**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

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**x**                               ANNUAL REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the fiscal year ended December 31, 2006**

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

**Forthe transition period from                                 to                               **

**CommissionFile Number 0-24752**

**WaveSystems Corp.**

(Exactname of registrant as specified in its charter)

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

 

**413-243-1600**

(Registrant’stelephone number, including area code)

Securitiesregistered pursuant to Section 12(b) of the Act:

**None**

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

**Class ACommon Stock, $.01 par value**

(Titleof Class)

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.  YES o  NO x

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act.  YES o  NO x

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. YES x  NO o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. o

Indicateby check mark whether the registrant is a large accelerated filer, an acceleratedfiler, or a non-accelerated filer. See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act. (checkone)

Large acceleratedfiler  o   Acceleratedfiler  x   Non-acceleratedfiler  o

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Act.)  YES o  NO x

Theaggregate market value of the shares of Common Stock of the registrant held bynon-affiliates as of March 1, 2007, was $98,869,918. (For purposes of thiscalculation, the market value of a share of Class B Common Stock wasassumed to be the same as a share of Class A Common Stock, into which itis convertible.)

Asof December 31, 2006 there were 42,203,773 shares of the registrant’s Class ACommon Stock and 39,232 shares of the registrant’s Class B Common Stockoutstanding.

**DOCUMENTSINCORPORATED BY REFERENCE:**

Portions of our definitive Proxy Statementfor the 2007 Annual Meeting of Stockholders, to be filed pursuant to Regulation14A on or before April 30, 2007, have been incorporated by reference into Part IIIof this annual report.

 

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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 PART I, ITEM 1 OF THIS FORM 10-K  IN ASSESSING FORWARD-LOOKING STATEMENTSCONTAINED HEREIN, READERS ARE URGED TO READ CAREFULLY ALL RISK FACTORS ANDCAUTIONARY STATEMENTS CONTAINED IN THIS FORM 10-K.

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**Table of Contents**

| PART I   | 2                                                                                                                        |
|---------------|--------------------------------------------------------------------------------------------------------------------------|
| Item 1.       | Business                                                                                                                 | 2 |
| Item 1A.      | Risk Factors                                                                                                             | 14 |
| Item 1B.      | Unresolved Staff Comments                                                                                                | 20 |
| Item 2.       | Properties                                                                                                               | 20 |
| Item 3.       | Legal Proceedings                                                                                                        | 20 |
| Item 4.       | Submission of Matters to a  Vote of Security Holders                                                                     | 21 |
| PART II  | 22                                                                                                                       |
| Item 5.       | Market for Registrant’s  Common Equity, Related Stockholder Matters and Issuer Purchases of  Equity Securities | 22 |
| Item 6.       | Selected Financial Data                                                                                                  | 25 |
| Item 7.       | Management’s Discussion and Analysis  of Financial Condition and Results of Operations                              | 26 |
| Item 7A.      | Quantitative and Qualitative  Disclosures about Market Risk                                                              | 44 |
| Item 8.       | Financial Statements and  Supplementary Data                                                                             | 44 |
| Item 9.       | Changes in and Disagreements  with Accountant on Accounting and Financial Disclosure                                     | 44 |
| Item 9A.      | Controls and Procedures                                                                                                  | 44 |
| Item 9B.      | Other Information                                                                                                        | 46 |
| PART III | 47                                                                                                                       |
| Item 10.      | Directors and Executive  Officers of the Registrant                                                                      | 47 |
| Item 11.      | Executive Compensation                                                                                                   | 47 |
| Item 12.      | Security Ownership of  Certain Beneficial Owners and Management and Related Stockholder Matters                          | 47 |
| Item 13.      | Certain Relationships and  Related Transactions                                                                          | 47 |
| Item 14.      | Principal Accountant Fees  and Services                                                                                  | 47 |
| PART IV  | 48                                                                                                                       |
| Item  15.     | Exhibits  and Financial Statement Schedules                                                                              | 48 |

 

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**PART I**

**Item 1.**                        Business

Wave Systems Corp. develops, produces and marketsproducts for hardware-based digital security, including security applicationsand services that are complementary to and work with the specifications of theTrusted Computing Group, www.trustedcomputinggroup.org (“TCG”). Specificationsdeveloped by the TCG are designed to address a broad range of current andevolving digital security issues. These issues include: identity protection,data security, digital signatures, electronic transaction integrity, platformtrustworthiness, network security and regulatory compliance.

The TCG is an industry standards body, comprised ofcomputer and device manufacturers, software vendors and others, whose purposeis to develop, define and promote open industry standard specifications forembedded hardware-enabled computing products, including security technologiesacross multiple platforms, peripherals and devices. The current TCGspecification recommends a hardware-based trusted computing platform, which isa platform that uses a semiconductor device, known as a Trusted Platform Module(“TPM”) that performs protected activities, including protected storage, platformauthentication, protected cryptographic processes and attestable statecapabilities to provide the first level of trust for the computing platform(a “Trusted Platform”). The TPM is a hardware chip that is separate from theplatform’s main CPU(s) that enables secure protection of files and otherdigital secrets, and performs critical security functions such as generating,storing and protecting “cryptographic keys,” which are secret codes used todecipher encrypted or coded data. While TPMs provide the anchor for hardwaresecurity, known as the “root of trust”, trust is achieved by integrating theTPM within a carefully architected trust infrastructure and supporting the TPMwith essential operational and lifecycle services; such as, key management andcredential authentication.

Prior to the formation of the TCG, Wave developed itspioneering EMBASSY (EMBedded Application Security SYstem)Trust System. The EMBASSY Trust System is a combination of client hardwareconsisting of the EMBASSY 2100 security chip (the “EMBASSY chip”); and softwareconsisting of the Trust Assurance Network (“TAN”), a back-office infrastructurethat manages its security functions. As the market for TPM-enabled products has developed with computingdevices being shipped in volume by leaders in the PC industry, Wave has enabledthe development work on the EMBASSY Trust System to support security hardwarebased on the TCG specifications, by repurposing these product assets. Wavehas since developed a set of applications known as the EMBASSY Trust Suite,EMBASSY Trust Server products, middleware and software tools to work withvarious other chip manufacturers’ TCG-enabled TPMs that are now available. Wave’s products are unique in the fact thatthey support cross platform interoperability for the currently available TPMchips from Winbond Electronics Corporation (“Winbond”), (formerly NationalSemiconductor Corporation (“NSC”)), Atmel, Broadcom, Infineon, andSTMicroelectronics and have been verified for usage on TPM platforms shipped byIntel, IBM, HP, Fujitsu, Gateway and Dell.

Wave’s operations to date have consisted primarily ofproduct development, performance under contract to develop products andpreliminary marketing to personal computer (“PC”) and Semi-conductor Chip (“Chip”)original equipment manufacturers (“OEMs”), resellers, and enterprises. Inaddition, Wave has signed distribution contracts for its products with a numberof OEMs that have resulted in a marked increase in revenues for the year ended December 31,2006 versus prior years.

