   |   |
| Purchase of intangible  assets                               |       | —     |       | —     |       | —      |       |                              | (2,500,000  | ) |   |
| Short-term loans to  affiliate                               |       | —     |       | —     |       | —      |       |                              | (1,672,934  | ) |   |
| Organizational costs                                         |       | —     |       | —     |       | —      |       |                              | (14,966     | ) |   |
| Proceeds provided by sale  of marketable equity securities   |       | 6,759,751  |       | 430,934    |       | —      |       |                              | 9,353,138   |   |   |
| Exercise of warrant to  acquire marketable equity securities |       | —     |       | —     |       | —      |       |                              | (1,620,000  | ) |   |
| Net cash provided by (used  in) investing activities         |       | 6,455,579  |       | (554,212   | )          | (1,327,509  | )          |                              | (13,508,342 | ) |   |
| Cash flows from financing activities:                        |       |       |       |       |       |        |       |                              |        |   |   |
| Net proceeds from  issuance of common stock                  |       | 8,286,920  |       | 11,924,486 |       | 44,099      |       |                              | 212,822,624 |   |   |
| Net proceeds from  issuance of preferred stock and warrants  |       | —     |       | 4,780,540  |       | —      |       |                              | 16,988,573  |   |   |
| Payment on (issuance of)  note receivable from stockholder   |       | —     |       | 1,135,320  |       | 164,319     |       |                              | —      |   |   |
| Payment of dividends on  preferred stock                     |       | —     |       | (212,517   | )          | —      |       |                              | (212,517    | ) |   |
| Proceeds from notes  payable and warrants to Stockholders    |       | —     |       | —     |       | —      |       |                              | 4,083,972   |   |   |
| Repayments of notes  payable to stockholders                 |       | —     |       | —     |       | —      |       |                              | (1,069,972  | ) |   |
| Proceeds from notes  payable and warrants                    |       | —     |       | —     |       | —      |       |                              | 1,284,250   |   |   |
| Repayments of note  payable                                  |       | —     |       | —     |       | —      |       |                              | (255,000    | ) |   |
| Redemption of Preferred  Stock                               |       | —     |       | —     |       | —      |       |                              | (506,440    | ) |   |
| Net cash provided by  financing activities                   |       | 8,286,920  |       | 17,627,829 |       | 208,418     |       |                              | 233,135,490 |   |   |
| Net increase  (decrease) in cash and cash equivalents        |       | (3,012,393 | )          | (1,402,819 | )          | (30,215,995 | )          |                              | 5,805,912   |   |   |
| Cash and cash equivalents  at beginning of year              |       | 8,818,305  |       | 10,221,124 |       | 40,437,119  |       |                              | —      |   |   |
| Cash and cash  equivalents at end of year                    |       | 5,805,912  |       | $          | 8,818,305  |        | $          | 10,221,124                        |        |   | $ | 5,805,912 |   |   |
|                                                              |            |            |            |            |            |             |            |                                   |             |  |  |  |  |  |

 

**Supplementalinformation about noncash investing and financing activities:**

On March 27, 2003 Wave granted a bonus to anofficer that was used to repay a note receivable in the amount of $281,399,consisting of $250,000 in principal and $31,899 in accrued interest (see note5).

Wave recorded accretion of discount of $5,485,000 forthe nine months ended September 30, 2003 in connection with the issuanceof 548.5 shares of its Series H Convertible Preferred Stock (see note 8).

During 2003 Wave issued 7,217,105 shares of Class ACommon Stock in connection with the conversion of 548.5 shares of Series HConvertible Preferred Stock, with an aggregate face value of $5,485,000 at aconversion price of $0.76 per share of Class A Common Stock.

On July 24, 2002, 1,700,000 shares of our commonstock were issued to acquire 60% of GlobalWave, Ltd., (see note 13).

See accompanying notes to consolidated financial statements.

F-13

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements**

**(1) Business of the Company**

Wave Systems Corp., a development stage company,develops, produces and markets products for hardware-based digital securityincluding security applications and services that are complementary to andcompliant with the specifications of the Trusted Computing Group,www.trustedcomputinggroup.org (“TCG”). Specifications developed by the TCG aredesigned to address a broad range of current and evolving digital securityissues facing the industry. These issues include the following: identityprotection, data security, digital signatures, electronic transactionintegrity, platform trustworthiness, network security, and regulatorycompliance. Wave’s products are designed to solve many of these digitalsecurity issues.

The financial statementsof Wave have been presented in the development stage format as prescribed byStatement of Financial Accounting Standards No. 7. Management hasdetermined that Wave meets the criteria of a development stage enterprise asprescribed in Statement of Financial Accounting Standard No. 7 because ithas devoted substantially all of its efforts since inception toward researchand development activities and establishing a new business; and althoughplanned principal operations have commenced, there has been no significantrevenue from those operations.

**(2) Liquidity**

The accompanying consolidated financial statementshave been prepared assuming that Wave will continue as a going concern. Wavehas incurred substantial operating losses since its inception, and as of December 31,2004, has an accumulated deficit of $267,184,364. We also expect Wave willincur an operating loss for the calendar year of 2005. As of December 31,2004, we had working capital of $3,549,095.

Considering our current cash balance and marketableequity securities, we project that we have enough liquid assets to continueoperating into May, 2005. We will need approximately $13,000,000 of additionalcash to fund operating expenses and capital expenditures for the twelve-monthperiod ending December 31, 2005.

Wave has begun market introduction of its security andbroadband media distribution software products and has signed its initialdistribution contracts for these applications. However, due to the early stagenature of this market, Wave is unable to predict with a high level of certaintywhether enough revenue will be generated over the twelve-month period ending December 31,2005, to fund its cash flow requirements, referred to above.

It is likely that we will be required to raiseadditional capital through either equity or debt financings, in order toadequately fund our capital requirements. To this end, on April 15, 2004,we filed a shelf registration statement for up to $25,000,000 of common stock,which was declared effective by the Securities and Exchange Commission on May 10,2004.

On August 2, 2004 we received $2,777,897 net ofunderwriter and other fees, from the sale of 3,529,412 shares of our Class ACommon Stock that are covered by the shelf registration statement. In addition,a total of 3,529,412 shares were offered in connection with this sale andissuance of these shares, in the form of an additional investment right with anexercise price of $1.00 per share and warrants for  4,411,765 shares at exercise prices rangingfrom $1.15 to $1.30 per share. The additional investment right expired on November 2,2004. The warrants are exercisable during the period January 30, 2005through 

F-14

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(2)Liquidity (Continued)**

January 30, 2006, andif exercised, may yield approximately $5.0 million in proceeds, net of offeringexpenses.

On December 16, 2004 we received $5,474,728 netof underwriter and other fees, from the sale of 5,484,790 shares of our Class ACommon Stock that are covered by the shelf registration statement.

We intend to continue to utilize this shelfregistration to issue and sell additional shares of our Class A CommonStock to the extent necessary to fund our operations for the foreseeable future. Presently, after subtracting the $8,252,625in net proceeds referred to above and the potential proceeds from theoutstanding warrants described above, there remains approximately $11 millionin available proceeds, less offering expenses, from this shelf registration.

If Wave is not successfulin raising the needed capital referred to above, or is not successful inexecuting its business plan, it could be forced to cease operations or mergewith another company. No assurance can be provided that any of theseinitiatives will be successful. Due to our current cash position, our capitalneeds over the next year and beyond, the fact that we have not at this timesecured enough financing to fund our operations through December 31, 2005,and the uncertainty as to whether we will achieve our sales forecast for ourproducts and services, substantial doubt exists with respect to our ability tocontinue as a going concern.

**(3) Significant Accounting Policies**

*(a) Basis ofConsolidation*

The consolidated financialstatements include the financial statements of Wave, Wave Systems Holdings, Inc.,a wholly owned subsidiary and Wavexpress, Inc. a majority-owned jointventure. All significant intercompany accounts and transactions have beeneliminated in consolidation.

*(b) Use ofEstimates*

The preparation of financialstatements and related disclosures in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect amounts reported in the Consolidated FinancialStatements and accompanying notes. Estimates are used for, but not limited to,depreciation and amortization, charges for other than temporary declines invalue of marketable equity securities and other special charges, inventoryallowances and contingencies. Actual results could differ from those estimates.

*(c) Method ofAccounting for Joint Ventures*

Wave accounts for itsinvestments in joint ventures using the equity method of accounting when itsownership interest in the joint venture is less than fifty percent and it is determinedthat Wave has the ability to exercise significant influence over the jointventure’s operating and financial policies. The financial statements of jointventures in which Wave owns greater than a fifty percent interest areconsolidated with Wave’s financial statements pursuant to APB Opinion No. 18(see note 13).

F-15

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(3)Significant Accounting Policies (Continued)**

*(d) Cash andCash Equivalents*

Wave considers all highlyliquid instruments with an original or remaining maturity of three months orless to be cash equivalents. Substantially all cash and cash equivalents arecustodial with two major financial institutions.

*(e) MarketableSecurities*

Investments, which consistsolely of equity securities, are accounted for under Statement of FinancialAccounting Standards (SFAS) No. 115, “Accounting for Certain Investmentsin Debt and Equity Securities” issued by the Financial Accounting StandardsBoard (FASB). Pursuant to the provisions of SFAS No. 115, investments areclassified as “trading”, “available-for sale” or “held to maturity”. “Trading”securities are bought and held principally for the purpose of selling them inthe near term and are recorded at fair value. Fair value is based upon quotedmarket prices. Unrealized gains and losses on trading securities are includedin the determination of net earnings. “Available-for-sale” securities are beingheld for an unspecified period of time and may be used for liquidity or othercorporate purposes and are recorded at fair value. Unrealized gains and losseson available-for-sale securities are reported as a separate component ofcomprehensive income (loss) in stockholders’ equity. Unrealized losses that aredetermined to be other than temporary are recognized as charges againstearnings. Factors considered when determining if an other than temporarydecline has occurred include: whether a decline in market value is related tospecific concerns of the issuer of the securities as opposed to general marketconditions, the length of time of the decline in market price, the financialcondition and near-term prospects of the issuer and other factors that mayindicate that the value of the securities will not recover. “Held to maturity”securities are debt securities that are intended to be held to maturity and arerecorded at amortized cost. As of December 31, 2004, all of Wave’smarketable equity securities are classified as available-for-sale.

*(f) Propertyand Equipment*

Property and equipment,including purchased computer software, are stated at cost less accumulateddepreciation and amortization. Depreciation and amortization are computed usingthe straight-line method over the estimated useful lives of the assets whichrange from between three to five years. Amortization of leasehold improvementsis computed using the remaining lease terms.

*(g) IncomeTaxes*

Wave accounts for incometaxes under the asset and liability method. As such, deferred tax assets andliabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases and operating loss and taxcredit carryforwards. Deferred tax assets and liabilities are measured usingenacted tax rates expected to apply to taxable income in the years in whichthose temporary differences are expected to be recovered or settled. The effecton deferred tax assets and liabilities of a change in tax rates is recognizedin income in the period that includes the enactment date.

F-16

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(3)Significant Accounting Policies (Continued)**

*(h) StockOption Plan*

Statement of Financial Accounting Standards  No. 123, “*Accountingfor Stock-based Compensation*,” as amended by SFAS No. 148 “*Accounting for Stock-Based Compensation Transition and Disclosure—anamendment to FASB Statement No. 123*,” (“SFAS No. 123”)allows companies to recognize expense for the fair value of stock-based awardsor to continue to apply the provisions of Accounting Principles Board (“APB”)Opinion No. 25 “Accounting for Stock Issued to Employees,” and disclosethe effects of SFAS No. 123 as if the fair-value-based method defined inSFAS No. 123 had been applied. Under APB Opinion No. 25, compensationexpense is recognized only if on the measurement date the fair value of theunderlying stock exceeds the exercise price. Wave has elected to apply theintrinsic value method pursuant to APB Opinion No. 25 and provide the proforma disclosure provisions of SFAS No. 123 and SFAS No. 148.

Thefollowing table presents Wave’s pro forma net loss and loss per share as if thecompany had accounted for stock options under SFAS No. 123 for the yearsended December 31:
| ** **                                               | ** ** | **2004**    | ** **  | **2003**    | ** ** | **2002**    | ** ** |
|----------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|
| Net loss—as  reported                               |       | $           | (14,498,038 | )           | $          | (19,594,798 | )          | $ | (43,467,405 | ) |
| Pro-forma  compensation cost using the fair-value method |       | (2,840,103  | )           | (3,023,011  | )          | (7,409,143  | )          |
| Net loss—pro  forma                                 |       | (17,338,141 | )           | (22,617,809 | )          | (50,876,578 | )          |
| Net loss to  Common stockholders—as  reported       |       | (14,498,038 | )           | (25,292,316 | )          | (43,467,405 | )          |
| Net loss to  Common shareholders—pro forma          |       | (17,338,141 | )           | (28,315,327 | )          | (50,876,578 | )          |
| Loss per Common  share—as reported                  |       | (0.21       | )           | (0.45       | )          | (0.85       | )          |
| Loss per Common share—pro  forma                    |       | $           | (0.25       | )           | $          | (0.51       | )          | $ | (0.99 | ) |

 

Theper share weighted-average fair value of stock options granted under all plansfor the years ended December 2004, 2003 and 2002 pursuant to SFAS No. 123were $1.03, $1.20 and $1.62, respectively. The expense that would have beenrecognized pursuant to SFAS No. 123 and the weighted average fair valuesper share referred to herein were arrived at using the Black Scholesoption-pricing model with the following weighted-average assumptions:
| ** **             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected Life  (Years) |       | 5        |       | 5        |       | 5        |       |
| Interest Rate          |       | 3.675    | %          | 3.25     | %          | 3.0      | %          |
| Volatility             |       | 120      | %          | 125      | %          | 113      | %          |
| Dividend Yield         |       | 0        | %          | 0        | %          | 0        | %          |

 

Wave applies APB Opinion No. 25in accounting for its Plans. Compensation expense has been recognized in thefinancial statements for Stock options granted to employees at exercise pricesbelow the market value of approximately $0 in 2004, $146,000 in 2003 and$367,000 in 2002.

F-17

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(3)Significant Accounting Policies (Continued)**

*(i) Researchand Development and Software Development Costs*

Research and developmentcosts are expensed as incurred. Software development costs are accounted forpursuant to Statement of Financial Accounting Standards No. 86 “Accountingfor the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed”which requires software development costs for products that have achievedcommercial marketability to be capitalized subsequent to the establishment of aproduct’s technological feasibility and prior to general release of theproduct. Wave capitalized software development costs of approximately $73,000,$712,000 and $610,000 during the years ended December 31, 2004, 2003 and2002, respectively. Amortization of capitalized software costs for the yearsended December 31, 2004, 2003 and 2002 was $538,781, $232,373 and $0,respectively

*(j)  Loss Per Share*

Basic net loss per commonshare has been calculated based upon the weighted average number of shares ofcommon stock outstanding during the period. Diluted net loss per share is alsocomputed using the weighted average number of common shares and excludesdilutive potential common shares outstanding, as their effect is anti-dilutive.Dilutive potential common shares consist primarily of employee stock options,stock warrants and convertible preferred stock. Diluted net loss per share isequal to basic net loss per share and is therefore not presented separately inthe financial statements. The weighted average number of potential commonshares that would have been included in diluted loss per share had their effectnot been anti-dilutive for the each of the years ended December 31, 2004,2003 and 2002 were approximately 261,000 shares, 4,200,000 shares and 432,000shares, respectively. Employee stock options and other stock warrants topurchase a weighted average of approximately 14,260,000, 8,784,000  and 9,535,000 shares were outstanding for theyears ended December 31, 2004, 2003 and 2002 respectively, but would nothave been included in the computation of diluted loss per share because theirexercise price was greater than the average share price of Wave’s common sharesand, therefore, their effect would have been anti-dilutive.

*(k) Impairmentof Long-Lived Assets and Long-Lived Assets to Be Disposed Of*

Wave reviews thevaluation of long-lived assets, including property and equipment andcapitalized software, under the provisions of SFAS No. 144,*”Accounting for the Impairment or Disposal of Long-Lived Assets”*(“SFAS No. 144”) and SFAS No.86, *“Accounting for the Costsof Computer Software to Be Sold, Leased, or Otherwise Marketed”* (“SFASNo. 86”), respectively. Wave is required to assess the recoverability oflong-lived assets and capitalized software development costs basis wheneverevents and circumstances indicate that the carrying value may not berecoverable. Factors we consider important that could trigger an impairmentreview include the following:

·       significantunderperformance relative to expected historical or projected future operatingresults;

·       significantchanges in the manner of our use of the acquired assets or the strategy of ouroverall business;

·       significantnegative industry or economic trends; and

·       significantdecline in our stock price for a sustained period.

F-18

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(3) SignificantAccounting Policies (Continued)**

In accordance with SFAS No. 144,when we determine that the carrying value of applicable long-lived assets maynot be recoverable based upon the existence of one or more of the aboveindicators of impairment, we evaluate whether the carrying amount of the assetexceeds the sum of the undiscounted cash flows expected to result from the useand eventual disposition of that asset. If such a circumstance exists, we wouldmeasure an impairment loss to the extent the carrying amount of the particularlong-lived asset or group exceeds its fair value. We would determine the fairvalue based on a projected discounted cash flow method using a discount ratedetermined by our management to be commensurate with the risk inherent in ourcurrent business model. In accordance with SFAS No. 86, when we determinethat the carrying value of capitalized software development costs may not berecoverable, we evaluate whether the unamortized cost exceeds the expectedfuture net realizable value of the products. If the unamortized costs exceedthe expected future net realizable value of the products, the excess amount iswritten off. Changes in judgments on any of these factors could impact thevalue of the asset being evaluated.

*(l) RevenueRecognition*

Wave’s business model targets revenues from varioussources including: licensing of EMBASSY Trust Suite, Wavexpress’ broadbandmedia distribution and eTMS software products, sales of hardware anddevelopment contracts. Many of our sales arrangements includemultiple-elements, and/or required significant modification or customization ofour software.

Wave follows the provisions of statement of position “SOP”97-2, *Software Revenue Recognition*as amendedby SOP 98-9, Modification of SOP 97-2, *Software RevenueRecognition, with Respect to Certain Transactions*. Generally, Waverecognizes revenue when it is realized or realizable and earned. Wave considersrevenue realized or realizable and earned when persuasive evidence of anarrangement exists, delivery has occurred, the sales price is fixed ordeterminable and collectibility is reasonably assured. Wave reduces revenue forestimated customer returns, rotations and sales rebates when such amounts canbe estimated. When these amounts cannot be estimated Wave defers revenue untilthe product is sold to the end-user. Revenue from software license agreementsthat have significant customizations and modification of the software productis deferred and recognized in a manner that approximates the percentage ofcompletion method. In addition to the aforementioned general policy, thefollowing are the specific revenue recognition policies for each major categoryof revenue.

PRODUCTS—SOFTWARE AND HARDWARE

Revenue from delivered elements of one-time charge licensedsoftware is recognized at the inception of the license term, provided Wave hasvendor-specific objective evidence of the fair value of each undeliveredelement, for arrangements that contain multiple elements. Revenue is deferredfor undelivered elements for these arrangements. Revenue is also deferred forthe entire arrangement, if vendor-specific objective evidence does not existfor each undelivered contract element. Examples of undelivered elements inwhich the timing of delivery is uncertain include contractual elements thatgive customers rights to any future upgrades at no additional charge or futuremaintenance that is provided within the overall price. The revenue that isdeferred for any contract element is recognized when all of the revenuerecognition criteria have been met for that element.

F-19

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(3)Significant Accounting Policies (Continued)**

Prepaid royalty fees received pursuant to distributionsoftware licenses with OEMs in which Wave earns a royalty, based upon unitsshipped by the OEM to end customers, are deferred when received, and recognizedas revenue as units are shipped by the OEM.

Revenue from the sale of hardware components isrecognized when persuasive evidence of an arrangement exists, the product hasbeen shipped to the customer, the sales price is fixed or determinable, andcollectivity is reasonably assured. All of the product is shipped withownership passing to the buyer upon leaving our premises and payment terms aregenerally net 30.

SERVICES

Revenue from time andmaterial service contracts is recognized as the services are provided. Revenuefrom fixed price, long-term service or development contracts is recognized overthe contract term based on the percentage of services that are provided duringthe period compared with the total estimated services to be provided over theentire contract. Losses on fixed price contracts are recognized during theperiod in which the loss first becomes apparent. Payment terms vary bycontract.

*(m) Accountingfor Warrants Containing Cash Settlement Provisions*

Wave follows the FASB’s Emerging Issues Task Forcepronouncement No. 00-19 (“EITF 00-19”) to account for derivative financialinstruments indexed to, and settled in our own stock. These would includefinancial instruments such as options or warrants to purchase Wave stock, butdoes not include employee stock options. EITF 00-19 requires that freestandingfinancial instruments of this nature be classified as an asset or liability atfair value, in the event that the contract underlying any such financialinstruments includes a net cash settlement provision. In addition, EITF 00-19requires any such asset or liability to be marked to market at the end of eachperiod, with any resulting difference in fair value to be recorded as income orloss, through the company’s statement of operations, depending upon whether thedifference results in a gain or loss.

On November 18, 2003, Wave granted warrants topurchase 931,309 shares of Wave common stock at an exercise price of $2.62 pershare, in connection with a private placement of common stock with a group ofaccredited investors. The warrants have a three-year term. The contractunderlying the warrants includes a provision that would require Wave to pay liquidateddamages in cash to the warrant holders if the warrants are “in the money” andthe registration statement underlying such shares ceases to remain continuouslyeffective. Because of this provision, the contract is considered to contain anet cash settlement provision as defined in EITF 00-19. Although theregistration statement was declared effective by the Securities ExchangeCommission on February 12, 2004, the net cash settlement provision stillapplies because of the stipulation that it must remain continuously effectiveand there are circumstances that could potentially cause the registrationstatement to cease to remain effective. Accordingly, Wave recorded a liabilityin its balance sheet that was valued at $493,128 as of December 31, 2004,and $991,851 

F-20

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(3)Significant Accounting Policies (Continued)**

as of December 31,2003. These values were arrived at utilizing the Black-Scholes option pricingmodel with the following assumptions:
| ** **                       | ** ** | **As of  December 30,  2004** | ** ** | **As of  December 31,  2003** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| Expected life  remaining (years) |       |                                    | 1.92       |                                    |       |   | 3 |   |   |
| Interest rate                    |       |                                    | 3.0        | %                                       |       |   | 3.25 | % |   |
| Volatility                       |       |                                    | 128        | %                                       |       |   | 121 | % |   |
| Dividend yield                   |       |                                    | 0          | %                                       |       |   | 0 | % |   |

 

The decrease in fair valueof the liability associated with the warrants of $498,723 was recorded as anunrealized gain in Wave’s statement of operations in the year ended December 31,2004, in accordance with EITF 00-19. For the year-ended December 31, 2003an unrealized gain of $263,097 was recorded for the decrease in the fair marketvalue of the liability from inception of the warrants through December 31,2003.

**(4) BusinessCombinations**

On August 31,2000, Wave purchased substantially all of the assets of Indigo and itse-commerce shopping network, iShopHere.com. The aggregate purchase pricetotaled $7,445,000, which consisted of 374,889 shares of Class A CommonStock priced at $19.30 per share, for a total value of $7,235,000 plustransaction costs of $210,000. The purchase price was based on the averageclosing price of Wave’s Class A Common Stock for the ten trading daysimmediately preceding the date of the purchase, in accordance with the purchaseagreement. The following is a summary of the allocation of the purchase price:
| Fair market value  of tangible assets     |   | $         | 690,000   |   |
|-------------------------------------------|--------|-----------|-----------|--------|
| In-Process  R&D                       |   | 2,176,000 |      |
| Goodwill and  purchased intangible assets |   | 4,579,000 |      |
| Total consideration                       |   | $         | 7,445,000 |   |

 

The amount allocated to in-process research anddevelopment totaling $2,176,000 was determined using established valuationtechniques and was expensed upon acquisition as technological and/or commercialfeasibility had not been established, and was recorded as a charge againstearnings for the year ended December 31, 2000. The amount allocated togoodwill and purchased intangible assets amounted to approximately $4,600,000and was being amortized on a straight-line basis over periods not exceedingthree years. During the year ended December 31, 2001, Wave recorded acharge of $2,284,570 related to the impairment of goodwill and purchasedintangible assets associated with the Indigo asset purchase in 2001, as Wavehad realigned its resources to focus on what it considered high-growth marketsand core opportunities, due to a decline in business conditions. This amountwas equal to the carrying amount of the assets prior to the impairment charge.

F-21

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(4)Business Combinations (Continued)**

The following table setsforth the goodwill and purchased intangible asset values and their ultimatedisposition, as of December 31, 2001:
| ** **                                      | ** ** | **2001**   | ** ** |
|-------------------------------------------------|------------|------------|------------|
| Developed  Technology                           |       | $          | 779,000    |   |
| Assembled  Workforce                            |       | 310,000    |       |
| Contracts                                       |       | 77,300     |       |
| Goodwill and  purchased intangible assets       |       | 3,412,446  |       |
| Total Goodwill  and purchased intangible assets |       | $          | 4,578,746  |   |
| Accumulated Amortization                        |       | (2,294,176 | )          |
| Net Book Value  before impairment charge        |       | 2,284,570  |       |
| Impairment Charge                               |       | (2,284,570 | )          |
| Net Book Value                                  |       | $          | -0-        |   |

 

**(5) Related PartyTransactions**

*(a) NotesReceivable from Officers*

Prior to the enactment of the Sarbanes-Oxley Act of2002, Wave had made loans to certain of its officers. Some of the loans wereextended beyond their original terms by one year. These loans and theextensions thereon, were granted to the officers, prior to the enactment of theSarbanes-Oxley Act of 2002, to allow them to satisfy certain personal financialobligations that would otherwise have required them to liquidate some of theirholdings of Wave shares. The loans were granted as a means to mitigate apotential unfavorable impact to Wave’s share price as a result of the officersselling large blocks of shares. All loans to officers were paid in full,resulting in a balance of $0 as of December 31, 2003. Details with respectto the officer loans are as follows:

On March 26, 2001 Wave made a personal loan to Mr. GerardT. Feeney, Senior Vice President, Chief Financial Officer and Secretary of Waveas evidenced by a demand note for $250,000, which sum was due and payable toWave on March 26, 2002 and bore interest at a rate per annum equal to 1%over the prime interest rate. Interest on the loan accrued monthly and waspayable at maturity. The terms of the loan were substantially equivalent tomarket terms at that time. The due date of the demand note was subsequentlyextended until March 26, 2003. As of March 26, 2003 the loan balance,including accrued interest thereon was $281,399. On March 27, 2003, theCompensation Committee approved a bonus in an amount equal to Mr. Feeney’sobligations with respect to such loan and accrued interest. Proceeds of this bonuswere used to repay the loan and all interest accrued on such loan. The bonuswas granted during the year so that Mr. Feeney could repay his loan,rather than at fiscal year end when bonuses are usually awarded. The factorsused in granting this extraordinary bonus were the amount of the loan, theability to repay the loan and the impact that non-repayment of the loan wouldhave on Mr. Feeney’s abilities to fulfill his duties for Wave. Wave nolonger intends to award bonuses to executive officers or directors in order forthem to repay outstanding loans because there are no outstanding loans to anycurrent executive officers or directors and the Sarbanes-Oxley Act of 2002prohibits any future such loans. The largest aggregate amount outstanding withrespect to indebtedness of Mr. Feeney during the year ended 

F-22

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**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(5)Related Party Transactions (Continued)**

December 31, 2003 was$281,399. Wave has taken this bonus into account when considering future bonusawards to Mr. Feeney.

Also during 2001, Wave made personal loans to Mr. PeterJ. Sprague, former Chairman of Wave evidenced by demand notes for $713,320dated February 27, 2001, $184,500 dated July 25, 2001 and $164,000dated September 5, 2001 for a total of $1,062,000. These demand notescarried terms of one year and bore interest at a rate per annum equal to 1%over the prime rate of interest. Interest on the loans accrued monthly and waspayable at maturity. The terms of the loans were substantially equivalent tomarket terms at that time. Two of the loans in the amount of $713,320 and$184,500 plus accrued interest came due on February 27, 2002 and July 25,2002, respectively and were extended for an additional year beyond theiroriginal due dates, prior to the enactment of the Sarbanes-Oxley Act of 2002. Theremaining loan that had an original face value of $164,319, the balance ofwhich was $174,391 including accrued interest, came due in September 2002.On November 12, 2002, the Compensation Committee approved the payment of abonus that Mr. Sprague used to repay the $164,319 balance of the note plusaccrued interest of $10,072. This bonus was granted during the year so that Mr. Spraguecould repay his loan, rather than at fiscal year end when bonuses are usuallyawarded. This bonus was awarded based on the same factors as the bonus awardedto Mr. Feeney.

Wave had recorded a reserve for uncollectibility for100% of the loans that were outstanding as of December 31, 2002, whichtotaled $999,518, because the Company had determined that there was substantialdoubt as to Mr. Sprague’s ability to repay the loans. Mr. Spragueresigned as Chairman of Wave as of March 31, 2003 and was appointedChairman and Chief Executive Officer of Wavexpress. On August 14, 2003, Mr. Spraguerepaid the entire balance outstanding as of that date of $1,028,087, consistingof $897,820 in original principal and $130,267 in interest from originationthrough the date of repayment. Accordingly, Wave reversed the reservepreviously established in the amount of $999,518 and recorded interest incomeof $28,569 in its Statement of Operations for the year ended December 31,2003.

Consistent with theprovisions of the Sarbanes-Oxley Act of 2002, Wave has adopted a written policyprohibiting future loans to officers and directors.

*(b) Paymentsto Related Party*

In March 2003, Mr. Peter Sprague, who isthe  former Chairman of Wave, wasappointed Chairman and Chief Executive Officer of Wavexpress. Mr. Spraguewas paid $175,667 in 2004 and $185,000 in 2003 ($138,750 of which was paid byWavexpress for Mr. Sprague’s duties as an officer of Wavexpress and$46,250 of which was paid by Wave for Mr. Sprague’s duties as an officerof Wave) in salary in this capacity. Mr. Peter Sprague is the father ofWave’s President and Chief Executive Officer, Steven Sprague.

On August 1, 1997,Michael Sprague became an employee of Wave, at an annual salary of $110,000. OnNovember 1, 1999 he became an employee of Wavexpress at an annual salaryof $120,000 and was paid $150,000, $143,750 and $125,319 for the years ended December 31,2004, 2003 and 2002, respectively. Michael Sprague is the brother of StevenSprague and the son of Wave’s former Chairman, Peter Sprague.