Since 2003, Wave has beensuccessful in signing distribution contracts with Intel, NSC (now Winbond), STMicroelectronics, Dell Products LP, Gateway and Broadcom. However, due to theearly stage nature of its market category, Wave is unable to predict with ahigh enough level of certainty whether enough revenue will be generated in calendar2007 to fund its cash flow requirements. Given the uncertainty with respect toWave’s revenue forecast for 2007, it is likely that Wave will be required toraise additional capital through either equity or debt financing in order toadequately fund its capital 

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requirementsfor the year ending December 31, 2007. Furthermore, in the event that weare successful in executing our business plan for 2007, we will likely still bein a cash shortfall position and we will need to begin to generate sufficient salesto fund operations in future years, or we will be required to raise additionalcapital to continue beyond 2007. As of December 31, 2006, we had workingcapital of approximately $5.4 million. Considering our current cash balance andWave’s projected operating cash requirements, we anticipate that we will need aminimum of approximately $11.5 million of additional cash to satisfy ourcurrent forecasted cash flow requirements for the year ending December 31,2007. As discussed above, Wave has begun market introduction of its softwareproducts for Trusted Platforms and has signed its first distribution contractsfor these applications. Due to our current cash position, our capital needsover the next year and beyond, the fact that we have not secured additionalfinancing at this time and uncertainty as to whether we will achieve our salesforecast for our products and services, substantial doubt exists with respectto our ability to continue as a going concern.

**Formation of theTrusted Computing Group and introduction of TCG Compliant Products**

The TCG was formed in April, 2003. The PromotingFounders were AMD, HP, IBM, Intel, and Microsoft. Wave Systems was invited tojoin the founding group as a Contributing Member. Upon its inception, the TCGformally accepted the initial technical specifications developed by the TrustedComputing Platform Alliance (“TCPA”) for Trusted Platform Modules Version 1.1and formally superseded the TCPA organization. The TCG has significantlyexpanded the industry participation in security hardware standards and nowincludes industry leaders offering additional platforms such as cell phones,PDAs and consumer electronics. During 2003, several manufacturers ofsemiconductors for the PC industry, including National Semiconductor, Atmel andInfineon, were offering products capable of functioning as TPMs meeting the TCGTPM Version 1.1 standard for trusted computing. In addition, PC platforms thatincluded TPMs were announced and/or available from IBM, Intel, and HP. In 2004,the rate of adoption of TPMs accelerated with additional platforms announced bythe major OEMs that were already shipping platforms and an additional OEM,Fujitsu, announced products with TPM’s. In 2005 through 2006, the rate ofadoption of TPMs continued to grow with the availability of TPM-equipped PCsand servers from additional PC OEMs including Dell, Gateway and Lenovo. Theoverall number of TPM-equipped PC models being offered from the OEMsshipping with TPMs, combined with the increased number of OEMs that haveintroduced TPM-equipped models, has continued to accelerate the total rate ofTPMs being shipped by the PC industry. In 2005, The TCG released a new versionof the TPM specification, Version 1.2, which includes a number of enhancementsand extensions over the Version 1.1b. TPM Version 1.2 is fully backwardscompatible to Version 1.1b, which provides a smooth transition for deploymentof the TPM technology and increases the TPM functionality. In addition, vendorssuch as Atmel announced TPM products targeted to support embedded systemsapplications beyond the traditional PC market. There are also TCG WorkingGroups that are developing specifications to extend TCG technologies to otherdevices such as network products, 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. Wave has begunexecuting a strategy to leverage its EMBASSY Trust System in an effort to becomea leading developer of software, applications and services for this market. Waveis providing solutions in the market that are designed to work with manycommercially available products using TCG specifications.

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**Products andServices**

***Client-sideApplications***

*The EMBASSY TrustSuite*

**The current version of the EMBASSYTrust Suite is a set of applications and services that are designed tobring functionality and user value to TPM-enabled products. Designed to makethe TPM easy for users to set up and use, the EMBASSY Trust Suite includesthe EMBASSY Security Center (the “ESC”), Document Manager Vault (“Vault”),Private Information Manager (“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. Wavealso announced that it would develop the Trusted Drive Manager functions forESC to support the newly announced Seagate Full Disc Encryption drives.

Data Protection is addressed by the Vault, whichprovides document encryption, decryption and client side storage of documents.The Vault, which works with Microsoft Windows, and 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 these password issues, PIM uses theTPM to securely store and manage user information such as user names,passwords, credit card numbers and other personal information. It retrieveslogin information 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.

SmartSignature is a digital signing application thatutilizes the signing keys generated by the TPM.

Additionally, Wavehas developed TPM Wizards as part of the EMBASSY Trust Suite which allowusers to setup and use the TPM for securing 802.11x wireless networks, theWindows Encrypting File System and encrypting email. The TPM Wizard enhancement was releasedduring the 1st quarter of 2005.

In August 2005, Wave signed an agreement withSeagate Technology LLC (“Seagate”) to develop a trusted drive manager softwaremodule for the EMBASSY Trust Suite, which will support the Seagate Momentus5400 Full Disc Encryption products announced by Seagate (the “Seagate TrustedDrives”). Wave’s support for the Seagate Trusted Drives will also utilize itsEMBASSY Trust Suite software for TPM and key management.

Wave plans to continue todevelop and enhance the current products being developed within this productgroup and will develop new applications and services as the trusted computingmarket continues to evolve. Current planned development costs for this productgroup are expected to be approximately $3.2 million for the year ending December 31,2007.

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***Middlewareand Tools***

*TCG-Enabled Toolkit*

The Wave TCG-EnabledToolkit is a compilation of software****designed toassist application developers writing new applications or modifying existingones to function on TCG-compliant platforms. Wave provides two versions of theToolkit, Discovery and Commercial, which enable developers to leverage basicand enhanced TCG services such as integrated key lifecycle management,including key escrow and key recovery. The Discovery Toolkit offers applicationdevelopers a license for internal evaluation only, whereas the CommercialToolkit is a license for external redistribution.

*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$4.4 million for the year ending December 31, 2007.

***EMBASSYTrust Server Applications***

*EMBASSY KeyManagement Server (EKMS)*

EKMS is a serverapplication that is designed to provide corporate-level backup and transitionof the TPM keys, a process known as key migration. Key migration using EKMS isdesigned to help prevent the risk of serious data loss in the event that a TPM,hard drive or motherboard becomes corrupted, or a user leaves the organization.For instance, an organization may require access to a former employee’sencrypted data or TPM-secured keys for business continuity or disaster recoverypurposes. EKMS enables enterprise level key protection services while ensuringproper archive procedures and recovery capabilities.

*EMBASSYAuthentication Server (EAS)*

EAS provides centralizedmanagement, provisioning and enforcement of multifactor domain access policies.With EAS, authentication policies can be based on TPM credentials, Smart Cardcredentials, user passwords and fingerprint templates. With EAS, authenticationpolicies can be provisioned and managed from the domain controller. EAS has anintegrated biometric template capability with support for a variety of 3rd-party vendors.

*EMBASSY RemoteAdministration Server (ERAS)*

The Embassy Remote Administration Server (ERAS) is aserver product that provides centralized management and auditing of TrustedPlatform Modules (TPMs) and Seagate Trusted Hard Drives. ERAS is designed togive IT administrators the ability to deploy and remotely manage Trusted Drivesand TPM systems. ERAS will also provide the ability to remotely manage newlyavailable Trusted Drives. It provides for initialization, pre-bootauthentication management, recovery, and repurposing of TPMs and Trusted Drives.ERAS is designed to provide auditing capabilities that aid in compliancemanagement by allowing for validation of TPM and Trusted Drive securitysettings, thus allowing IT administrators to assess the risk of whether a lostor compromised PC is adequately secure. ERAS is designed to facilitateenterprise adoption of TPM and Trusted Drive technology as it provides ITadministrators with tools to utilized the security of these devices whilereducing deployment and management costs.