F-23

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(6) Property andEquipment**

Propertyand equipment as of December 31 consisted of the following:
| ** **                                       | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|
| Computer  Equipment                              |       | $          | 5,848,420  |       | $          | 5,685,094 |   |
| Furniture,  fixtures and improvements            |       | 882,492    |       | 882,492    |       |
| Computer software                                |       | 4,821,248  |       | 4,981,769  |       |
|                                             |       | 11,552,160 |       | 11,549,355 |       |
| Less: Accumulated  depreciation and amortization |       | 10,117,107 |       | 9,262,479  |       |
| Total                                            |       | $          | 1,435,053  |       | $          | 2,286,876 |   |

 

Computer software includes $1,864,256 and $2,092,944of capitalized software development costs pursuant to SFAS 86 as of December 31,2004 and 2003 respectively. Capitalized software pursuant to SFAS 86 isamortized over a three-year life using the straight-line method, once theproduct is ready to bring to market.

Depreciation andamortization expense on property and equipment amounted to approximately$855,000, $1,241,000 and $2,001,000 for the years ended December 31, 2004,2003, 2002, respectively.

**(7) Accounts Payableand Accrued Expenses**

Accountspayable and accrued expenses as of December 31 consisted of the following:
| ** **                                                                   | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| Accounts payable                                                             |       | $         | 819,278    |      | $          | 704,977 |   |
| Accrued  consulting and professional fees                                    |       | 531,165   |       | 222,288   |       |
| Accrued payroll  and related costs                                           |       | 1,012,897 |       | 1,178,416 |       |
| Accrued Rent                                                                 |       | 77,670    |       | 104,875   |       |
| Annual Report and  Shareholders Meeting                                      |       | 80,404    |       | 85,383    |       |
| State &  Local Taxes Payable                                        |       | 72,472    |       | 27,499    |       |
| Accrued Software  Licenses                                                   |       | 162,500   |       | 162,500   |       |
| Accrued  Liquidated damages in connection with securities purchase agreement |       | 0         |       | 155,716   |       |
| Accrued expenses  in connection with sales of unregistered securities        |       | 43,544    |       | 132,909   |       |
| Other Accrued  Expenses                                                      |       | 100,134   |       | 61,961    |       |
| Total accounts payable  and accrued expenses                                 |       | $         | 2,900,064  |      | $          | 2,836,524 |   |

 

**(8) Preferred Stock**

*(a) Series HPreferred Stock*

Wave has authorized 2,000,000 shares of preferredstock having a par value of $.01 per share.

On April 30, 2003, Wave completed a privateplacement of 548.5 shares of its Series H Convertible Preferred Stock (the“Series H Stock”) and warrants to purchase Wave’s Class A CommonStock for an 

F-24

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(8) PreferredStock (Continued)**

aggregate purchase priceof $5,485,000, with a group of institutional and accredited investors. Waverealized aggregate proceeds of $4,780,540 net of commissions and other cashfees of $704,460, in connection with the transaction.  In addition, Wave incurred commissions of$315,971 for the fair market value of warrants granted to placement agents topurchase approximately 325,000 shares of Wave’s Class A Common Stock at$0.01. As of December 31, 2003 all 548.5 shares of Series H Stockwere converted at a conversion price of $0.76 into 7,217,105 shares of Class ACommon Stock. In addition, 2,632,311 shares of Class A Common Stock wereissued in connection with the exercise of Series H Warrants for netproceeds of $2,490,167. Series H Warrants to acquire 65,789 shares of Class ACommon Stock remain outstanding as of March 1, 2005, at an exercise priceof $1.13 per share.

Dividends on the Series H Stock accrued on theinitial liquidation preference amount of each share ($10,000) at an annual rateof 10%, and would have increased to 12% on April 30, 2004. Dividends werepayable out of any assets legally available to pay dividends when and ifdeclared by the board of Directors of the Company, or upon liquidation orconversion of the Series H Stock. Dividend expense in connection withconverted Series H Stock (not including accretion of discount on the Series HStock) for year ended December 31, 2003 totaled $212,510.

Pursuantto the Series H Convertible Preferred Stock Purchase Agreement (the “Series HPurchase Agreement”), the Series H Stock was convertible, at the option ofthe holder, on the trading day following the date of Wave’s 2003 annual meetingof stockholders in which stockholders would vote on the proposal to approve theissuance of shares of Class A Common Stock in excess of 19.99% of thenumber of shares of Class A Common Stock outstanding prior to April 30,2003, upon the conversion and exercise of shares of Series H ConvertiblePreferred Stock and the related Warrants.  The Series H Stock was initiallyconvertible into 7,217,105 shares of Wave’s Class A Common Stock at aninitial conversion price of $0.76 per share**.**The excess of the estimated aggregate fairvalue of the Series H Stock upon conversion over the proceeds of the Series HStock has been calculated as follows:
| Class A  Common Shares if converted |   | 7,217,105 |      |
|------------------------------------------|--------|-----------|-----------|
| Closing price on  April 30, 2003    |   | $         | 0.98      |   |
| Aggregate fair  value upon conversion    |   | $         | 7,072,763 |   |
| Gross Proceeds of  Series H Stock   |   | 5,485,000 |      |
| Excess fair value upon  conversion       |   | $         | 1,587,763 |   |

 

As part of the transaction, Wave issued to theinvestors warrants to purchase shares of Class A Common Stock, with aninitial exercise price of $1.13 per share and a five (5) year life (the “Series HWarrants” and, together with Series H Stock, the “Series H Securities”).Initially, the Series H Warrants were exercisable for a total of 3,608,558shares of Class A Common Stock on the trading day following the date ofWave’s 2003 annual meeting of stockholders. If exercised in full, the original Series HWarrants would have generated up to an additional $4,077,671, at the initialexercise price.

During September 2003 the terms of the Series HPurchase Agreement and other documents governing the Series H Stock andthe Series H Warrants were modified, pursuant to a letter agreement andwaiver (collectively the “Waiver”) whereby, each holder that executed theWaiver was required to convert their Series H Stock on the effective dateof the Waiver and agreed to allow Wave to reduce their 

F-25

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**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(8)Preferred Stock (Continued)**

Series H Warrantshares by the holders’ proportion of a 900,000 reduction in the total number ofSeries H Warrant shares. This allowedthe holders of the Series H Securities to convert and exercise their Series HSecurities prior to the shareholder vote to approve or disapprove the issuanceof shares because it was no longer in excess of 19.99% of the Class ACommon Stock outstanding before the issuance of the Series H Securities. Inthe absence of these Waivers, any such conversion or exercise prior to theshareholder vote would have violated Nasdaq listing requirements. Also,pursuant to the Waiver, the exercise price of the Series H Warrants wasreduced from $1.13 to $1.00 for the holders that signed the Waiver.

Inconnection with the issuance of the Series H Stock and the Series HWarrants, Wave recorded a beneficial conversion feature discount of $2,903,146in the quarter ended June 30, 2003. In addition, $1,561,424 was allocatedto the Series H Warrants as an additional discount to the Series HStock. The remaining gross proceeds of $1,020,430 were allocated to commissionsand fees on the Series H Stock, therefore, no proceeds remained toallocate to the preferred stock. Wave followed the Financial AccountingStandards Board’s Emerging Issues Task Force (“EITF”) 98-5 and EITF 00-27 indetermining the beneficial conversion feature, whereby the proceeds were firstallocated to the Series H Stock and the warrants on a relative fair valuebasis. Wave utilized the Black Scholes option pricing model to calculate thefair value of the Series H Warrants with the following assumptions:
| Expected Life in  years |   | 5     |   |
|-------------------------|--------|-------|--------|
| Interest rate           |   | 3.0   | %      |
| Volatility              |   | 112.8 | %      |
| Dividend yield          |   | 0     | %      |

 

F-26

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**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(8)Preferred Stock (Continued)**

The fair value of the Series HStock was calculated as the number of shares of Class A Common Stock thatthe Series H Stock is convertible into, multiplied by the closing price ofWave’s Class A Common Stock on Nasdaq on the closing date of thisfinancing.  The value of the beneficialconversion feature was calculated by multiplying the number of Class ACommon shares that the Series H Stock was convertible into by the intrinsicvalue per share, which was calculated as the closing price of Wave’s Class ACommon Stock on Nasdaq as of April 30, 2003 less the effective conversionprice of the Series H Stock. The beneficial conversion feature and warrantdiscount were accreted as a dividend on a straight line basis, whichapproximated the effective yield over the period from the date of issuancethrough the trading day following Wave’s annual meeting of stockholders inwhich stockholders would vote on the proposal to approve the issuance of sharesof Class A Common Stock in excess of 19.99% of the number of shares of Class ACommon Stock outstanding prior to April 30, 2003, upon the conversion andexercise of shares of Series H Stock and the related Warrants, which wasinitially scheduled for August 27, 2003 and then amended on August 11,2003 to be held by November 17, 2003. As of December 31, 2003, thebalance of the Series H Stock, net of all discounts, consisted of thefollowing:
| Gross offering  proceeds                            |   | $          | 5,485,000 |   |
|-----------------------------------------------------|--------|------------|-----------|--------|
| Fees and Commissions  deducted from proceeds        |   | (704,459   | )         |
| Net Cash proceeds                                   |   | 4,780,541  |      |
| Placement agent  warrants                           |   | (315,970   | )         |
| Net Series H  Stock after all fees             |   | 4,464,571  |      |
| Additional Discounts:                               |   |       |      |
| Series H  Warrants                             |   | (1,561,425 | )         |
| Beneficial  Conversion Feature (BCF)                |   | (2,903,146 | )         |
| Total Additional  Discounts                         |   | (4,464,571 | )         |
| Net Series H  Stock after allocations          |   | -0-        |      |
| Accretion of Discounts:                             |   |       |      |
| Placement agent  warrants                           |   | 315,971    |      |
| Fees paid or  deducted from proceeds in cash        |   | 704,458    |      |
| Series H  Warrants                             |   | 1,561,425  |      |
| BCF                                                 |   | 2,903,146  |      |
| Total Accretion  of Discounts                       |   | 5,485,000  |      |
| Preferred Stock  value as of December 31, 2003 |   | 5,485,000  |      |
| Conversion of  548.5 shares of Series H Stock  |   | (5,485,000 | )         |
| Balance as of  December 31, 2003               |   | $          | -0-       |   |

 

The registration statementthat Wave filed with the Securities and Exchange Commission covering the resaleof the shares of Wave’s Class A Common Stock issuable upon conversion orexercise of the Series H Stock and the Series H Warrants was declaredeffective by the Securities and Exchange Commission on August 24, 2003.

F-27

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(8)Preferred Stock (Continued)**

*(b) Series GPreferred Stock*

During March of 1998,Wave issued 150,000 shares of newly created Series G Convertible PreferredStock for an aggregate purchase price of $3,000,000. The Series GConvertible Preferred Stock was senior to Wave’s classes of Common Stock, andwas junior to Wave’s Series A Preferred Stock in liquidation rights. The Series GConvertible Preferred Stock accrued dividends at the rate of 6% per annum. The Series GConvertible Preferred Stock was convertible into Wave’s unregistered Class ACommon Stock at the lower of $1.12 or 80% of the average of the five lowestclosing bids for the 25 calendar days prior to conversion. In addition, Waveissued warrants to the purchaser and placement agent for 225,000 shares of Wave’sClass A Common Stock at an exercise price of $1.38. The Series GConvertible Preferred Stock was converted into 2,394,494 and 377,102 shares ofWave’s Class A Common Stock during 1998 and 1999, respectively.

*(c) Series FPreferred Stock*

In October 1997 Waveraised approximately $1,850,000, net of issuance costs of $397,000 ($224,000 ofwhich related to the value ascribed to warrants issued), through the privateplacement of 112,500 shares of newly created Series F ConvertiblePreferred Stock. The Series F Convertible Preferred Stock had a statedvalue of $20 per share, which accrued dividends payable quarterly in cash at 6%.The Series F Convertible Preferred Stock was convertible into the Class ACommon Stock at an effective conversion price of the lower of (a) $1.05and (b) 80% of the average of the five (5) lowest trading prices of Class ACommon Stock. During 1997 all of the Series F Convertible Preferred Stockwas converted into 2,961,086 shares of Wave’s Class A Common Stock.

*(d) Series DPreferred Stock*

In May of 1997 Wave raised approximately$1,316,000, net of issuance costs of $272,000 ($162,000 of which related to thevalue ascribed to warrants issued), through the placement of 80,000 shares ofnewly created Series D Convertible Preferred Stock. The Series DPreferred Stock had a stated value of $20 per share, which accrued dividendspayable quarterly in cash at 6%.

The Series DConvertible Preferred Stock was convertible into the Class A Common Stockof Wave at an effective conversion price of the lower of (i) $1.35, or (ii) 80%of the average closing bid price on the NASDAQ National Market System of Wave’sClass A Common Stock for the five (5) trading days immediatelypreceding the date of conversion. During 1997 all of the Series DConvertible Preferred Stock was converted into 2,070,095 shares of Wave’s Class ACommon Stock.

*(e) Series CPreferred Stock*

In December of 1996, Wave raised $2,634,037 netof issuance costs of $365,963 ($101,964 of which related to the value ascribedto warrants issued) through the placement of 150,000 shares of Series CPreferred Stock pursuant to Regulation D of the Act. The Series CPreferred Stock had a stated value of $20 per share, which accrued dividendspayable quarterly in cash at 6% per annum.

F-28

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(8)Preferred Stock (Continued)**

The Series CPreferred Stock ranked senior to Wave’s Common Stock and junior to the Series Aand B Preferred Stock. Series C Preferred Stock was convertible by theholder, in increments, into Wave’s Class A Common Stock based on themarket price of Wave’s Class A Common Stock at the time of conversion. TheSeries C Preferred Stock was convertible at the lesser of $2.31 per shareor 80%, as adjusted, of the average of the fair value of the Class ACommon Stock for the five days prior to the conversion date. During 1997 all ofthe Series C Preferred Stock was converted into 2,850,439 shares of Wave’sClass A Common Stock.

*(f) Series BPreferred Stock*

In May of 1996, Wave raised $3,214,026, net ofissuance costs of $285,974, through the placement of 350 shares of Series BPreferred Stock (“Series B Preferred Stock”) pursuant to Regulation S ofthe Securities Act of 1933 (“the Act”). The Series B Preferred Stock had astated value of $10,000 per share, accrued dividends for liquidation andconversion purposes at 6% per annum and ranked senior to Wave’s Common Sock andSeries C Convertible Preferred Stock (“Series C Preferred Stock”) andjunior to the Series A Preferred Stock. Series B Preferred Stock wasconvertible by the holder, in increments, into Wave’s Class A Common Stock.The Series B Preferred Stock was convertible at the lesser of 110% of the averageclosing bid price for the five days immediately preceding the issue date or 85%of the average closing bid price for the five days immediately preceding theconversion date.

During 1996, 330 shares ofWave’s Series B Preferred Stock were converted into 2,960,303 shares ofWave’s Class A Common Stock and the remaining 20 shares of Series BPreferred Stock were converted in 1997 into 117,240 shares of Wave’s Class ACommon Stock.

*(g) Series APreferred Stock*

On October 19, 1992, the Board of Directorsdesignated and issued 360 shares of this preferred stock of Wave as “Series ACumulative Redeemable Preferred Stock” (“Series A Preferred Stock”). The Series APreferred Stock was issued in settlement of compensation owed to a formerofficer of Wave for services provided to Wave. The holder of the Series APreferred Stock was entitled to receive a dividend at the rate of $60 per shareper annum, when and as declared by the Board of Directors of Wave. Dividendswere cumulative from the date of original issue, and payable upon redemption. OnAugust 11, 1999, Wave redeemed these shares for a total payment of$506,440, including accrued and unpaid dividends.

F-29

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(9) Common Stock**

On December 16, 2004, Wave entered into aSecurities Purchase Agreement, pursuant to which Wave sold and issued 5,484,790shares of Class A Common Stock, par value $.01 per share (the “CommonShares”), to certain purchasers who are parties to the Purchase Agreement (the “Purchasers”)for an aggregate purchase price of $5,759,030. The Common Shares were priced at$1.05. Corpfin Inc. (the “Placement Agent”), had entered into a placementagency agreement with Wave in which they agreed to act as placement agent inconnection with the offering. Wave paid the Placement Agent a fee equal to 4.0%of the gross proceeds of this offering. Wave realized net proceeds of$5,474,728 after deducting placement agent and other fees associated with theissuance of these securities. The Common Shares were drawn-down off of a shelfregistration statement which was filed by Wave on April 15, 2004 anddeclared effective by the Securities and Exchange Commission (the “SEC”) on May 10,2004.

On July 30, 2004, Wave entered into a securitiespurchase agreement, pursuant to which Wave sold and issued 3,529,412 shares of Class ACommon Stock, par value $.01 per share for an aggregate purchase price of$3,000,000. The shares of Class A Common Stock were priced at $0.85. Waverealized net proceeds of $2,777,897 after deducting placement agent and otherfees associated with the issuance of these securities. These shares weredrawn-down off of a shelf registration statement, which was filed by Wave on April 15,2004, and declared effective by the Securities and Exchange Commission on May 10,2004. Wave also granted the purchaser a 90-day additional investmentright and two series of warrants.

The additional investment right granted in thistransaction allowed the purchaser to purchase up to 3,529,412 additional sharesof Class A Common Stock at a price of $1.00 per share, and expired on November 2,2004 unexercised. These shares would have been drawn-down off of the shelfregistration statement, had the investment right been exercised.

Corpfin Inc. (the “Placement Agent”) entered into aplacement agency agreement with Wave in which they have agreed to act asplacement agent in connection with the offering. Wave has agreed to pay thePlacement Agent a fee equal to 4.0% of the actual gross proceeds from the saleof the shares and exercise of the investment rights and warrants referred toabove.

On November 18, 2003, Wave issued 3,725,263shares of its Class A Common Stock at a price of $1.90 per share andgranted warrants to purchase 931,309 shares of Class A Common Stock at aan exercise price of $2.62 per share in a private placement to a group ofaccredited investors for proceeds of approximately $6,562,000, net of issuancecosts of approximately $516,000. The warrants have a three (3) year term.  In addition, in connection with thetransaction, Wave incurred commissions of $218,000 for the fair market value ofwarrants granted to placement agents to purchase approximately 161,595 sharesof Wave’s Class A Common Stock. The warrants granted to the placementagents are also exercisable at a price of $2.62 per share and have a 3 yearlife as well. Ifexercised in full, the warrants granted in connection with this financing willgenerate up to an additional $2,863,000, at the exercise price. Pursuant to aregistration rights agreement entered into with the accredited investors forthe sales of these shares, Wave agreed to file a registration statement withthe Securities and Exchange Commission covering the resale of the Class ACommon Shares sold and those underlying the warrants. Wave filed a registrationstatement on Form S-3 covering the resale of the shares on January 20,2004. On February 12, 2004 the registration statement was declaredeffective by the Commission.

F-30

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(9)Common Stock (Continued)**

On July 24, 2002 Wave issued 1,700,000 shares ofits Class A Common Stock to Redwave plc in exchange for 60% of theremaining assets of GlobalWave Limited for a total purchase price ofapproximately $2,244,000. Prior to this transaction, Wave owned 40% ofGlobalWave Limited (See Note 13 Joint Ventures).

On February 2, 2001 Wave issued 2,000,000 sharesof its Class A Common Stock, at a price of $7.16 per share, for anaggregate purchase price of $14,312,800 to acquire 3,600,000 shares of the Series BPreferred Stock of BIZ, then a privately held company, in a private placementexempt from registration under code section 4(2) of the Securities Act of1933, as amended. Wave’s investment in BIZ represented approximately 17.8% ofthe outstanding capital stock of BIZ. On August 24, 2001 Litronic, Inc.(“Litronic”), a provider of authentication and encryption security technology,completed a merger with BIZ to form SSP Solutions. SSP Solutions trades on the NASDAQNational Stock Market as SSPX. As a result of the merger, Wave’s 3,600,000shares of BIZ were converted into 3,083,083 shares of common stock of SSP.

On August 31, 2000 the Company sold 374,889shares of its Class A Common Stock, at a price of $19.30 per share inexchange for substantially all of the assets of Indigo Networks, LLC and its e-commerceshopping network, iShopHere.com. Additional costs to complete the transactionwere $210,000. These Securities were registered on September 21, 2000.

On March 7, 2000 Wave sold 3,600,800 shares ofits Class A Common Stock at a price of $34.00 per share, for an aggregatepurchase price of $122,427,200. The shares were sold to a group of accreditedinvestors pursuant to Regulation D promulgated under the Securities Act of1933, as amended. Pacific Growth Equities, Inc. acted as sole placementagent for the private placement, receiving a commission of 6% or approximately$7.3 million for their services.

In January 2000, the Company issued 275,000shares of its class A Common Stock to one (1) accredited investor, for anaggregate purchase price of $1,100,000. These shares were issued upon theexercise of a warrant granted on January 26, 1999.  The warrant to purchase 275,000 shares of theCompany’s Class A Common Stock at an exercise price of $4.00 per share,was exercisable until January 26, 2004. The Warrants were issued asconsideration for a $2,000,000 promissory note, bearing no interest, due January 26,2002.

On March 23, 1999, Wave sold 2,090,954 shares of itsClass A Common Stock at a price of $11.00 per share, for an aggregatepurchase price of $23,000,494. These shares were sold to a group of accreditedinvestors pursuant to Regulation D promulgated under the securities act of1933, as amended. Pacific Growth Equities, Inc. acted as sole placementagent for the private placement, receiving a commission of 6% or approximately$1.2 million for their services.

During 1997 Wave issued 126,885 shares of Wave’s Class ACommon Stock to vendors or for the settlement of liabilities. Expenses of$305,496 have been recorded representing the stocks’ fair value at the date ofissuance.

During 1997 Wave sold approximately 800,000 shares ofWave’s Class A Common Stock and warrants to purchase 160,000 shares ofWave’s Class A Common Stock, exercisable at an exercise price of $1.00,for an aggregate purchase price of $800,000. The warrants were exercised orexpired during 1999.

F-31

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(9)Common Stock (Continued)**

During 1997 Wave issued 500,000 shares of Wave’s Class ACommon Stock in connection with a license agreement with Aladdin KnowledgeSystems, Ltd. for its proprietary persistent encryption technology. The shareswere issued at their fair value on the date of issuance.

In July and August 1996, Wave issued 15,000and 3,077 shares of Class A Common Stock to two consultants ascompensation for services rendered. Expenses of $40,938 have been recordedrepresenting the stock’s fair value of $2.06 and $3.44 per share, respectively,at their dates of issuance.

In July 1995, Wave issued 19,559 shares to twovendors in payment for services rendered. Costs of $20,000 were recordedrepresenting the stock’s fair value of approximately $1.00 per share at thetime the services were rendered.

In February 1995, Wave agreed to grant 36,000shares of Class A Common Stock, 12,000 of which were issued in 1995 withthe remainder issued in 1996, to two consultants and six non-employee directorsas compensation for services rendered. Expenses of $112,500 were recorded in1995 representing the stock’s fair value of $3.13 per share at the time of theagreement to grant.

In May and November, 1992, Wave issued 770,000shares of Class B restricted Common Stock to certain employees, officersand stockholders of Wave for a purchase price of $.003 per share, payable inthe form of services to Wave. As these shares were issued for servicesrendered, compensation expense of $1,927,500 was recorded representing theestimated fair value of $2.50 per share at the date of issuance, the price atwhich Common Stock was sold to third parties near the time of issuance.

In January 1994, the Board of Directorsauthorized Wave to amend and restate Wave’s Certificate of Incorporation toreflect the authorization of 25,000,000 shares of a newly created Class ACommon Stock, which stock has voting rights of one vote per share, and thereclassification of the then current outstanding shares of Common Stock into Class BCommon Stock. In June 1994, the Board of Directors authorized that the Class BCommon stock will have one vote per share, except that Class B CommonStock will have five votes per share in cases where one or more directors arenominated for election by persons other than Wave’s Board of Directors andwhere there is a vote on any merger, consolidation or other similartransaction, which is not recommended by Wave’s Board of Directors. Inaddition, the Class B Common Stock will have five votes per share on allmatters submitted to a vote of the stockholders in the event that any person orgroup of persons acquires beneficial ownership of 20% or more of theoutstanding voting securities of Wave. The Class B Common Stock isconvertible into shares of Class A Common Stock at any time. The classesof Common Stock are alike in all other respects.

In December 1989, March through October 1990,and November 1991, substantially all stockholders as of December 29,1989 were offered the right to acquire a number of shares equivalent to theirpre-offering holdings at a price of $.003 per share. Substantially allstockholders that received the offer accepted this offer. This was accountedfor essentially as a stock split effected in the form of a rights offering, andall shares issued in conjunction with this offering were reflected in theaccompanying consolidated financial statements retroactively.

Two principal stockholdersdid not acquire the full amount of shares to which they were entitled. Most ofthe additional proportionate shares that these stockholders would have beencredited with were offered instead to certain officers, employees andstockholders for $.003 per share. To the extent that these rights 

F-32

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(9)Common Stock (Continued)**

wereoffered to the individuals as compensation for services rendered to Wave,compensation expense equal to the difference between the estimated fair valueas of the date of issuance and the purchase price of the stock was recorded. Theestimated fair value of the Common Stock was determined based on sales to thirdparties near the date of issuance. Compensation expense associated with theissuance of these shares of $430,250 is included in the accompanyingconsolidated statement of operations for the period from inception to December 31,2004.

**(10) Options and Warrants**

*1994 Plans*

In January 1994, the Board of Directorsauthorized the establishment of the 1994 Employee Stock Option Plan (the “1994Plan”). The initial term of the plan was ten years and the initial number ofshares of Class A Common Stock subject to the 1994 Plan was 1,000,000.   Options are granted with exercise prices thatapproximate fair market value at the date of grant. In May 1996, July 1997,November 1998, June 2000, November 2003 and June 2004, Wave’sshareholders approved amendments to Wave’s 1994 Plan to increase the number ofshares of Class A Common Stock reserved for issuance there under by1,000,000, 1,000,000, 5,000,000, 5,000,000, 2,500,000, and 5,000,0000,respectively. Therefore, the total number of shares of Class A CommonStock reserved for issuance under the 1994 Plan, as amended is 20,500,000shares. In addition, in November 1993, Wave’s shareholders approved anamendment to the 1994 Plan to extend its termination date until January 1,2009.

In January 1994, the Board of Directorsauthorized the establishment of the Non-Employee Directors Stock Option Plan(the “Directors’ Plan”). The total number of shares of Class A CommonStock subject to the Directors’ Plan was initially 200,000. Pursuant to theDirectors’ Plan, each director who was not an employee of Wave received aninitial grant of options to purchase 12,000 shares of Class A Common Stock. Options are granted with exercise pricesthat approximate fair market value at the date of grant.

Any person subsequently elected as a director who wasnot an employee of Wave received an initial grant of options to purchase 12,000shares of Class A Common Stock on the day he or she was elected a director.In addition, on the day immediately following each of the dates on which anincumbent director was reelected, he or she received an additional grant ofoptions to purchase 2,000 shares of Class A Common Stock.

The Stockholders of Wave have since, authorizedcertain changes to the Directors’ Plan. In February 1995, the annual optiongrant for directors was increased from a total of 2,000 shares of Class ACommon Stock to 10,000 shares of Class A Common Stock. In July 1995,the Board authorized an increase to the total number of shares subject to theDirectors’ Plan from 200,000 shares to 500,000 shares. In November 1998,the stockholders of Wave authorized an increase to the total number of sharessubject to the Directors’ Plan from 500,000 shares to 1,000,000 shares. Thestockholders also amended the Directors’ Plan to provide that options issued tonon-employee directors under such plan vest on the day following the grant. (Initialoption grants under the Directors’ Plan vested one-third upon grant, andone-third on each of the first and second anniversaries. Annual option grants vested25% after each three-month period following grant.)  In June 2004, Wave’s Stockholdersapproved an additional amendment to the Directors Plan to extend thetermination date of the Directors’ Plan from January 18, 2004 to January 18,2009.

F-33

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(10)Options and Warrants (Continued)**

Options under theDirectors’ Plan are exercisable for a period of ten years from the date ofgrant. Options may not be exercised after the option holder ceases to be adirector of Wave, except that in the event of death or disability of the optionholder, the option may be exercised for a period of one year after the date ofdeath or disability, and, in the event of retirement of the option holder, theoption may be exercised for a period of three months after the date ofretirement.

*The 1996 Plan*

In September 1996, the Board of Directorsauthorized and the shareholders approved the establishment of the 1996Performance Stock Option Plan (the “1996 Plan”). The initial number of sharesof Class A Common Stock subject to the 1996 Plan was 800,000. The terms ofthe 1996 Plan are similar to those of the Plan. Options are granted withexercise prices that approximate fair market value at the date of grant.