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Current planneddevelopment costs for this product are expected to be approximately $1.6million for the year ending December 31, 2007.

***DigitalSignature and 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 initially made up our eSign TransactionManagement Suite, also known as eTMS (“eTMS”), which consisted 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. In Q4 of 2005, Wave launched SmartSignature Server,a server-side electronic signature application, which enables individuals toelectronically sign and store virtually any format of document, while connectedto a server, as opposed to the signing taking place on the client PC**.**

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 paper-baseddocumentation methods. SmartSignature Version 3.0 and SmartSAFE Version 3.0have been completed and Wave commercially released these products in the firstquarter of 2003. SmartIdentity, an optional service to verify a signer’sidentity through strong authentication methods, including issuing encrypteddigital certificates based on public key infrastructure technology, wascompleted and released in January of 2003. Wave will continue to allocateresources toward marketing and sales to promote these products.

Wave’s eTMS, in addition to being part of the EMBASSYTrust Suite applications and supporting TPMs, is also being independentlymarketed in the insurance, mortgage, finance, government and other marketswhich are seeking digital and electronic signature solutions that are compliantwith the Electronic Signatures in Global and National Commerce Act (“ESIGN”). In2005, eTMS’ SmartSignature Server product was licensed to a la mode, Inc.,a leading provider of desktop, mobile, and Web tools for the real estate andmortgage industries, to provide digital signature solutions for their XSitesproduct line. Wave also signed a licensing agreement in 2005 with EfficientForms, LLC, a leading provider of interview-based electronic forms creation, tooffer a comprehensive managed-service solution for electronic forms andelectronic signatures. In Q4 of 2005, the Wave/Efficient Forms managed servicewas launched, and deployed at FISERV ISS to automate internal and consumerbusiness processes. Wave has focused on digital signature applications that canmake effective use of the stronger security features provided by trustedcomputing platforms.

Current planneddevelopment costs for this product are expected to be approximately $334,000for the year ending December 31, 2007.

***BroadbandMedia Distribution Services***

Wave offers broadband content distribution productsand services through Wavexpress, a joint venture between Wave and SarnoffCorporation. The joint venture was established on October 15, 1999. Underthe joint venture agreement, Sarnoff and its affiliates received a 40% equitystake in Wavexpress. Wave received a 53% equity interest and its affiliates,who purchased founders stock in April 1999 for a nominal amount, owned theremaining 7% of the outstanding capital stock. The affiliates of Wave include 

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Peter Sprague, formerChairman of Wave, Steven Sprague, Chief Executive Officer of Wave, certainmembers 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. The current product offering combines industry standardsyndication protocols with proprietary back-end software to create anend-to-end content syndication and monetization platform. This system isoffered to content providers looking to deliver high-quality broadband mediaservices using either Wavexpress’ distribution facility or on their own,through Really Simple Syndication (“RSS”). RSS is the standard format for blogsand podcasts and is being increasingly used for open video distribution on theInternet. Content providers connect through the Wavexpress client and backendsoftware to generate advertising revenue or subscription fees for premiumservices. Wavexpress’ business model intends to derive revenue either fromdirect fees charged to content providers for the use of Wavexpress software andfacilities, or from a share of advertising proceeds collected. Wavexpressproprietary client software is integrated and promoted through Microsoft’s XPMedia Center Edition operating system, as well as the Vista Premium and VistaUltimate operating systems which began shipping in January 2007, it isalso available through Microsoft’s Internet Explorer web browser.

We believe Wavexpress’ products deliver value tocontent providers by bringing a traditional advertising sales model to theemerging market for cached, syndicated, high-quality video content. Byleveraging an open standard, RSS, Wavexpress believes it is in a position towork with any content provider—large or small. Wavexpress’ investment inproprietary backend and distribution technology creates opportunities todifferentiate and capitalize on this rapidly growing segment of the contentindustry.

Planned future development expenditures are expectedto approximate $1.6 million for the year ending December 31, 2007.

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.

Although Wave’s revenuehas grown considerably, Wave’s revenue in 2006 of approximately $3,116,000 wassignificantly below operating expenses, which were approximately $21,085,000. Forthe years ended December 31, 2006, 2005, and 2004, Wave incurred losses tocommon shareholders of approximately $18,785,000, $17,562,000 and $14,498,000respectively. At December 31, 2006, we had an accumulated deficit ofapproximately $303,532,000. There can be no assurance that we will ever besuccessful in achieving commercial acceptance of our products and services.

**Markets andBusiness Strategy**

***OurMarket***

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 devices toguard against these persistent security risks. The TCG was formed to develop,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. The underlying premise of the creation of a Trusted Platform thatmeets the TCG specification is that only when a platform is secured byhardware, in effect creating a root of trust and an 

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authenticatablesecurity environment within the computer itself, will the information stored onthe platform be adequately secure. Wave is seeking to become a software,application and services leader in hardware-based digital security ande-commerce products markets. Because Wave has been a pioneer in developinghardware-based computer security systems, it is distinctively positioned totake advantage of its unique knowledge, significant technology assets andtrusted computing intellectual properties.

Because hardware-basedtrusted computing involves a new approach to conducting business and exchanginginformation using computer systems, it will require that traditionalsoftware-based security be augmented with next generation hardware-basedsecurity and an enhanced support infrastructure. Intensive marketing and salesefforts have been and will continue to be necessary, in order to generatedemand for products using Wave’s technology, and to ensure that Wave’s solutionis accepted in this emerging market. Our objective is to make our EMBASSYbranded products and services the preferred applications and infrastructure forTrusted Platforms. Key components in achieving this goal include:

***Capitalizingon Information Security Industry Trends***

For 2006 and 2007 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. Keyindustry initiatives and security specifications that will require the additionof trusted hardware are moving forward in a number of platforms includingMicrosoft’s Next Generation Secure Computing Base (“NGSCB”) now known asWindows Vista operating system, Intel’s LaGrande secure computing program, andAMD’s Secure Execution Mode (“SEM”). Similar programs are under considerationin network devices, and mobile devices such as PDAs and cell phones andconsumer electronics devices.

Wave has designedits products with features and functionality that it believes uniquelypositions them to capitalize on information security industry issues andtrends. 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

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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.

***PursueStrategic Marketing 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, Lenovo, Gatewayand others in the PC industry. In addition, we are engaged in strategicactivities with semi-conductor manufacturers Broadcom, STMicroelectronics,Winbond (formerly NSC), Atmel and Infineon Technologies to support and/or deploy EMBASSY applicationswith their TPMs designed to the TCG specifications. TCG has expanded its scope to include networking systems, trustedperipherals, data storage devices, mobile wireless products and consumerelectronics devices. Wave believes its trusted computing offerings can providesignificant value in these new markets and platforms and thus, is working toestablish relationships with key partners in each of these markets.

***EnhancingOur Current 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.

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:

·       Cross-platforminteroperability: There is TCG hardware coming from multiple suppliers, as wellas supporting software from multiple vendors. In order for applications fromindependent software vendors to work with any of these multiple combinations ofproducts, Wave is developing TCG specific toolkits that provide for thisinteroperability across platforms. Wave will continue to expand the functionsavailable to systems integrators (“SIs”), independent software vendors (“ISVs”)and independent hardware vendors (“IHVs”) within these enabling toolkits tomake it easier to bring new applications to Trusted Platforms.