F-34

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(10) Options and Warrants(Continued)**

*Summary of Option Activity*

A summary of optionactivity for all Wave option plans through December 31, 2004 follows:
| ** **                         | ** ** | **Class A and B shares** | ** ** | **Weighted average** | ** ** |
|------------------------------------|------------|----------------------------------------------|------------|---------------------------|------------|
| ** **                         | ** ** | **subject to option**              | ** ** | **exercise price**   | ** ** |
| Balance at  January 1, 1991   |       |                                         | —     |                      |       |   | $ | — |   |   |
| Options granted                    |       |                                         | 30,000     |                      |       |   | 1.67 |   |   |
| Balance at  December 31, 1991 |       |                                         | 30,000     |                      |       |   | 1.67 |   |   |
| Options granted                    |       |                                         | 816,750    |                      |       |   | 1.18 |   |   |
| Balance at  December 31, 1992 |       |                                         | 846,750    |                      |       |   | 1.20 |   |   |
| Options granted                    |       |                                         | 949,186    |                      |       |   | 3.10 |   |   |
| Balance at  December 31, 1993 |       |                                         | 1,795,936  |                      |       |   | 2.20 |   |   |
| Options granted                    |       |                                         | 310,200    |                      |       |   | 3.05 |   |   |
| Options canceled                   |       |                                         | (108,500   | )                         |       |   | 3.38 |   |   |
| Balance at  December 31, 1994 |       |                                         | 1,997,636  |                      |       |   | 2.27 |   |   |
| Options granted                    |       |                                         | 777,850    |                      |       |   | 2.22 |   |   |
| Options canceled                   |       |                                         | (349,205   | )                         |       |   | 2.11 |   |   |
| Options exercised                  |       |                                         | (681,700   | )                         |       |   | 0.64 |   |   |
| Balance at  December 31, 1995 |       |                                         | 1,744,581  |                      |       |   | 2.92 |   |   |
| Options granted                    |       |                                         | 1,342,075  |                      |       |   | 2.65 |   |   |
| Options canceled                   |       |                                         | (503,879   | )                         |       |   | 3.20 |   |   |
| Options exercised                  |       |                                         | (214,091   | )                         |       |   | 1.97 |   |   |
| Balance at  December 31, 1996 |       |                                         | 2,368,686  |                      |       |   | 2.79 |   |   |
| Options granted                    |       |                                         | 707,914    |                      |       |   | 1.02 |   |   |
| Options canceled                   |       |                                         | (676,741   | )                         |       |   | 1.57 |   |   |
| Options exercised                  |       |                                         | (70,326    | )                         |       |   | 1.90 |   |   |
| Balance at  December 31, 1997 |       |                                         | 2,329,533  |                      |       |   | 2.38 |   |   |
| Options granted                    |       |                                         | 5,756,893  |                      |       |   | 2.47 |   |   |
| Options canceled                   |       |                                         | (707,384   | )                         |       |   | 2.48 |   |   |
| Options exercised                  |       |                                         | (78,653    | )                         |       |   | 1.94 |   |   |
| Balance at  December 31, 1998 |       |                                         | 7,300,389  |                      |       |   | 2.40 |   |   |
| Options granted                    |       |                                         | 1,925,447  |                      |       |   | 10.15 |   |   |
| Options canceled                   |       |                                         | (450,378   | )                         |       |   | 3.51 |   |   |
| Options exercised                  |       |                                         | (964,000   | )                         |       |   | 1.69 |   |   |
| Balance at  December 31, 1999 |       |                                         | 7,811,458  |                      |       |   | 4.33 |   |   |
| Options granted                    |       |                                         | 3,444,037  |                      |       |   | 13.58 |   |   |
| Options canceled                   |       |                                         | (905,145   | )                         |       |   | 12.33 |   |   |
| Options exercised                  |       |                                         | (2,030,958 | )                         |       |   | 2.51 |   |   |

 

F-35

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(10) Options and Warrants (Continued)**
| ** **                         | ** ** | **Class A and B shares** | ** **  | **Weighted average** | ** ** |
|------------------------------------|------------|----------------------------------------------|-------------|---------------------------|------------|
| ** **                         | ** ** | **subject to option**              | ** **  | **exercise price**   | ** ** |
| Balance at  December 31, 2000 |       |                                         | 8,319,392   |                      |       |   | 7.90 |   |   |
| Options granted                    |       |                                         | 2,934,272   |                      |       |   | 3.46 |   |   |
| Options canceled                   |       |                                         | (1,128,327) |                      |       |   | 8.16 |   |   |
| Options exercised                  |       |                                         | (473,511    | )                         |       |   | 1.42 |   |   |
| Balance at  December 31, 2001 |       |                                         | 9,651,826   |                      |       |   | 6.85 |   |   |
| Options granted                    |       |                                         | 1,607,959   |                      |       |   | 1.94 |   |   |
| Options canceled                   |       |                                         | (1,033,989  | )                         |       |   | 8.44 |   |   |
| Options exercised                  |       |                                         | (42,553     | )                         |       |   | 1.04 |   |   |
| Balance at  December 31, 2002 |       |                                         | 10,183,243  |                      |       |   | 5.94 |   |   |
| Options granted                    |       |                                         | 2,287,670   |                      |       |   | 1.41 |   |   |
| Options canceled                   |       |                                         | (1,589,495  | )                         |       |   | 8.08 |   |   |
| Options exercised                  |       |                                         | (1,340,739  | )                         |       |   | 2.14 |   |   |
| Balance at  December 31, 2003 |       |                                         | 9,540,679   |                      |       |   | 5.03 |   |   |
| Options granted                    |       |                                         | 2,344,538   |                      |       |   | 1.22 |   |   |
| Options canceled                   |       |                                         | (515,355    | )                         |       |   | 6.19 |   |   |
| Options exercised                  |       |                                         | (32,809     | )                         |       |   | 1.04 |   |   |
| Balance at  December 31, 2004 |       |                                         | 11,337,053  |                      |       |   | $ | 4.20 |   |   |
|                                    |            |                                              |             |                           |            |  |  |  |  |  |

 

At December 31, 2004, there were 7,282,428options exercisable at prices ranging from $0.80 to $37.50 and there were anadditional 6,900,900 shares available for grant.

Thefollowing table summarizes information about stock options outstanding at December 31,2004:
| ** **                    | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                            | ** ** |
|-------------------------------|------------|------------------------------|------------|---------------------------------------------------------|------------|
| **Exercise  Price  Range**    | ** ** | **Number  Outstanding**      | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Outstanding** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| $  0.80–$1.12  |       | 2,386,230                    |       |                                                    | 8.6 years  |   |   |   | $ | 0.91 |   |   | 475,292 |   |   | $ | 1.03 |   |   |
| $  1.13–$1.69  |       | 2,464,249                    |       |                                                    | 7.9 years  |   |   |   | 1.54 |   |   | 894,781 |   |   | 1.39 |   |   |
| $  1.70–$2.55  |       | 1,330,723                    |       |                                                    | 7.2 years  |   |   |   | 1.98 |   |   | 776,504 |   |   | 1.96 |   |   |
| $  2.56–$3.84  |       | 1,628,048                    |       |                                                    | 3.7 years  |   |   |   | 3.60 |   |   | 1,608,048 |   |   | 3.61 |   |   |
| $  3.85–$5.78  |       | 1,576,500                    |       |                                                    | 5.5 years  |   |   |   | 4.04 |   |   | 1,576,500 |   |   | 4.04 |   |   |
| $  5.79–$8.68  |       | 111,540                      |       |                                                    | 5.6 years  |   |   |   | 6.76 |   |   | 111,540 |   |   | 6.76 |   |   |
| $  8.69–$13.04 |       | 1,014,963                    |       |                                                    | 4.9 years  |   |   |   | 11.87 |   |   | 1,014,963 |   |   | 11.87 |   |   |
| $13.05–$19.58            |       | 591,550                      |       |                                                    | 5.0 years  |   |   |   | 15.16 |   |   | 591,550 |   |   | 15.16 |   |   |
| $19.59–$29.38            |       | 201,250                      |       |                                                    | 5.6 years  |   |   |   | 19.69 |   |   | 201,250 |   |   | 19.69 |   |   |
| $29.39–$37.50            |       | 32,000                       |       |                                                    | 5.1 years  |   |   |   | 31.64 |   |   | 32,000 |   |   | 31.64 |   |   |
| Total                         |       | 11,337,053                   |       |                                                    | 6.6 years  |   |   |   | $ | 4.20 |   |   | 7,282,428 |   |   | $ | 5.79 |   |   |

 

F-36

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(10)Options and Warrants (Continued)**

*1999 WavexpressStock Incentive Plan*

In April 2000, the board of directors ofWavexpress authorized the establishment of a stock option plan. The totalnumber of shares of Wavexpress’ Class A Common Stock subject to the Planis 2,500,000. Options terminate upon the earlier of the date of expiration ofthe option or upon termination of the employment relationship betweenWavexpress and the optionee for any reason other than death, disability orretirement.

Employees are entitled to exercise their options ondates determined by Wavexpress’ Compensation Committee of the Board ofDirectors. Vesting provisions for options granted generally range fromimmediate vesting to pro rata vesting over a three-year period.

Stockoption activity during 2004, 2003 and 2002 is as follows:
| ** **                                            | ** ** | **2004**                   | ** ** | **2003**                               | ** ** | **2002**                   | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|----------------------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Balance at  Beginning of year                         |       | 1,315,062                  |       |                                   | 1.21       |                       |       | 1,402,841 |   |   | $ | 1.21 |   |   | 1,029,975 |   |   | $ | 1.22 |   |   |
| Granted                                               |       | 24,500                     |       |                                   | 1.20       |                       |       | — |   |   | — |   |   | 1,011,799 |   |   | 1.20 |   |   |
| Exercised                                             |       | —                     |       |                                   | —     |                       |       | — |   |   | — |   |   |   |   |   |   |   |   |
| Canceled                                              |       | (36,733                    | )          |                                   | 1.20       |                       |       | (87,779 | ) |   | 1.20 |   |   | (638,933 | ) |   | 1.20 |   |   |
| Balance at end of  year                               |       | 1,302,829                  |       |                                   | 1.21       |                       |       | 1,315,062 |   |   | 1.21 |   |   | 1,402,841 |   |   | 1.21 |   |   |
| Exercisable at  end of year                           |       | 1,210,029                  |       |                                   | 1.21       |                       |       | 927,105 |   |   | 1.22 |   |   | 658,156 |   |   | 1.23 |   |   |
| Additional shares  available for grant at end of year |       | 1,169,394                  |       |                                   |       |                       |       | 1,157,161 |   |   |   |   |   | 1,069,382 |   |   |   |   |   |

 

Theper share weighted-average fair value of stock options granted during 2004 and2002 was $0.72 and $0.89, respectively, on the date of grant using aBlack-Scholes option-pricing model with the following weighted-averageassumptions:
| ** **               | ** ** | **2004** | ** ** | **2002** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Expected dividend  yield |       | 0%       |       | 0%       |       |
| Risk-free  interest rate |       | 3%       |       | 3%       |       |
| Expected Volatility      |       | 114%     |       | 119%     |       |
| Expected life            |       | 3 years  |       | 3 years  |       |

 

No options were granted under the Wavexpress stockoption plan during the year ended December 31, 2003.

F-37

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(10)Options and Warrants (Continued)**

The following tablesummarizes information about Wavexpress’ stock options outstanding at December 31,2004:
| ** **      | ** ** | **Options Outstanding** | ** ** | ** **                | ** ** | ** **        | ** ** |
|-----------------|------------|------------------------------|------------|---------------------------|------------|-------------------|------------|
| ** **      | ** ** | ** **                   | ** ** | **Weighted**              | ** ** | ** **        | ** ** | **Options Exercisable** | ** ** |
| ** **      | ** ** | ** **                   | ** ** | **Average**               | ** ** | **Weighted**      | ** ** | ** ** | ** ** | **Weighted ** | ** ** |
| ** **      | ** ** | ** **                   | ** ** | **Remaining **       | ** ** | ** Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Exercise**    | ** ** | **Number**                   | ** ** | **Contractual Life** | ** ** | **Exercise**      | ** ** | **Number** | ** ** | **Exercise ** | ** ** |
| **Price**       | ** ** | **Outstanding**              | ** ** | **(in years)**       | ** ** | ** Price**   | ** ** | **Outstanding** | ** ** | **Price** | ** ** |
| $1.20           |       | 1,294,632                    |       |                      | 7.0        |              |       |   | $ | 1.20 |   |   | 1,201,832 |   |   | $ | 1.20 |   |   |
| $3.00–4.50 |       | 8,197                        |       |                      | 5.6        |              |       |   | $ | 3.37 |   |   | 8,197 |   |   | $ | 3.37 |   |   |
| $1.20–4.50 |       | 1,302,829                    |       |                      | 7.0        |              |       |   | $ | 1.21 |   |   | 1,210,029 |   |   | $ | 1.21 |   |   |

 

*Warrants*

On July 30, 2004, warrants to purchase up to4,411,765 shares of Class A Common Stock, in connection with a securitiespurchase agreement, pursuant to which Wave sold and issued 3,529,412 shares of Class ACommon Stock, par value $.01 per share for an aggregate purchase price of$3,000,000. The warrants granted in this transaction are made up of twodifferent series, Series A and Series B. The Series A warrantsare exercisable for up to 3,529,412 shares of Class A Common Stock at anexercise price of $1.15 per share. The Series A warrants are exercisablefrom January 30, 2005, until July 30, 2005. The Series Bwarrants are exercisable for up to 882,353 shares of Class A Common Stockat an exercise price of $1.30 per share. The Series B warrants areexercisable from July 30, 2005, until January 30, 2006. The shares ofClass A Common Stock issuable upon exercise of the Series A warrantsand Series B warrants are also to be drawn-down off of the shelfregistration statement, if the warrants are exercised. The Series A and Series Bwarrants issued in this transaction carry a subsequent equity clause thatrequires Wave to adjust the initial exercise price, pro-rata, for anysubsequent equity sales that are made at a price that is lower than the initialexercise price. In December 2004 Wave sold 5,484,790 shares for $1.05 pershare. As a result of this sale, the exercise prices of the Series A and Series Bwarrants were adjusted to $1.1428 and $1.282, respectively, in accordance withthe formula pursuant to the warrant agreements. All of the warrants granted inconnection with the July 30, 2004 securities purchase  agreement remain outstanding as of December 31,2004.

In connection with an agreement that Wave entered intowith an outside software development consultant, Wave issued warrants topurchase 65,000 shares of Class A Common Stock at a price of $1.00 pershare, pursuant to an individual compensation plan with the consultant. Thefair market value of these warrants was approximately $81,000 and was recordedas consultant expense in 2004. No additional warrants are required to begranted pursuant to the individual compensation plan for the sales representative.These warrants are currently exercisable and expire January 2, 2009through April 30, 2009.

On November 18, 2003, Wave granted warrants topurchase 931,309 shares of Class A Common Stock at an exercise price of$2.62 per share in connection with a private placement to a group of accreditedinvestors. The warrants have a three year term.  In addition, in connection with thetransaction, Wave granted additional warrants to purchase 161,595 shares of Class ACommon Stock as commissions to placement agents in connection with the privateplacement. The warrants granted to the placement agents are also exercisable ata price of $2.62 per share and have a 3 year life as well. If exercised in full, the 

F-38

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(10) Optionsand Warrants (Continued)**

warrantsgranted in connection with this financing will generate up to an additional$2,863,000, at the exercise price. All of the warrants granted in connectionwith the November 18, 2003 private placement remain outstanding as of December 31,2004.

On April 30,2003, Wave granted the Series HWarrants to purchase shares of Class A Common Stock, with an initialexercise price of $1.13 per share and a five (5) year life. Initially, theSeries H Warrants were exercisable for a total of 3,608,556 shares of Class ACommon Stock on the trading day following the date of Wave’s 2003 annualmeeting of stockholders. During September 2003 the terms of the Series HPurchase Agreement and other documents governing the Series H Stock and theSeries H Warrants were modified, asdiscussed in note 8(a), above. As of December 31, 2003, 2,632,315shares of Class A Common Stock were issued in connection with the exerciseof Series H Warrants for net proceeds of $2,565,167. Series HWarrants to acquire 65,789 shares of Class A Common Stock remainoutstanding as of December 31, 2004.

In connection with an agreement that Wave entered intowith an outside sales representative, Wave issued warrants to purchase 44,365shares of Class A Common Stock at prices ranging from $0.95 to $1.45 pershare, pursuant to an individual compensation plan with the salesrepresentative. The fair market value of these warrants was approximately$146,000 and was recorded as consultant expense in 2003. No additional warrantsare required to be granted pursuant to the individual compensation plan for thesales representative. These warrants are currently exercisable and expire January 1,2013 through April 30, 2013.

In connection with a software development agreementthat Wave entered into with Archon Technologies, Inc. (“Archon”), Waveissued to Archon a warrant to purchase 50,000 shares of Wave Class ACommon Stock at $3.48 per share. The warrant became exercisable on November 9,2002, and expires on November 9, 2007.

In 1993 and 1994, Wave issued warrants to acquire atotal of 151,600 shares of Class B Common Stock at $3.50 per share inconjunction with sales of Class B Common Stock to individuals andinstitutions. All warrants were exercisable for a period of five years from thedate of issuance and were subsequently canceled or exercised in 1998 and 1999.