·       Clientapplications: Wave’s EMBASSY Trust Suite provides important end user PCapplications such as Embassy Security Center, Document Manager, PrivateInformation Manager, Key Transfer Manager and SmartSignature. Wave willcontinue to add new client applications and enhance the current applicationswith advanced functions to exploit the strong security of the TCG platforms.

·       Serverapplications: Trusted devices require a number of life cycle managementproducts to address the set up, registration, operations and systems managementrequirements of the platforms. Wave’s current server and life cycle managementproducts consist of the EKMS, EAS and ERAS. Wave plans to enhance theseproducts with future versions and to expand these products to offer additionaltrust 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, our continued research and developmentefforts will require substantial capital resources, which will likely 

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necessitatethe need for further funding so that Wave may ultimately be able to capitalizeon the emerging market opportunities for its products and services. Waveannounced major products in 2006, primarily for TPM applications, and isdeveloping significant new client and server-based products and productenhancements, which are planned to be introduced in 2007. For example: At theInterop Conference, 2006, on May 2, 2006, Wave announced its introductionof the “EMBASSY Endpoint Enforcer”, a new Wave network security product that isdesigned to enable third party applications and services to make informednetwork access decisions by providing protected access to client securitymetrics.

***Marketing,Sales and Customers***

Because Wave’s products involve a new approach toconducting business and exchanging information using computer systems, it will requirethat traditional software-based security be enhanced and/or replaced with nextgeneration products designed using the TCG and related specifications. Intensivemarketing and sales efforts have been and will continue to be necessary inorder to increase recognition of and generate demand for products using Wave’stechnology and to ensure that Wave’s solutions are accepted in this emergingmarket. The current primary focus is on closing business with chip OEMs, PCOEMs, enterprise customers and systems integrators. Wave has also undertakensteps 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 on business PC platforms, but isexpected to extend to consumer PCs over time. Wave anticipates providingenabling tools to SIs, ISVs, andIHVs in order to take advantage of the new trusted computing features of theseplatforms.

·       Networkproducts, Peripherals and Mobile Devices—As TCG-based specifications are releasedand product deployment begins, Wave anticipates extending its products tosupport these new trusted computing platforms and marketing to the associatedOEMs, 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. In 2005, Wave upgraded its Liberty Alliance membership toSponsor Level in order to participate in the new Strong Authentication ExpertGroup, which is being driven primarily by financial institutions which arelooking for new alternatives for strong authentication for electronictransactions.

·       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 Wave’s TCG-compliant offerings.

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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.

Wave’ssales for the year ended December 31, 2006 consisted primarily oflicensing its software applications, engineering and support services. Of thetotal revenue realized for the year ended December 31, 2006, 99% wasderived from Wave’s EMBASSY computer security products and services and theremaining 1% was derived from Wavexpress’ broadband media distribution segment,for the year ended December 31, 2005 96% was derived from Wave’s EMBASSYcomputer security products and services and 4% was from Wavexpress’ broadbandmedia distribution segment and for the year ended December 31, 2004 79%was derived from Wave’s EMBASSY computer security products and services and 21%was from Wavexpress’ broadband media distribution segment. Customers from whichWave derived revenue in 2006 in excess of 10% or total revenues that would havea material adverse effect on Wave’s business if Wave were to lose suchcustomers are as follows:

| **Customer**        | ** ** | ** **          | ** ** | **Product or Service Sold** | ** ** | **Percentage of Total   Revenue for the year   ended December 31, 2006** | ** ** |
|---------------------|------------|---------------------|------------|--------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------|------------|
| Dell, Inc.     |       | Software  Licensing |       |                                       | 35         | %                                                                                                                          |       |
| ST Microelectronics |       | Software  Licensing |       |                                       | 25         | %                                                                                                                          |       |
| Broadcom            |       | Software  Licensing |       |                                       | 11         | %                                                                                                                          |       |
| US  Government      |       | Services contract   |       |                                       | 11         | %                                                                                                                          |       |

 

Wave’s business plan on aforward-looking basis, will continue to depend heavily on a small number of OEMcustomers, partners and prospective customers, the loss of, or lack ofsubstantial future revenues from any of whom, may have a material adverseeffect on our business plan going forward. These include Broadcom, STMicroelectronics, Dell, Inc. and the US Government. However, Wave isseeking to expand its presence as a security solutions provider to small,medium and large business enterprises and will aggressively market its productsand services to these enterprises in concert with its OEM customer base.

***Competition***

*Wave EMBASSYDigital Security 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, despite the substantial increase in distribution of the technology. Themarkets for our products are developing and, while the TCG specifications haveprovided the basis for the industry to move forward, there remains significantstandards work efforts in order for the eco-system supporting trusted computingto move forward. Wave’s potential competitors include security solutionsproviders such as RSA Security, Inc., Symantec, Computer Associates,Verisign, Inc., Entrust, Inc., Utimaco, Safenet and major systemsintegrators such as IBM, HP and EDS. In addition, Wave competes with otherclient security applications companies that are developing trusted computerapplications including Softex, Phoenix, Infineon and Microsoft. The competitivefactors 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 competefavorably through product differentiation include: cross-platform,interoperable solutions; easy-to-use features; and leading edge 

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trusted client/serverinfrastructure solutions. In addition, Wave continues to have leading solutionswith its digital signature products, especially when combined with trustedcomputing platforms and features.

One of the marketchallenges facing Wave is the establishment of a newly defined market categorywithin the overall information security market for trusted computing softwareand services that includes a more complex business model for adoption. Whilethe TCG specifications define a very complex and comprehensive cryptographicsystem that 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, therebymaking our products non-competitive or obsolete. We can offer no assurancesthat Wave’s products will become industry standards or become widely acceptedby the marketplace.

*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 by providing bothcontent providers and viewers a television-like viewing experience of Internetvideo using the Microsoft Media Center platform. Several companies compete forthe delivery of television over broadband, including startup video networkssuch as Akimbo, Joost and Veoh and streaming service providers such as YouTubeand Brightcove.

**InternationalMarket**

Most of our software products are controlled undervarious United States export control laws and regulations and may require exportlicenses for certain exports of the products and components outside of theUnited States and Canada. With respect to our EMBASSY Trust Suite andEMBASSY Trust Server software applications, we have applied for and receivedexport classifications that allow us to export our products, without a licenseand with no restrictions, to any country throughout the world with theexception 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 will be subjectto reviews by the BXA to determine what export classification they will receive.Some of our partners demand that our products be allowed to be exported withoutrestrictions and/or reporting requirements. Current export regulations have, inpart, allowed us to receive the desired classification without undue cost oreffort. However, the export regulations may be modified at any time.Modifications to the export regulations could prevent us from exporting ourexisting and future products in an unrestricted manner without a license, as weare currently allowed for the products that we’ve received classification, or make it more difficult to receive thedesired classification. If export regulations were to be modified insuch a way, we may be put at a competitive disadvantage with respect to sellingour products internationally.

**Proprietary Rightsand 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.

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Wave has been issued eleven (11) United States patentsrelating to encryption and to our proprietary EMBASSY and Wave Commerce technology.We also have eight (8) patents pending before the United States PatentOffice. In addition, we have two (2) foreign patents and twenty-nine (29)pending foreign patent applications. Our patents are material to protectingsome 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 substantial investmentsin the design of information security applications and services, including theEMBASSY Trust Suite, EMBASSY Server applications, eTMS products, and broadbandmedia distribution products. For the years ended December 31, 2006, 2005and 2004, we spent approximately $8.5 million, $6.9 million and $6.9 million,respectively, on research and development (“R&D”) activities. Planneddevelopment expenditures for the year ended December 31, 2007 are expectedto be approximately $11.1 million.