In 1993 and 1994, Wave issued warrants to acquire atotal of 376,253 shares of Class B Common Stock at $3.50 per share inconjunction with the issuance of its 10% Convertible Notes which have sincebeen repaid and in 1994, Wave issued warrants to acquire a total of 46,799shares of Class B Common Stock at $6.00 per share in conjunction with theissuance of its 15% Notes, also which have since been repaid. All warrants wereexercisable for a period of five years from their dates of issuance. Thesewarrants were exercised or canceled in 1998 and 1999.

Under the terms of Wave’s initial public offering, theunderwriter acquired warrants to purchase 360,000 Class A Common Stock ata price of $6.50 per share for nominal consideration. These warrants wereexercisable for four years commencing in September 1995. These warrantswere exercised during 1999.

As a result of the successful placement of 350 sharesof Series B Preferred Stock, a consultant from Digital Media Group, Inc.was issued warrants by Wave to purchase 15,000 Class A Common shares at a 

F-39

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(10)Options and Warrants (Continued)**

price of $3.09 per share. Thesewarrants are exercisable for ten years commencing in March 1996, and arestill outstanding.

Due to the successful placement of 150,000 shares ofWave’s Series C Convertible Stock, Wharton Capital Partners Ltd. and TheShemano Group, Inc., two financial consulting firms, were issued warrantsby Wave to purchase 37,500 Class A Common Stock each at a price of $2.54per share. These warrants were exercised in 1999.

In connection with the acquisition of WIN, Wave issueda warrant that allowed the holder the ability to purchase unregistered sharesof Wave’s Class A Common Stock at a price of $1.25 per share at theearlier of the conversion of a note or April 18, 1998 for a period of fiveyears. The number of shares able to be purchased under this warrant is based ona formula of $170,000 divided by 80% of the fair market value of the Class ACommon Stock at the time of conversion. This warrant was subsequently extendedone year by issuing 100,000 additional warrants to be exercised at pricesranging from $1.49 to $3.43. These warrants were exercised during July 1999.

As a result of the successful placement of 80,000shares of Wave’s Series D Preferred Stock, JNC Opportunity Fund, theacquirer of the placement, received 80,000 warrants to purchase Wave’sunregistered Class A Common Stock, and financial consultants, primarilyWharton Capital Partners, received a total of 40,000 warrants. The warrantswere exercised in 1999 at an exercise price of $1.62.

As a result of the successful placement of 112,500shares of Wave’s Series F Preferred Stock, Combination Inc., the acquirerof the placement, received 112,500 warrants to Wave’s unregistered Class ACommon Stock, and Wharton Capital Partners received 56,250 warrants. Thewarrants had an exercise price of $1.26, and expired on October 9, 2002. Thewarrants were exercised in 1998.

In connection with the private placement ofapproximately 800,000 shares of Wave’s Class A Common Stock, Wave issued160,000 warrants to purchase shares of Wave’s unregistered Class A CommonStock at an exercise price of $1.00. The warrants were exercised or expiredduring 1999.

In connection with a technology license agreement withAladdin, Wave issued two warrants on July 18, 1997 to purchase Wave’s Class ACommon Stock. The first warrant was exercisable in 100,000 share lots, andprovided the holder with the right to acquire 1,216,136 shares of Wave’sunregistered Class A Common Stock at an exercise price of $1.70 per share.The first warrant had a life of two years. The second warrant provided theholder with the right to acquire 7% of Wave’s Class A Common Stock on afully diluted basis for the average closing price for the 15 trading days priorto exercise and had a three year life. During June of 1998, Aladdinexercised a portion of the second warrant to purchase 1,000,000 shares ofCommon Stock.On March 31, 1999 Aladdin exercised their entire firstwarrant for 1,216,136 Class A Common Stock.  Associatedwith the second warrant,Aladdin had the right to acquire shares approximating 3.45% ofWave’s Class A Common Stock. The remaining shares under the second warrantwere not exercised, and expired July 17, 2001.

In connection with a $2,000,000 convertible promissorynote, warrants to acquire 275,000 shares of Class A Common Stock wereissued. Wave incurred a non-cash charge to interest expense for approximately$666,000. These warrants were subsequently exercised in January 2000.

F-40

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(10)Options and Warrants (Continued)**

A summary of warrantsoutstanding at December 31, 2004, follows:
| ** **              | ** ** | ** **               | ** ** | **Options Outstanding**    | ** ** | ** **          | ** ** | ** **                   | ** ** | ** **         | ** ** |
|-------------------------|------------|--------------------------|------------|---------------------------------|------------|---------------------|------------|------------------------------|------------|--------------------|------------|
| ** **              | ** ** | ** **               | ** ** | **Weighted**                    | ** ** | ** **          | ** ** | **Options Exercisable** | ** ** |
| ** **              | ** ** | ** **               | ** ** | **Average**                     | ** ** | **Weighted **  | ** ** | ** **                   | ** ** | **Weighted ** | ** ** |
| ** **              | ** ** | ** **               | ** ** | **Remaining**                   | ** ** | **Average **   | ** ** | ** **                   | ** ** | **Average**        | ** ** |
| ** **              | ** ** | **Number of ** | ** ** | **Contractual Life ** | ** ** | **Exercise**        | ** ** | **Number of**           | ** ** | **Exercise**       | ** ** |
| **Exercise Price** | ** ** | ** **               | ** ** | **Shares**                      | ** ** | **(in years)** | ** ** | **Price**                    | ** ** | **Shares**         | ** ** | **Price** | ** ** |
| $0.95–$1.52        |       | 4,586,920                |       |                            | 1.5        |                |       |                         | $          | 1.17               |       |   | 175,155 |   |   | $ | 1.08 |   |   |
| $1.53–$3.90        |       | 1,157,904                |       |                            | 1.9        |                |       |                         | 2.66       |               |       | 1,157,904 |   |   | 2.66 |   |   |
|                    |       | 5,744,824                |       |                            | 1.6        |                |       |                         | $          | 1.47               |       |   | 1,333,059 |   |   | $ | 2.46 |   |   |
|                         |            |                          |            |                                 |            |                     |            |                              |            |                    |            |  |  |  |  |  |  |  |  |  |  |

 

*Employee StockPurchase Plan*

In November 2004, theBoard of Directors adopted the Wave Systems Corp. 2004 Employee Stock PurchasePlan (the “Purchase Plan”) pursuant to which a total of 3,000,000 shares ofWave’s Common Stock may be sold to eligible employees at a 15% discount fromthe market value of the shares. Under the terms of the Purchase Plan, employeesmay elect to have withheld, up to 15% of their base earnings to purchase theseshares during each offering period, up to a maximum of $25,000 in market valueof Wave Common Stock. Offering periods commence on May 1st and December 1stand are for a period of six months. The purchase price under the Purchase Planis 85% of the lesser of the market price on the beginning or the ending of theoffering period. Approximately 72% of eligible employees elected to participatein the Purchase Plan in the initial offering period. The Purchase Plan has notyet been approved by Wave’s shareholders. Wave anticipates holding ashareholder vote for the approval of the plan in its 2005 annual shareholdermeeting..

**(11) Development Contract with SSP Solutions, Inc.**

In October 2000, Wave entered into a $10 millioncomprehensive development agreement with BIZ Interactive Zone, Inc. tointegrate Wave’s EMBASSY Trusted Client technology into BIZ’s suite of productsfor deployment into 5 million digital set top boxes and integrated gatewayproducts such as cable and DSL modems. The development agreement outlined thebroad objectives of the project but it required that the parties complete amore detailed plan with related milestones in order to guide the overallproject.

In May of 2001, the development agreement withBIZ discussed above was amended whereby, the parties agreed to a $5 milliondevelopment services contract whereby Wave agreed to port its EMBASSY platformto run in a Linux environment. In addition, SSP agreed to place with Wave anopen $5 million purchase order for EMBASSY products. Payment terms of theagreement provided that SSP make payments of $277,778 per month for eighteenmonths. In addition, the parties agreed that in the event that SSP failed topay any monthly instalment within 30 days of receiving written notice by Wavethat it is in default, the unpaid portion of the instalment would automaticallyconvert into a stock acquisition right allowing Wave to acquire a number ofshares in SSP to be determined by dividing the unpaid amount by the fair marketvalue of SSP common stock. As the contract was for a discrete project tointegrate our technology with the SSP platform, revenue under the developmentservices agreement had been recognized on a percentage of completion basis inaccordance with SOP 97-2 as it relates to contract accounting under SOP 81-1. Percentagecomplete is determined based upon the actual costs incurred 

F-41

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(11)Development Contract with SSP Solutions, Inc. (Continued)**

compared to the totalestimated costs to complete, limited to cash received and milestonesaccomplished. Milestones included specific software development objectives thatmust be accepted by SSP.

As of December 31, 2001, Wave received $555,556in cash and had not exercised any stock appreciation rights. Wave recognizedapproximately $358,000 in revenue under the development agreement at December 31,2001 under the percentage of completion method of accounting.

Effective January 29,2002, due to a refocus of SSP’s development efforts, SSP formally requestedWave to suspend work on the Linux project. SSP further requested Wave to (i) agreeto amend the existing contract, (ii.) agree to identify any balance of development budget left from the Linuxproject commitment and (iii) agree to formally estimate the costs tocomplete two other projects that SSP would like Wave to focus upon. At thattime, Wave had ceased all work relating to SSP and recognized the remainingnon-refundable cash received, $198,000 in during the quarter ended March 31,2002. Revenue was recognized under the percentage of completion method of accounting.OnSeptember 30, 2002 Wave and SSP executed a Termination Agreement andMutual Release whereby Wave was issued an additional 1,600,000 shares of SSP Class ACommon Stock and a non-negotiable, non-interest bearing, subordinatedconvertible promissory note due December 31, 2005 in the principal amountof $270,000 (the “Note”) as a fee for the termination by SSP of the contract. TheNote was convertible into SSP Class A common stock at the rate of $1.35which was subject to adjustments for anti-dilution stock splits, stockdividends, reclassifications, reorganizations and the like. In exchange, Wavewas released from its obligation to provide any further services under thedevelopment contract as amended. The shares that Wave received were recorded onits balance sheet at estimated fair value based on the average closing price ofthe shares on the Nasdaq National Exchange for the period from the two tradingdays before to the two trading days after the date of issuance of the shares,or $1.05 per share, for an aggregate value of $1,680,000. A termination feegain of $1,680,000 was recognized in Wave’s statement of operations inconnection with this transaction. On December 13, 2002 SSP exercised itsright to convert the Note into 200,000 shares of SSP common stock. The 200,000shares that Wave received from the Note conversion were initially recorded onthe balance sheet  at $0.69 per share,for an aggregate value of $138,000, which was also recognized as a gain ontermination of the contract in Wave’s Statement of Operations for the yearended December 31, 2002.

**(12) Investments**

On February 2, 2001, Wave issued 2,000,000 sharesof its Class A Common Stock, at a price of $7.16 per share, for anaggregate purchase price of $14,312,800 to acquire 3,600,000 shares of the Series BPreferred Stock of BIZ Interactive Zone, Inc., then a privately heldcompany, in a private placement exempt from registration under Section 4(2) ofthe Securities Act of 1933, as amended. Wave’s investment in BIZ representedapproximately 17.8% of the outstanding capital stock of BIZ. Accordingly, theinvestment had been accounted for under the cost method of accounting, becausethe investment was less than 20% of the outstanding capital stock of BIZ andbecause Wave could not exercise significant influence over BIZ. On August 24,2001, SSP Solutions, Inc. was formed through a merger with Litronic, Inc.,a publicly traded company that provided authentication and encryption securitytechnology. As a result of the merger, Wave was issued 3,083,083 shares(14.95%) of the common stock of SSP in exchange for the BIZ shares it held.

F-42

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(12)Investments (Continued)**

During 2002, SSP issued Wave an additional 1,800,000shares of common stock in connection with the cancellation of a developmentagreement that was entered into in October 2000. The basis of the sharesacquired in 2002 of $1,818,000 was recorded as a gain from termination of thedevelopment contract.

In August 2004, SSP merged with Saflink Corporation.Pursuant to the merger agreement between SSP and Saflink, holders of SSP commonstock were issued 0.6 shares of Saflink common stock for every share of SSPcommon stock held. At the time of the merger, Wave held 2,043,283 shares ofSSP, which were surrendered in exchange for 1,225,970 shares of Saflink, inaccordance with the 0.6 ratio.

Asdetailed in the table below, Wave’s investments in marketable securities, whichwere classified as available-for-sale securities, consisted of 259,670 shares ofSaflink valued at $721,880, as of December 31, 2004 and 4,550,583 sharesof SSP valued at $6,325,310, as of December 31, 2003.
| ** **                                                                         | ** ** | **Shares** | ** ** | **Adjusted cost  basis** | ** ** | **Unrealized  gain (loss)** | ** ** | **Carrying value** | ** ** | **Value per  Share** | ** ** |
|------------------------------------------------------------------------------------|------------|------------|------------|-------------------------------|------------|----------------------------------|------------|-------------------------|------------|---------------------------|------------|
| Balance of  investment in SSP                                                      |       |       |       |                          |       |                             |       |                    |       |                      |       |
| Common Stock as of December 31, 2002                                          |       | 4,883,083  |       | $                             | 2,881,016  |                             | —     |                    | $          | 2,881,016                 |       | $ | 0.59 |   |
| Sales of SSP  Common Stock                                                         |       | (332,500   | )          | (196,175                      | )          | —                           |       | (196,175                | )          | ($0.59                    | )          |
| Other  comprehensive income—change in accumulated unrealized gain (see below) |       | —     |       | —                        |       | 3,640,469                        |       | 3,640,469               |       | —                    |       |
| Balance of  investment in SSP                                                      |       |       |       |                          |       |                             |       |                    |       |                      |       |
| Common Stock as of December 31, 2003                                          |       | 4,550,583  |       | 2,684,841                     |       | 3,640,469                        |       | 6,325,310               |       | 1.39                      |       |
| Sales of SSP  common stock                                                         |       | (2,507,300 | )          | (1,479,308                    | )          | —                           |       | (1,479,308              | )          | (0.59                     | )          |
| Conversion of  shares to Saflink Corp.                                             |       | (817,313   | )          | —                        |       | —                           |       | —                  |       | —                    |       |
| Sales of Saflink  Corp. common stock                                               |       | (966,300   | )          | (950,195                      | )          | —                           |       | (950,195                | )          | (0.98                     | )          |
| Other  comprehensive income—change in accumulated unrealized gain (see below) |       | —     |       | —                        |       | (3,173,927                       | )          | (3,173,927              | )          | —                    |       |
| Balance as of December 31,  2004                                              |       | 259,670    |       | $                             | 255,338    |                             | $          | 466,542                 |       | $                         | 721,880    |   | $ | 2.78 |   |
|                                                                                    |            |            |            |                               |            |                                  |            |                         |            |                           |            |  |  |  |  |

 

During the year ended December 31, 2004, Wavesold 2,507,300 shares of SSP, in a series of separate sales, at an averageselling price of $1.73 per share, and 966,300 shares of Saflink at an averageselling price of $2.50 per share, realizing an aggregate gain from the sales of$4,330,248. For the year ended December 31, 2003, Wave sold 332,500 sharesof SSP at an average selling price of $1.30 per share, realizing an aggregategain from the sales of $234,759. In addition, for the year ended December 31,2003, Wave received $2,370 as the liquidation value of 107,975 common shares ofXO Communications Corporation (“XO”) that it held as of December 31, 2002.The carrying value of these shares as of December 31, 2002 was zero,accordingly, Wave realized a gain of $2,370 as a result of the liquidation. Waveuses the specific identification method to determine cost in computing realizedgains or losses.