**Employees**

As of December 31,2006, we employed ninety-six (96) full-time employees, forty-four (44) ofwhom were involved in sales, marketing and administration and fifty-two (52) ofwhom were involved in research and development (including thirteen (13)employed by Wavexpress, three (3) of whom were in sales, marketing andadministration and ten (10) of whom were involved in research anddevelopment). As of December 31, 2006, we retained the services of seven (7) full-timeconsultants, one (1) of whom was retained by Wavexpress. We believe ouremployee relations are satisfactory.

**AvailableInformation**

**Wave makesavailable, free of charge on its website by means of a link to www.nasdaq.com,its annual report on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K and amendments to those reports filed orfurnished pursuant to Section 13(a) or 15(d) of the Exchange Act.Reports may be viewed and obtained on the Company’s website, www.wave.com, orby calling Investor Relations at (212) 835-8500.**

**The public may read and copy any materials the Companyfiles with the SEC at the SEC’s Public Reference Room at 100 FStreet, N.E., Washington, DC 20549. Information on the operation of the PublicReference Room may be obtained by calling the SEC at 1-800-SEC-0330.The SEC also maintains an Internet site that contains reports, proxies andinformation statements, and other information regarding issuers that fileelectronically with the SEC at http://www.sec.gov.**

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**Item 1A.**                RiskFactors

**We have a history of net losses and expect net losseswill continue. If we continue to operate at a loss, our business will not befinancially viable.**

We have experienced significant losses and negativecash flow from operations since our inception. We have not realized a netoperating profit in any quarter since we began our operations. Wave’s revenuein 2006 was significantly below operating expenses, as our products have notyet attained widespread commercial acceptance. This is due primarily to theearly stage nature of the digital security industry in which we operate. As of December 31,2006, we had an accumulated deficit of approximately $303.5 million andworking capital of approximately $5.4 million. Given the lack of widespreadadoption of the technology for our products and services, there is little basisfor evaluating the financial viability of our business and our long-termprospects. You should consider our prospects in light of the risks, expensesand difficulties that companies in their early stage of development encounter,particularly companies in new and rapidly evolving markets, such as digitalsecurity and online commerce.

To achieve profitability we must, among other things:

·       Continueto convince chip, personal computer motherboard, personal computer and computerperipheral manufacturers to license and distribute our products and servicesand/or make them available to their customers through their sales channels;

·       Convincecomputer end users and enterprise computer users to purchase our upgradesoftware and server products for trusted computing:

·       Convinceconsumers to choose to order, purchase and accept products using our productsand services;

·       Continueto maintain the necessary resources, especially talented software programmers;

·       Continueto develop relationships with personal computer manufacturers, computer chipmanufacturers and computer systems integrators to facilitate and to maximizeacceptance of our products and services; and

·       Generatesubstantial revenue, complete one or more commercial or strategic transactionsor raise additional capital to support our operations until we can generatesufficient revenues and cash flows.

If we do not succeed in these objectives, we will notgenerate revenues; hence, our business will not be sustainable.

**We may not be ableto fund our operations and continue as a going concern.**

Since we began our operations, we have incurred netlosses and experienced significant negative cash flow from operations. This isdue to the early stage nature of market development for our products andservices and the digital security industry as a whole. Wave expects to continueto incur substantial additional expenses associated with continued research anddevelopment and business development activities that will be necessary tocommercialize our technology. This will likely result in significant losses forthe foreseeable future. Considering our current cash balance and Wave’sprojected operating cash requirements, we anticipate that our existing capitalresources will be adequate to satisfy our cash flow requirements through mid-May 2007.In order to fund our business through May 2007 and beyond, it will benecessary for us to generate substantial revenue, complete one or morecommercial or strategic transactions or raise additional capital. Wave isuncertain as to the availability of financing from other sources to fund anycash deficiencies. Even if we are successful in raising additional capital,uncertainty with respect to Wave’s viability will continue until we aresuccessful in achieving our objectives. Furthermore, although we may besuccessful at achieving our business objectives, a positive cash flow from 

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operations may notultimately be realized unless we are able to sell our products and services ata profit. Given the early stage nature of the markets for our products andservices, considerable uncertainty exists as to whether or not Wave’s businessmodel is viable.

**We may be unable toraise the $11.5 million of additional cash flow, which is necessary to continueas a going concern for the next twelve months.**

Based upon our current expense forecast, assumingcurrent revenue levels, we estimate that our current available capital issufficient to fund Wave through mid-May 2007. In addition to our effortsto begin to generate revenue sufficient to fund our operations, or complete oneor more commercial or strategic transactions, Wave is evaluating additionalfinancing options to generate additional capital in order to continue as agoing concern, to capitalize on business opportunities and market conditionsand to insure the continued development of our technology, products andservices. We estimate, based upon our current forecasts, we will need togenerate a minimum of $11.5 million from a combination of revenue growth,commercial or strategic transactions and/or additional financings, to continueas a going concern for the twelve months ended December 31, 2007. Weexpect we will be required to generate a significant portion of this cashthrough additional financings in the form of sales of newly issued securities.We do not know if additional financing will be available or that, if available,it will be available on favorable terms. If we issue additional shares of ourstock, our stockholders’ ownership will be diluted, or the shares issued mayhave rights, preferences or privileges senior to those of our common stock. Inaddition, if we pursue debt financing we may be required to pay interest costs.The failure to generate sufficient cash flow to fund our forecastedexpenditures would require us to reduce our cash burn rate which would in turnimpede our ability to achieve our business objectives. Furthermore, if we arenot successful in generating sufficient cash flow or obtaining additionalfunding, we will be unable to continue our operations, develop or enhance ourproducts, take advantage of future opportunities, respond to competitivepressures and continue as a going concern.

**Our market is inthe early stage of development so we are unable to accurately ascertain thesize and growth potential for revenue in such a market.**

The market for our products and services is stilldeveloping and is continually evolving. As a result, substantial uncertaintyexists with respect to the size of the market for these products and the levelof capital that will be required to meet the evolving technical requirements ofthe marketplace.

Wave’s business model relies on an assumed market oftens of millions of units shipping with built-in security hardware and for Waveto be successful selling its upgraded version of client and server softwareproducts to these users. Because this market remains in the early stage ofdevelopment, there is significant uncertainty with respect to the validity ofthe future size of the market. If the market for computer systems that utilizeour products and services does not grow to the extent necessary for us torealize our business plan, we may not be successful.

As this early stage market develops and evolves,significant capital will likely be required to fund the resources needed tomeet the changing technological demands of the marketplace. There isuncertainty with respect to the level of capital that may be required to meetthese changing technological demands. If the amount of capital resources neededexceeds our ability to obtain such capital, we may not be a viable enterprise.

**Wave is notestablished in the industry so we may not be accepted as a supplier or serviceprovider to the market.**

Wave’s offering represents a highly complexarchitecture designed to solve many of the security issues currently presentwith computer systems, such as identity theft, fraudulent transactions, virusattacks, unauthorized access to restricted networks and other security problemsthat users of computer systems generally encounter. We are uncertain as towhether the marketplace will accept our solution to these 

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security problems. We willnot be successful if the market does not accept the value proposition that weperceive to be present in our products and services.

Although Wave has expended considerable resources indeveloping technology and products that utilize our technology and in businessdevelopment activities in an attempt to drive the development of the hardwaresecurity market, we do not have a track record as a substantial supplier orservice provider to consumers of computer systems. Therefore, uncertaintyremains as to whether we will be accepted as a supplier to the enterprise andconsumer markets, which will likely be necessary for us to be a successfulcommercial enterprise.

**Our products havenot been accepted as industry standards, which may slow their sales growth.**

We believe platforms adopting integrated hardwaresecurity into the PC will become a significant standard feature in the overallPC marketplace. However, our technologies have not been accepted as industrystandards. Standards for trusted computing are still evolving. To besuccessful, we must obtain acceptance of our technologies as industrystandards, modify our products and services to meet whatever industry standardsultimately develop, or adapt our products to be complementary to whatever thesestandards become. If we fail to do any of these, we will not be successful incommercializing our technology; and therefore, we will not generate sales tofund our operations and develop into a self-sustaining, profitable business.

**If we do not keepup with technological changes, our product development and business growth willsuffer.**

Because the market in which we operate ischaracterized by rapidly changing technology, changes in customer requirements,frequent new products, service introductions and enhancements, and emergingindustry standards, our success will depend, among other things, upon ourability to improve our products, develop and introduce new products andservices that keep pace with technological developments, remain compatible withchanging computer system platforms, respond to evolving customer requirementsand achieve market acceptance on a timely and cost effective basis. If we donot identify, develop, manufacture, market and support new products and deploynew services effectively and timely, our business will not grow, our financialresults will suffer, and we may not have the ability to remain in business.

**We are subject torisks relating potential security breaches of our software products.**

Although we have implemented in our products varioussecurity mechanisms, our products and services may nevertheless be vulnerableto break-ins, piracy and similar disruptive problems caused by Internet users.Any of these disruptions would harm our business. Advances in computercapabilities, new discoveries in the field of security, or other developmentsmay result in a compromise or breach of the technology we use to protectproducts and information in electronic form. Computer break-ins and otherdisruptions would jeopardize the security of information stored in andtransmitted through the computer systems of users of our products, which mayresult in significant liability to us and may also deter potential customers.

A party who is able to circumvent our securitymeasures could misappropriate proprietary electronic content or causeinterruptions in our operations and those of our strategic partners. We may berequired to expend significant capital and other resources to protect againstsecurity breaches or to alleviate problems caused by breaches. Our attempts toimplement contracts that limit our liability to our customers, includingliability arising from a failure of security features contained in our productsand services, may not be enforceable. We currently do not have productliability insurance to protect against these risks.

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**Competition andcompeting technologies may render some or all of our products non-competitiveor obsolete.**

An increasing number of market entrants haveintroduced or are developing products and services that compete with Wave’s.Our competitors may be able to develop products and services that are moreattractive to customers than our products and services. Many of our competitorsand potential competitors have substantially greater financial, technical andmarketing resources than we have. Also, many current and potential competitorshave greater name recognition and larger customer bases that could be leveragedto enable them to gain market share or product acceptance to our detriment.Wave’s potential competitors include security solutions providers such as RSASecurity, Inc., Symantec, Computer Associates, Verisign, Inc.,Entrust, Inc., Ultimaco, Safenet and major systems integrators such asIBM, HP and EDS. In addition, Wave competes with other client securityapplications companies that are developing trusted computing applications,including Softex, Phoenix, Infineon and Microsoft.

Other companies have developed or are developingtechnologies that are, or may become, the basis for competitive products in thefield of security and electronic content distribution. Some of thosetechnologies may have an approach or means of processing that is entirelydifferent from ours. Existing or new competitors may develop products that aresuperior to ours or that otherwise achieve greater market acceptance than ours.Due to Wave’s early stage, and lower relative name recognition compared to manyof our competitors and potential competitors, our competitive position in themarketplace is vulnerable.

**We have a highdependence on relationships with strategic partners that must continue or ourability to successfully produce and market our products will be impaired.**

Due in large part to Wave’s early stage and lower namerecognition, we depend upon strategic partners such as large, well establishedpersonal computer and semiconductor manufacturers and computer systems’integrators to adopt our products and services within the Trusted Computingmarketplace. These companies may choose not to use our products and coulddevelop or market products or technologies that compete directly with us. Wecannot predict whether these third parties will commit the resources necessaryto achieve broad-based commercial acceptance of our technology. Any delay inthe use of our technology by these partners could impede or prohibit thecommercial acceptance of our products. Although we have established somebinding commitments from some of our strategic partners, there can be noassurance that we will be able to enter into additional definitive agreementsor that the terms of such agreements will be satisfactory. It will be necessaryfor Wave to expand upon our current business relationships with our partners,or form new ones, in order to sell more products and services for Wave tobecome a viable, self-sufficient enterprise.

**Product defects ordevelopment delays may limit our ability to sell our products.**

We may experience delays in the development of our newproducts and services and the added features and functionality to our existingproducts and services that our customers and prospective customers aredemanding. If we are unable to successfully develop products that contain thefeatures and functionality being demanded by these customers and prospectivecustomers in a timely manner, we may lose business to our competitors. Inaddition, despite testing by us and potential customers, it is possible thatour products may nevertheless contain defects. Development delays or defectscould have a material adverse effect on our business if such defects and delaysresult in our inability to meet the market’s demand.

**If we lose our keypersonnel, or fail to attract and retain additional personnel, we will beunable to continue to develop our products and technology.**

We believe that our future success depends upon thecontinued service of our key technical and management personnel and on ourability to attract and retain highly skilled technical, management, sales andmarketing personnel. Our industry is characterized by a high level of employeemobility and aggressive 

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recruiting of skilledpersonnel. There can be no assurance that our current employees will continueto work for us or that we will be able to hire any additional personnelnecessary for our growth. Our future success also depends on our continuingability to identify, hire, train and retain other highly qualified technicaland managerial personnel. Competition for these employees can be intense. Wemay not be able to attract, assimilate or retain qualified technical andmanagerial personnel in the future, and the failure of us to do so would have amaterial adverse effect on our business.

**We have a limitedability to protect our intellectual property rights and others could infringeon or misappropriate our proprietary rights.**

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 and topreserve our trade secrets. We cannot assure you that any patent owned orlicensed by us will provide us with adequate protection or will not bechallenged, invalidated, infringed or circumvented.

We rely on trade secrets and proprietary know-how,which we protect, in part, by confidentiality agreements with our employees andcontract partners. However, our confidentiality agreements may be breached, andwe may not have adequate remedies for these breaches. Our trade secrets mayalso otherwise become known or be independently discovered by competitors. Wealso rely on intellectual property laws to prevent the unauthorized duplicationof our software and hardware products. While we have and will continue toprotect our software and our patented technology, intellectual property lawsmay not adequately protect our technology. We have registered trademark andservice mark registrations with the United States Patent and Trademark Officefor the marks WaveMeter and WaveNet, EMBASSY, Second Shift (the Wave jugglerlogo), WaveDirect and Charity Wave. Wave intends to apply for additional nameand logo marks in the United States and foreign jurisdictions, as appropriate,but we cannot assure you that federal registration of any of these trademarkswill be granted.

**Regulation ofinternational transactions may limit our ability to sell our products inforeign markets.**

Most of our software products are controlled undervarious United States export control laws and regulations and may requireexport licenses for certain exports of the products and components outside ofthe United States and Canada. With respect to our EMBASSY Trust Suite andEMBASSY Trust Server software applications, we have applied for and receivedexport classifications that allow us to export our products, without a licenseand with no restrictions, to any country throughout the world with theexception of Cuba, Iran, Iraq, Libya, North Korea, Sudan and Syria.