F-43

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(12)Investments (Continued)**

Wave recorded unrealizedholding gains on marketable equity securities included in other comprehensiveincome, as follows, for the years ended December 31:
| ** **                                                                                 | ** ** | **2004**   | ** ** | **2003** | ** ** | **2002**  | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------|------------|----------|------------|-----------|------------|
| Unrealized  holding gains                                                                  |       | $          | 1,156,321  |     | $          | 3,875,228 |       | 1,404,992 |   |
| Reclassification  adjustment for realized gains on securities sold, included in net income |       | (4,330,248 | )          | (234,759 | )          | —    |       |
| Net change in  accumulated unrealized gain                                                 |       | $          | (3,173,927 | )        | $          | 3,640,469 |       | 1,404,992 |   |

 

**(13) JointVentures**

*(a) GlobalWave,Ltd.*

In July of 1997, Wave entered into a jointventure with ITG, a United Kingdom Internet service provider. The joint venturewas initially owned 25% by Wave and 75% by ITG. Wave contributed its technicalexpertise and ITG contributed initial working capital and the commitment tofund all future working capital requirements of the joint venture. Theobjective of the joint venture company, GlobalWave was to promote andcommercialize Wave’s technology in certain European, African and Middle Easternmarkets. Pursuant to the joint venture agreement, Wave received a license feeof $5 million in exchange for the joint venture’s right to market Wave’stechnology in European, African and Middle Eastern markets. The license fee waspaid by ITG in 1997 and 1998. As part of the agreement, after the final licensefee was paid, the companies issued a warrant to each other to purchaseapproximately one million shares of each other’s Common Stock. The exerciseprice of the Wave warrants was $1.75 per share. The exercise price of the ITGwarrant was approximately .995 British pound per share. On June 5, 1998,the final milestone for the last payment on the license fee was attained andWave became obligated to issue its warrant to ITG pending approval by theshareholders of ITG for it to issue its reciprocal warrant. On this date thenet fair market value of the exchange of warrants represented a net cost toWave of approximately $1.1 million. Wave recorded this cost as ITG net warrantcost in the Consolidated Statement of Operations.

On November 5, 1999, Wave exercised its warrantfor 1,000,000 shares in ITG at a total cost of $1,620,000. Also during 1999,ITG exercised its 1,000,000 warrants in Wave yielding total proceeds of$1,750,000.

In February, 2000, ITG was acquired by ConcentricNetwork Corporation. As a result of this transaction, Wave received $2,162,457in cash and 83,910 shares of Concentric Common Stock. Subsequently, Concentricwas acquired by XO, whereby Wave’s 83,910 shares in Concentric were convertedinto 107,975 shares of XO. (See Note 12—Investments). In addition, certainassets of ITG, namely the 1,000,000 shares of Wave Common Stock and ITG’sinterest in GlobalWave, were distributed to Redwave.

In June, 2000, Wave increased its ownership percentageof GlobalWave from 25% to 40%. As part of the new joint venture agreement, Wave’spartner in the venture, Redwave, agreed to contribute $7.5 million and 500,000shares of Wave Common Stock held by Redwave, in exchange for 600,000 shares ofGlobalWave class A Common Stock.  Wavereceived 400,000 shares of GlobalWave class B Common 

F-44

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(13)Joint Ventures (Continued)**

Stock in exchange for atechnology license granted by Wave to GlobalWave. Prior to September 30,2000, no value had been assigned to these shares, as Wave had not provided anyfunding to GlobalWave.

On October 10, 2000, Wave entered into anagreement with GlobalWave and Redwave to subscribe for additional Class Bshares of GlobalWave. Under the terms of the agreement, Wave subscribed for40,000 additional “B” shares of GlobalWave at £100 per share (approximately$142.80), the consideration for which consisted of £1.5 million (approximately$2.14 million) in development costs incurred by Wave on behalf of GlobalWave,£1.4 million in cash ($2.0 million), and £1.1 million (approximately $1.6million) in cash and/or future development services, for total consideration of£4.0 million (approximately $5.7 million).   In addition, Redwave had agreed to subscribefor an additional 60,000 GlobalWave “A” shares, the consideration for whichconsisted of the conversion of debt and cash totaling £6.0 million (£5,966,615in debt and £33,385 in cash; approximately $8.6 million). The resultingownership interest in the venture remained 60% for Redwave and 40% for Wave.

Also, in October 2000, Wave and Redwave formed ajoint venture holding company, Wave European Technologies plc, (“WET”) fortheir European interests, including their respective 40% and 60% stakes inGlobalWave. Subsequent to the formation of WET, WET’s name changed toGlobalWave Group, plc.

Wave had contributed its entire committed investmentof approximately $5.7 million in the form of development costs incurred andcash, as of the year ended December 31, 2002. Pursuant to the equitymethod of accounting, Wave had recognized its equity share (40%) of GlobalWave’snet losses in its operating results, up to its committed investment, with thefinal $2.3 million of its share of Global Wave’s losses having been recognizedin the year ended December 31, 2001. Accordingly, no such losses wereincurred subsequently.

On July 24, 2002 Waveissued 1,700,000 shares of its Class A Common Stock in exchange for 60% ofthe remaining assets of GlobalWave for a total purchase price of approximately$2,244,000. The purchase of the 60% of the remaining assets of GlobalWave wasaccounted for as an acquisition of assets and not considered a businesscombination, as GlobalWave had effectively ceased operations prior to theacquisition. In exchange for the 1,700,000 shares, Wave received approximately$1,380,000 in cash, tangible fixed assets of approximately $9,000 and theexclusive rights under the licenses that it had previously sold to GlobalWave,which granted GlobalWave the exclusive right to commercialize the Wave’scommerce system in Europe; the Middle East and Africa. Wave incurred a chargeto operations representing the amount by which the purchase price exceeded thetangible assets that Wave received of approximately $855,000. In addition,GlobalWave forgave its receivable from Wave of $189,000. The net charge ofapproximately $666,000 has been presented in the statement of operations forthe year ended December 31, 2002 as an impairment charge of the acquiredlicense. Wave assumed no liabilities as a result of this transaction.

*(b) Wavexpress*

In April 1999, Wave joined with SarnoffCorporation to form a new joint venture, Wavexpress. Wavexpress develops securebroadband media distribution software products, infrastructure and contentservices. This technology and these services allow content providers and otherenterprises to send digital content to properly equipped PCs. Consumers orenterprise end-users may receive this content directly 

F-45

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation)**

**Notes to Consolidated Financial Statements (Continued)**

**(13)Joint Ventures (Continued)**

through a secure networkconnection, thus enabling a new revenue stream for broadcasters or cabletelevision operators or a new content distribution method for enterprises.  On October 15, 1999, Wave and Sarnoffsigned a joint venture agreement that formally established Wavexpress. Underthis agreement, Sarnoff and its affiliates received a 40% equity stake inWavexpress. Wave received a 53% equity interest; and its affiliates, whopurchased founders stock in April 1999 for a nominal amount, owned theremaining 7% of the outstanding capital stock. The affiliates of Wave includePeter Sprague, former Chairman of Wave; Steven Sprague, Chief Executive Officerof Wave; certain members of the Board of Directors of Wave; and certain Waveemployees.

Wave has funded Wavexpress through a series ofconvertible notes, some with attached warrants. The notes bear interest atrates of 2% to 3% above the prime rate of Chase Manhattan Bank. Generally, thenotes are convertible into shares of Common Stock of Wavexpress at varyingprices per share. In addition, some of the notes carry attached warrants thatallow Wave to purchase additional shares of Wavexpress, generally at theconversion price of the notes. As of December 31, 2004, Wave owned 69% ofWavexpress while Sarnoff owned 26%. Through December 31, 2004, Wave hasfunded Wavexpress with approximately $35.9 million in cash, plus approximately$7.8 million in accrued interest. During 2001, some of the notes, totalingapproximately $9.5 million matured and were converted into 1,826,570 shares ofWavexpress common stock. These amounts are eliminated in consolidation.

Neither Sarnoff nor any of the other minorityshareholders have provided or are obligated to provide funding to Wavexpress. Accordingly,the financial statements of Wavexpress have been included in the consolidatedfinancial statements of Wave as of December 31, 2004 and for the periodthen ended. In addition, Wave has not recorded a minority interest inWavexpress in the consolidated financial statements and therefore has reflected100% of Wavexpress’ balance sheet and operating results in its consolidatedfinancial statements. Wavexpress has incurred net operating losses of $3.4,$3.9 million and $6.3 million, for the years ended December 31, 2004, 2003and 2002, respectively.

**(14) Cash Collected on Behalf of Charities**

As of December 31, 2004, Wave held no cash onbehalf of charities.

As of December 31,2003, Wave held cash received on behalf of charities of $211,717 in connectionwith CharityWave.com, Wave’s on-line charitable donation service. Thesedonations were received primarily on behalf of donors to the New York TimesNeediest Cases Fund. In addition, Wave had a receivable from its credit cardprocessor of $31,480 as of December 31, 2003, associated with thesedonations. The total of $243,197 is reflected as due to charities in the December 31,2003 financial statements, and was paid to the applicable charities within 30days, in accordance with the standard CharityWave.com contracts with its membercharities.

F-46

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation) (Continued)**

**Notes to Consolidated Financial Statements**

**(15) Commitments and Contingencies**

*Leases*

Summarizedbelow is a listing of properties leased by Wave pursuant to non-cancelableoperating leases. Our principal research and development activities areconducted at the Princeton and Cupertino facilities.
| **Location**     | ** ** | ** ** | ** ** | **Annual  Lease Cost** | ** **     | **Lease Expiration  Date** | ** ** |
|------------------|------------|------------|------------|-----------------------------|----------------|---------------------------------|------------|
| Lee, MA          |       | $          | 124,268    |                        |           | Jul. 2007                  |       |   |
| Princeton, NJ    |       | 126,750    |       |                        | —         |                            |       |
| Cupertino, CA    |       | 294,864    |       |                        | Feb. 2008 |                            |       |
| Orvault, France  |       | 67,260     |       |                        | Sep. 2007 |                            |       |
| New York, NY (1) |       | 364,932    |       |                        | Apr. 2006 |                            |       |
| Total            |       | $          | 978,074    |                        |           |                            |       |   |

----

(1)          *Wavexpressfacility*

Future minimum leasepayments under non-cancelable operating leases (with initial or remaining leaseterms in excess of one year) as of December 31, 2004 are as follows:
| 2005                          |   | $       | 847,714   |   |
|-------------------------------|--------|---------|-----------|--------|
| 2006                          |   | 713,019 |      |
| 2007                          |   | 397,075 |      |
| 2008                          |   | 55,036  |      |
| 2009                          |   | —  |      |
| Thereafter                    |   | —  |      |
| Total minimum lease  payments |   | $       | 2,012,844 |   |

 

Rent expense for the years ended December 31,2004, 2003, 2002 amounted to approximately $940,000, $978,000 and $1,804,000,respectively.

There were no capitallease obligations as of December 31, 2004.

*Securities andExchange Commission Investigation*

On December 17, 2003Wave received an Order by the Securities and Exchange Commission (the “Commission”)regarding a formal investigation. The focus of this investigation is on certainpublic statements made by Wave during and around August 2003, as well ascertain trading in Wave’s securities during such time. The Commission has notconcluded that there has been any wrongdoing and Wave is cooperating fully withthe Commission on this matter. Wave cannot predict the potential effect on Waveas a result of this investigation at this time.

*Purported Class Actions*

Several (9 known) similar purported class actioncomplaints have been filed between January 23, 2004 and February 23,2004 most in the United States District Court for the District ofMassachusetts, 

F-47

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**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation) (Continued)**

**Notes to Consolidated Financial Statements**

**(15)Commitments and Contingencies (Continued)**

seven (7) ofwhich name Wave, its Chief Executive Officer, its Chief Financial Officer andtwo (2) of which also name Wave’s Chairman, as defendants.

The purported class action complaints have been filedby alleged purchasers of Wave’s Class A Common Stock during the purportedclass period July 31, 2003 through February 2, 2004. The complaintsclaim that Wave and the named individuals violated the federal securities lawsby publicly disseminating materially false and misleading statements regardingWave, relating to Intel and IBM agreements, resulting in the artificialinflation of Wave’s Class A Common Stock price during the purported classperiods. The complaints do not specify the amount of alleged damages plaintiffsseek to recover.

Wave intends to defend theactions vigorously. At this time, Wave is unable to predict the outcome ofthese actions.

*Derivative Actions*

Wave has learned of three (3) other complaintsfiled in the United States District Court for the District of Massachusetts. Wavebelieves that the complaints name all of its directors as defendants and allegeclaims for breach of fiduciary duties and other claims. The allegations arevery similar to the allegations made in the purported securities class actionsbecause the allegations concern the very same alleged statements alleged in thepurported class actions. Wave is also named as a nominal defendant, althoughthe actions are derivative in nature and purportedly asserted on behalf of Wave.Wave is in the process of evaluating these claims.

Other than the mattersdescribed above, Wave was not involved in any material litigation, nor, tomanagement’s knowledge is any material litigation threatened against them ortheir properties other than routine litigation arising in the ordinary courseof business.

**(16) IncomeTaxes**

The Company did not provide for any income tax expenseor (benefit) for the years ending December 31, 2004, 2003 and 2002.

The following tablesummarizes the significant differences between the United States federalstatutory tax rate and the Company’s effective tax rate for financial statementreporting purposes:
| ** **                        | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory tax  rate               |       | 34       | %          | 34       | %          | 34       | %          |
| Gain on warrant  liability        |       | (1       | )          | —   |       | —   |       |
| Equity in loss  from subsidiaries |       | —   |       | —   |       | (1       | )          |
| Change in  valuation allowance    |       | (33      | )          | (34      | )          | (33      | )          |
| Total                             |       | —   | %          | —   | %          | —   | %          |

 

F-48

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation) (Continued)**

**Notes to Consolidated Financial Statements**

**(16)Income Taxes (Continued)**

The tax effects oftemporary differences that give rise to the deferred tax asset at December 31,2004 and 2003 are as follows:
| ** **                                   | ** ** | **2004**     | ** **  | **2003**    | ** ** |
|----------------------------------------------|------------|--------------|-------------|-------------|------------|
| Deferred tax assets:                         |       |         |        |        |       |
| Net operating and capital loss carryforwards |       | $            | 100,101,000 |        | $          | 86,053,000 |   |
| Accrued expenses and capital                 |       | 403,000      |        | 392,000     |       |
| Intangibles                                  |       | 666,000      |        | 1,954,000   |       |
| Reserves                                     |       | 1,010,000    |        | 1,030,000   |       |
| Depreciation                                 |       | 681,000      |        | 783,000     |       |
| Unrealized losses                            |       | 55,000       |        | 5,159,000   |       |
| Total gross deferred tax assets              |       | 102,916,000  |        | 95,371,000  |       |
| Less valuation allowance                     |       | (102,916,000 | )           | (95,371,000 | )          |
| Net deferred tax  asset                      |       | $            | —      |        | $          | — |   |

 

Income tax benefits derived from disqualifyingdispositions of employee stock options were approximately $16,000, $799,000 and$0 for the years ended December 31, 2004, 2003 and 2002, respectively, andwere allocated to stockholders’ equity. The tax benefits have been reservedwith a valuation allowance through additional paid in capital.

The cumulative deferred tax expense from certainunrealized gains on marketable securities and other comprehensive income ofapproximately $400,000, $1,400,000 and $0 for the years ended December 31,2004, 2003 and 2002, respectively was not included in the Statement ofOperations. In accordance with Statement on Financial Accounting Standard No. 130,“Reporting Comprehensive Income” the gross amount of those gains is presentedin Wave’s Consolidated Statements of Stockholders’ Equity.