We believe the export classifications that we havereceived for our software products allow us to sell our productsinternationally in an effective, competitively advantageous manner.Enhancements to existing products may, and new products will be subject toreviews by the BXA to determine what export classification they will receive.Some of our partners demand that our products be allowed to be exported withoutrestrictions and/or reporting requirements. Current export regulations have, inpart, allowed us to receive the desired classification without undue cost oreffort. However, the export regulations may be modified at any time. Currently,we are allowed to export the products for which we’ve received classification,in an unrestricted manner without a license. However, modifications to theexport regulations could prevent us from exporting our existing and futureproducts in an unrestricted manner without a license. Such modifications couldalso make it 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.

In addition, import and export regulations of encryption/decryptiontechnology vary from country to country. We may be subject to differentstatutory or regulatory controls in different foreign jurisdictions, and assuch, our technology may not be permitted in these foreign jurisdictions.Violations of foreign 

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regulations or regulationof international transactions could prevent us from being able to sell ourproducts in international markets. Our success depends in large part to havingaccess to international markets.

**Our stock price isvolatile.**

The price of ourClass A common stock has been and likely will continue to be subject towide fluctuations in response to a number of events and factors, such as:

·       quarterlyvariations in operating results;

·       announcementsof technological innovations, new products, acquisitions, capital commitmentsor strategic alliances by us or our competitors;

·       theoperating and stock price performance of other companies that investors maydeem comparable to us; and

·       newsreports relating to trends in our markets.

In addition, the stock market in general, and themarket prices for technology-related companies in particular, have experiencedsignificant price and volume fluctuations. These broad market fluctuations mayadversely affect the market price of our Class A common stock or any ofour other securities for which a market develops, regardless of our operatingperformance. Securities class action litigation has often been institutedagainst companies that have experienced periods of volatility in the marketprice for their securities. It is possible that we could become the target ofadditional litigation of this kind that would require substantial managementattention and expense. The diversion of management’s attention and capitalresources could have a material adverse affect on our business. In addition,any negative publicity or perceived negative publicity of any such litigationcould have an adverse impact on our business.

**We may be subject to conflicts of interest that couldadversely slow our corporate governance process.**

Our Board of Directors does not include anyrepresentatives of our strategic partners. However, our Board of Directors hasincluded in the past, and may include in the future, representatives of ourstrategic partners. It is possible that those corporations may be competingagainst us, or each other, directly or indirectly. A director who alsorepresents another company may voluntarily abstain from voting on matters,where there could be conflicts of interest. Even if such a director doesabstain, his presence on the Board could affect the process or the results ofthe Board’s deliberations. We have adopted no policies or procedures to reduceor avoid such conflicts. If such conflicts of interest arise, they may have amaterially adverse effect on our business.

**Governmentalregulation may slow our growth and decrease our profitability.**

There are currently few laws or regulations that applydirectly to the Internet. Because our business is dependent in significantrespect on the Internet, the adoption of new local, state, national orinternational laws or regulations may decrease the growth of Internet usage orthe acceptance of Internet commerce, which could, in turn, decrease the demandfor our products and services and increase our costs or otherwise have amaterial adverse effect on our business.

Tax authorities in a number of states are currentlyreviewing the appropriate tax treatment of companies engaged in Internetcommerce. New state tax regulations may subject us to additional state sales,use and income taxes.

**If we make any acquisitions, we will incur a varietyof costs and may never realize the anticipated benefits.**

If appropriate opportunities become available, we mayattempt to acquire businesses, technologies, services or products that webelieve are a strategic fit with our business. We currently have no commitmentsor agreements with respect to any material acquisitions. If we do undertake anytransaction 

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of this sort, the processof integrating an acquired business, technology, service or product may resultin operating difficulties and expenditures and may absorb significantmanagement attention that would otherwise be available for ongoing developmentof our business. Moreover, we may never realize the anticipated benefits of anyacquisition. Future acquisitions could result in potentially dilutive issuancesof equity securities, the incurrence of debt, contingent liabilities and/oramortization expenses related to certain intangible assets and increasedoperating expenses, which could adversely affect our results of operations andfinancial condition.

**A formalinvestigation by the Securities and Exchange Commission could affect ouroperations.**

The SEC has commenced aformal investigation into certain matters relating to Wave. The SECinvestigative order relates to certain public statements made by Wave duringand around August 2003, as well as certain trading in Wave’s securitiesduring such time. The SEC has not concluded that there has been any wrongdoingand Wave is cooperating fully with the SEC on this matter. An adverseresolution of the investigation may have a negative effect on our financialcondition and operating results.

**Item 1B.**               UnresolvedStaff Comments

**None.**

**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.We believe our office facilities are suitable and adequate for our business asit is presently conducted.

| ** **      | ** ** | ** ** | ** ** | **Annual**       | ** ** | ** **          | ** ** |
|-----------------|------------|------------|------------|------------------|------------|---------------------|------------|
| **Facility**    | ** ** | ** ** | ** ** | **Sq. Ft.** | ** ** | **Lease Cost** | ** ** | **Lease Expires** | ** ** |
| Lee, MA         |       | 13,473     |       |             | $          | 143,374             |       |   |   | Jul.  2010 |   |   |
| Princeton, NJ   |       | 7,128      |       |             | 160,931    |                |       |   | Dec.  2009 |   |   |
| Cupertino, CA   |       | 14,573     |       |             | 416,592    |                |       |   | Aug.  2010 |   |   |
| New York, NY    |       | 2,100      |       |             | 93,600     |                |       |   | Oct.  2007 |   |   |
| Orvault, France |       | 1,000      |       |             | 67,260     |                |       |   | Sept. 2007 |   |   |
|                 |            |            |            |                  |            |                     |            |  |  |  |  |  |  |  |

 

**Item 3.**                        LegalProceedings

*Securities andExchange Commission Investigation*

On December 17, 2003,Wave received an Order by the Securities and Exchange Commission (the“Commission”) regarding a formal investigation. The focus of this investigationis on certain public statements made by Wave during and aroundAugust 2003, as well as certain trading in Wave’s securities during suchtime. Wave is cooperating fully with the Commission in this investigation. Waveis unable to predict the outcome of this investigation at this time.

*PurportedClass Actions*

Wave, its Chief Financial Officer and Chief ExecutiveOfficer were named as defendants in a consolidated, purported securities classaction in the United States District Court for the District of Massachusetts,.Brumbaugh et al. v. Wave Systems Corp. et al., Civ. No. 04-30022 (D.Mass.) (MAP).

The purported class action was filed by allegedpurchasers of Wave’s Class A Common Stock during the purported classperiod July 31, 2003 through February 2, 2004. The complaint claimedthat Wave and the named individuals violated Section 10(b) of theSecurities Exchange Act of 1934 (the “1934 Act”), Rule 10(b)-5promulgated thereunder and Section 20(a) of the 1934 Act by publiclydisseminating 

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materially false andmisleading statements, relating to Wave’s agreements with Intel and IBM. Thecomplaint did not specify the amount of alleged damages plaintiffs sought torecover.

In January 2006, the Court granted in part anddenied in part defendants’ motion to dismiss. The Court dismissed two but letstand seven alleged misrepresentations or omissions. This was not a finding offault or liability, it was a decision not entirely to dismiss plaintiffs’pleading.