The valuation allowance increased by approximately$7.5 million and $9.3 million, during the years ended December 31, 2004and 2003, respectively.

Management has concluded that it is more likely thannot that Wave will not have sufficient taxable income of an appropriatecharacter within the carryback and carryforward periods permitted by currentlaw to allow for the utilization of the deferred tax assets and, therefore, avaluation allowance has been established against the deferred tax assets of$102,929,000 as of December 31, 2004. Subsequently reported tax benefitsrelating to the valuation allowance for deferred tax assets as ofDecember 31, 2004 will be allocated as follows: $102,114,000 to continuingoperations and $815,000 to additional paid-in capital for amounts attributableto exercise of employee stock options.

Wave has net operatingloss carryforwards for tax return purposes of approximately $223.5 million,which expire beginning in 2005 through 2024. Wave also has capital losscarryforwards for tax return purposes of approximately $8.5 million, whichexpire beginning in 2008 through 2009. Pursuant to  Section 382 of the Internal RevenueCode, the annual utilization of Wave’s net operating and capital losscarryforwards may be substantially limited if a cumulative change in ownershipof more than 50% occurs within any three-year period. Wave has not determinedwhether there have been such  cumulativechanges in ownership or the impact on the utilization of the loss carryforwardsif such changes have occurred. However, in considering Section 382 of theInternal Revenue Code, Wave 

F-49

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**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation) (Continued)**

**Notes to Consolidated Financial Statements**

**(16)Income Taxes (Continued)**

believesthat it is likely that such a change in ownership has occurred thus raising thelikelihood that such net operating and capital loss carryforwards are subjectto annual limitations.

**(17) Defined Contribution Plan**

Wave adopted the WaveSystems Corp. 401(k) Savings and Investment Plan, a defined contributionplan, to which substantially all employees can contribute, on January 1,1995. Employees of Wave become eligible immediately on employment. Wave has theoption to make discretionary matching contributions; no contributions were madein 2004, 2003 or 2002.

**(18) Disclosures about the Fair Value of FinancialInstruments**

*Cash and Cash Equivalents, Marketable Securities,Prepaid Expenses and Other Receivables, Accounts Payable and Accrued Expenses*

The carrying amounts of these instruments, other thanmarketable securities, approximate fair value because of their shortmaturities. Marketable securities are valued based on the value of thesecurities as traded on the Nasdaq Stock Exchange.

Fair value estimates aremade at a specific point in time, based on relevant market information andinformation about the financial instrument. These estimates are subjective innature and involve uncertainties and matters of significant judgment andtherefore cannot be determined with precision. Changes in assumptions couldsignificantly affect the estimates.

**(19) Restructuring Costs and Other Charges**

During the quarter ended March 31, 2002, Wavecompleted a restructuring and cost reduction program to prioritize itsinitiatives, reduce expenses and improve efficiency. This program included aworkforce reduction, the relocation of its Wavexpress office and restructuringof certain business functions.

As a result of this program, Wave recordedrestructuring costs and other related charges of $726,280 consisting of$229,000 in severance benefits associated with the workforce reduction,$426,000 for lease termination fees and brokerage fees and $71,000 for movingexpenses related to the Wavexpress office relocation. All costs were incurredand paid during the quarter ended March 31, 2002. Overall, Wave reducedits force by a total of thirty-six (36) employees, nineteen (19) of which werein research and development and seventeen (17) that were in selling, generaland administrative departments. All employees were notified of the workforcereduction during the quarter ended March 31, 2002. In addition, Waverecorded an impairment charge of $905,390 for leasehold improvements in theabandoned office and other tangible fixed assets that were disposed of orremoved from operations in connection with this transaction.

Wave also recorded acharge of approximately $488,000 in the quarter ended March 31, 2002,relating to a payment made to a former supplier as a settlement for a demandfor arbitration filed against Wave. The arbitration arose out of a claim thatWave had breached a contract with the supplier to purchase computer componentsto be incorporated into an Internet security device produced by Wave. The totalsettlement payment made by Wave was for $688,000, of which $200,000 was accruedfor as of December 31, 2001. This charge is included in “selling, generaland administrative expense”.

F-50

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**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation) (Continued)**

**Notes to Consolidated Financial Statements**

**(20) Impairment of Developed Software**

In thequarter ended June 30, 2004, Wave took a charge of $301,366 to write offdeveloped software that had been capitalized. The software that was written offwas developed for a distribution agreement that was entered into with NationalSemiconductor Corp. (“NSC”) whereby NSC was to distribute it with their trustedplatform module chip. The write-off was the result of the termination of theagreement, and because the version of the software that was written off hasbeen discontinued and superseded by a new version. Consequently, the value ofthe software became impaired because it had no alternative uses. Wave continuesto maintain a license agreement with NSC, whereby Wave is paid royalties basedon Wave Intellectual Property (“IP”) that is included in NSC’s chip design

**(21) Recent Accounting Pronouncements**

In December 2004, theFinancial Accounting Standard Board (FASB) issued a revision to Statement ofFinancial Accounting Standard No. 123, “Accounting for Stock-BasedCompensation” (SFAS 123R). SFAS 123R which eliminates our ability to use theintrinsic value method of accounting under APB Opinion 25, “Accounting forStock Issued to Employees,” and generally requires a public entity to reflecton its income statement, instead of pro forma disclosures in its financialfootnotes, the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value of the award. Thegrant-date fair value will be estimated using option-pricing models adjustedfor the unique characteristics of those equity instruments. Among other things,SFAS 123R also requires entities to estimate the number of instruments forwhich the requisite service is expected to be rendered and, if the terms orconditions of an equity award are modified after the grant date, to recognizeincremental compensation cost for such a modification by comparing the fairvalue of the modified award with the fair value of the award immediately beforethe modification. In addition, SFAS 123R amends FASB Statement No. 95, “Statementof Cash Flows,” to require that excess tax benefits be reported as a financingcash inflow rather than as a reduction of taxes paid. SFAS 123R is effectivegenerally for public companies as of the beginning of the first interim orannual reporting period that begins after June 15, 2005. SFAS 123R appliesto all awards granted after the required effective date and to awards modified,repurchased, or cancelled after that date. As of the required effective date,all public entities that used the fair-value-based method for eitherrecognition or disclosure under the original Statement 123 will apply thisrevised statement using a modified version of prospective application. Underthat transition method, compensation cost is recognized on or after therequired effective date for the portion of outstanding awards for which therequisite service has not yet been rendered, based on the grant-date fair valueof those awards calculated under the original Statement 123 for eitherrecognition or pro forma disclosures. For periods before the required effectivedate, those entities may elect to apply a modified version of retrospectiveapplication under which financial statements for prior periods are adjusted ona basis consistent with the pro forma disclosures required for those periods bythe original Statement 123. We are currently evaluating the requirements ofSFAS 123R and will adopt this statement at the effective date. Although wecannot estimate the exact amount at this time, we expect that the adoption ofthis statement will have a material effect on our financial statements.

**(22) Segment Reporting**

Effective December 31, 2000, Wave adopted SFAS No. 131“Disclosures about Segments of an Enterprise and Related Information” (“SFAS No. 131”).SFAS 131 supersedes previously issued segment 

F-51

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**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation) (Continued)**

**Notes to Consolidated Financial Statements**

**(22)Segment Reporting (Continued)**

reporting disclosure rules andrequires reporting of segment information that is consistent with the way inwhich management operates Wave. Prior to December 31, 2000, SFAS No. 131was not applicable because Wave only operated as one segment.

Wave’s products include the Wave EMBASSY® digitalsecurity products and services and Wavexpress broadband media distributionproducts and services. These products and services constitute Wave’s reportablesegments. Net losses for reportable segments exclude interest income,unrealized gains on decrease in value of warrant liability, liquidated damagesin connection with a private placement of equity securities, equity in lossesof equity method investees, gain on termination of a development contract, aprovision for loss on and recovery of a note receivable with a former officer,other than temporary declines in market value of available-for-sale securities,gain on sales of marketable securities, realized gains on marketable securitiesand other income. These items are not reported by segment since they areexcluded from the measurement of segment performance reviewed by Wave’smanagement.

F-52

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**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation) (Continued)**

**Notes to Consolidated Financial Statements**

**(22)Segment Reporting (Continued)**

The following sets forthreportable segment data:
| ** **                                                             | ** ** | **For the years ended December 31,** | ** **  |
|------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                             | ** ** | **2004**                                                      | ** **  | **2003** | ** ** | **2002** | ** ** |
| Operating Revenues:                                                    |       |                                                          |        |   |   |   |   |
| EMBASSY® digital security products and services                   |       | $                                                             | 164,350     |   | $ | 107,635 |   | $ | 446,588 |   |
| Wavexpress broadband media distribution products and  services         |       | 44,961                                                        |        | 81,728 |   | — |   |
| Total Operating Revenues                                               |       | 209,311                                                       |        | 189,363 |   | 446,588 |   |
| (Net Loss):                                                            |       |                                                          |        |   |   |   |   |
| EMBASSY® digital security products and services                   |       | (15,915,487                                                   | )           | (17,224,356 | ) | (26,914,035 | ) |
| Wavexpress broadband media distribution products and  services         |       | (3,436,453                                                    | )           | (3,839,292 | ) | (6,336,655 | ) |
| Total Segments Net Loss                                                |       | (19,351,940                                                   | )           | (21,063,648 | ) | (33,250,690 | ) |
| Interest Income                                                        |       | 24,931                                                        |        | 74,822 |   | 477,902 |   |
| Unrealized gain on decrease in value of warrant  liability             |       | 498,723                                                       |        | 263,097 |   | — |   |
| Liquidated damages in connection with private  placement               |       | —                                                        |        | (155,716 | ) | — |   |
| Equity in net losses of equity method investees                        |       | —                                                        |        | — |   | — |   |
| Gain on termination of development contract                            |       | —                                                        |        | — |   | 1,818,000 |   |
| Recovery of (Provision for loss on) officer note  receivable           |       | —                                                        |        | 999,518 |   | (999,518 | ) |
| Loss for Other than Temporary Decline in Marketable  Equity Securities |       | —                                                        |        | — |   | (11,513,099 | ) |
| Gain on sale of marketable securities                                  |       | 4,330,248                                                     |        | 234,759 |   | — |   |
| Other Income                                                           |       | —                                                        |        | 52,370 |   | — |   |
| Net Loss                                                               |       | $                                                             | (14,498,038 | ) | $ | (19,594,798 | ) | $ | (43,467,405 | ) |
| Depreciation and  Amortization Expense:                                |       |                                                          |        |   |   |   |   |
| EMBASSY® digital security products and services (1)               |       | 703,137                                                       |        | 932,869 |   | 1,563,987 |   |
| Wavexpress broadband media distribution products and  services         |       | 151,492                                                       |        | 308,166 |   | 436,718 |   |
| Total Depreciation Expense                                             |       | $                                                             | 854,629     |   | $ | 1,241,035 |   | $ | 2,000,705 |   |
| Capital Expenditures:                                                  |       |                                                          |        |   |   |   |   |
| EMBASSY® digital security products and services                   |       | 186,756                                                       |        | 831,147 |   | 1,074,968 |   |
| Wavexpress broadband media distribution products and  services         |       | 117,416                                                       |        | 153,999 |   | 73,755 |   |
| Total Capital Expenditures                                             |       | $                                                             | 304,172     |   | $ | 985,146 |   | $ | 1,148,723 |   |
| Assets:                                                                |       |                                                          |        |   |   |   |   |
| EMBASSY® digital security products and services                   |       | 8,167,614                                                     |        | 17,726,026 |   | 17,560,523 |   |
| Wavexpress broadband media distribution products and  services         |       | 286,968                                                       |        | 434,404 |   | 648,849 |   |
| Total Assets                                                           |       | $                                                             | 8,454,582   |   | $ | 18,160,430 |   | $ | 18,209,372 |   |

 

F-53

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**WAVE SYSTEMS CORP. AND SUBSIDIARIES (a development stage corporation) (Continued)**

**Notes to Consolidated Financial Statements**

**(23) SelectedQuarterly Financial Data (unaudited)**
| ** **                                        | ** ** | **For Quarters-ended** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|
| ** **                                        | ** ** | **December 31,**       | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** |
| ** **                                        | ** ** | **2004**                    | ** ** | **2004** | ** ** | **2004** | ** ** | **2004** | ** ** |
| Revenues                                          |       | $                           | 108,193    |   | $ | 44,375 |   | $ | 6.300 |   | $ | 50,443 |   |
| Gross Profit                                      |       | 21,756                      |       | 9,334 |   | 3,208 |   | 23,309 |   |
| Loss from  Operations                             |       | (4,262,591                  | )          | (4,602,961 | ) | (5,448,637 | ) | (5,037,751 | ) |
| Net loss to  common shareholders                  |       | (2,967,830                  | )          | (3,800,517 | ) | (4,320,927 | ) | (3,408,764 | ) |
| Net loss to  common shareholders per Common Share |       | $                           | (0.04      | ) | $ | (0.05 | ) | $ | (0.06 | ) | $ | (0.05 | ) |

 
| ** **                       | ** ** | **For  Quarters-ended** | ** ** |
|----------------------------------|------------|-------------------------|------------|
| ** **                       | ** ** | **December 31,**        | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** |
| ** **                       | ** ** | **2003**                | ** ** | **2003** | ** ** | **2003** | ** ** | **2003** | ** ** |
|                             |       |                    |       |   |   |   |   |   |   |
| Revenues                         |       | $                       | 59,104     |   | $ | 80,128 |   | $ | 33,727 |   | $ | 16,404 |   |
| Gross Profit                     |       | 43,973                  |       | 49,254 |   | 28,961 |   | 11,996 |   |
| Loss from  Operations            |       | (4,665,209              | )          | (5,507,053 | ) | (4,423,898 | ) | (6,467,488 | ) |
| Net loss                         |       | (4,309,723              | )          | (5,497,159 | ) | (3,394,287 | ) | (6,393,629 | ) |
| Net loss to  common shareholders |       | (4,311,019              | )          | (8,313,755 | ) | (6,273,913 | ) | (6,393,629 | ) |
| Net loss per Common  Share       |       | $                       | (0.07      | ) | $ | (0.15 | ) | $ | (0.12 | ) | $ | (0.22 | ) |

 

**(24) Subsequent Event**

On March 15,2005, Wave entered into a securities purchase agreement, pursuant to which Waveagreed to sell and issue 4,659,090 shares of Class A Common Stock, parvalue $.01 per share, to certain purchasers who are parties to the PurchaseAgreement (the “Purchasers”) for an aggregate purchase price of $4,100,000. TheCommon Shares are being priced at $0.88 per share. Corpfin Inc. (the “PlacementAgent”), had entered into a placement agency agreement with Wave in which theyagreed to act as Placement Agent in connection with the offering. Wave has agreedto pay the Placement Agent a fee equal to 4.0% of the gross proceeds of thisoffering. The transaction is anticipated to close by March 17, 2005, andWave expects to realize net proceeds of approximately $3,871,000 afterdeducting the placement agent fees of $164,000 and additional legal and otherfees associated with the issuance of these securities which Wave estimates willbe approximately $65,000. This securities purchase agreement specifies that theshares shall be issued pursuant to a shelf registration statement which wasfiled by Wave on April 15, 2004 and declared effective by the Securitiesand Exchange Commission (the “SEC”) on May 10, 2004.

F-54

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