Without admittingliability, the defendants recently reached a mediated settlement in principleof all claims asserted by the plaintiffs. Wave’s insurers agreed to pay theplaintiffs a total of $1,750,000 in exchange for the dismissal with prejudiceand release of the claims against all defendants. On January 10, 2007, the Court conducteda settlement fairness hearing resulting in an Order and Final Judgmentapproving the settlement and dismissing the action with prejudice.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders

None.

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**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities

On July 24, 2006, ourBoard of Directors approved a reverse stock split of our common stock at aratio of one-for-three, causing each three outstanding shares of Class Acommon stock and Class B common stock to convert automatically into oneshare of Class A common stock or Class B common stock, respectively.The par value of Class A common stock and Class B common stockremains $0.01 per share. The reverse split became effective at the close ofbusiness on July 25, 2006. In lieu of fractional shares, stockholdersreceived a cash payment based on an average trading price of the Class Acommon stock prior to the effectiveness of the reverse split. Except asotherwise noted, all references to common share and per common share amounts(including warrant shares, shares reserved for issuance and applicable exerciseprices) for all periods presented have been retroactively restated to reflectthis reverse split.

*MarketInformation & Dividends*

TheClass A Common Stock trades on the Nasdaq National Market under the symbol“WAVX”. The following table sets forth, for the periods indicated, the high andlow sales prices per share for the Class A Common Stock. There is noestablished trading market for our Class B Common Stock.

| ** **                         | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------|------------|----------|------------|---------|------------|
| Year Ended  December 31, 2006 |       |     |       |    |       |
| First Quarter                      |       | $        | 2.31       |    | 1.50       |   |
| Second Quarter                     |       | 3.03     |       | 1.80    |       |
| Third Quarter                      |       | 2.50     |       | 1.21    |       |
| Fourth Quarter                     |       | 3.85     |       | 1.67    |       |
| Year Ended  December 31, 2005 |       |     |       |    |       |
| First Quarter                      |       | $        | 3.81       |    | $          | 2.64 |   |
| Second Quarter                     |       | 2.97     |       | 1.74    |       |
| Third Quarter                      |       | 4.05     |       | 2.28    |       |
| Fourth Quarter                     |       | 2.94     |       | 1.95    |       |
|                                    |            |          |            |         |            |  |  |

 

As of March 1, 2007 there were approximately23,000 holders of our Class A Common Stock. As of such date, there were 13holders of our Class B Common Stock.

On March 1, 2007 the last sale price reported onthe Nasdaq National Market for the Class A Common Stock was $2.35

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.

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*Performance Graph*

The following line graphcompares the Company’s cumulative total return to stockholders with thecumulative total return of the Nasdaq Market Value Index and the ComputerRelated Services SIC Code Index from December 31, 2001 throughDecember 31, 2006. These comparisons assume the investment of $100 onDecember 31, 2001 and the reinvestment of dividends. The stock performanceon the graph is not necessarily indicative of future stock price performance.

**Wave Systems Corp.Comparison of Cumulative Total Return to Stockholders***December 31,2001 through December 31, 2006*

| ** ** | ** ** | **Wave Systems** | ** ** | **Peer Group  (SIC Code 7379)** | ** ** | **NASDAQ Market** | ** ** |
|------------|------------|-----------------------|------------|------------------------------------------------|------------|------------------------|------------|
| 12/31/01   |       |                  | $          | 100.00                                         |       |                   |       | $ | 100.00 |   |   |   | $ | 100.00 |   |   |
| 12/31/02   |       |                  | $          | 59.38                                          |       |                   |       | $ | 71.76 |   |   |   | $ | 69.75 |   |   |
| 12/31/03   |       |                  | $          | 73.21                                          |       |                   |       | $ | 125.03 |   |   |   | $ | 104.88 |   |   |
| 12/31/04   |       |                  | $          | 51.07                                          |       |                   |       | $ | 131.10 |   |   |   | $ | 113.70 |   |   |
| 12/31/05   |       |                  | $          | 30.36                                          |       |                   |       | $ | 142.18 |   |   |   | $ | 116.19 |   |   |
| 12/31/06   |       |                  | $          | 37.65                                          |       |                   |       | $ | 190.17 |   |   |   | $ | 128.12 |   |   |

 

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*SecuritiesAuthorized for Issuance Under Equity Compensation Plans*

Thefollowing pertains to Wave’s equity compensation plans as of December 31,2006:

| **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                |       |       | 4,840,035  |                                                                                                                                                  |       |                                                                                                                  | $          | 8.95                                                                                                                                                                                                             |       |   |   | 1,930,265 |   |   |
| Wave equity  compensation plans not approved by security holders       |       |       | 53,122     |                                                                                                                                                  |       |                                                                                                                  | 5.44       |                                                                                                                                                                                                             |       |   | — |   |   |
| Total Company plans                                                    |       |       | 4,893,157  |                                                                                                                                                  |       |                                                                                                                  | $          | 8.92                                                                                                                                                                                                             |       |   |   | 1,930,265 |   |   |
| Wavexpress equity  compensation plans not approved by security holders |       |       | 637,163    |                                                                                                                                                  |       |                                                                                                                  | $          | 1.23                                                                                                                                                                                                             |       |   |   | 1,835,060 |   |   |

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*                    Sharesremaining available for future issuance under Wave equity compensation plans arecomprised of 24,018 shares of the N*ABLE Technologies Incorporated 1997 EquityIncentive Plan, 1,072,697 shares of the 1994 Employee Stock Option Plan, 75,107shares of the 1996 Performance Stock Option Plan, 81,572 shares of the 1994Non-Employee Directors Stock Option Plan and 676,871 shares of the 2004Employee Stock Purchase Plan.

Equity compensation plans not approved by securityholders are comprised of the following:

In connection with an agreement that the Companyentered into with nClose, Inc., an outside software development firm, onJanuary 2, 2004 the Company issued a warrant to purchase 10,000 shares ofClass A Common Stock at an exercise price of $3.00 per share, pursuant toan individual compensation plan with nClose. Also, in connection with the sameagreement, on April 30, 2004 an additional warrant was issued tonClose, Inc. to purchase 11,667 shares of Class A Common Stock at anexercise price of $3.00 per share. The warrants are currently exercisable andexpire on January 2, 2009 and April 30, 2009, respectively. Noadditional warrants are required to be granted pursuant to the individual compensationplan for nClose.

In connection with an agreement that Wave entered intowith an outside sales representative, in 2003 Wave issued warrants to purchase14,788 shares of Class A Common Stock at prices ranging from $2.85 to$4.35 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 throughApril 30, 2013.

In connection with a software development agreementthat Wave entered into with Archon Technologies, Inc. (“Archon”), Waveissued to Archon a warrant to purchase 16,667 shares of Class A CommonStock at $10.44 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.

Wavexpress issues equitycompensation to certain of its employees pursuant to the Wavexpress 1999 StockIncentive Plan.

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**Item 6.***                       *SelectedFinancial Data

**ConsolidatedStatement of Operations Data**

| ** **                                                                                    | ** ** | **For the year-ended December 31,** | ** **  |
|-----------------------------------------------------------------------------------------------|------------|-------------------------------------|-------------|
| ** **                                                                                    | ** ** | **2006**                            | ** **  | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net Revenues                                                                                  |       | $                                   | 3,116,381   |   | $ | 1,018,464 |   | $ | 209,311 |   | $ | 189,363 |   | $ | 446,588 |   |
| Cost of Sales                                                                                 |       | 983,671                             |        | 726,853 |   | 151,704 |   | 55,179 |   | 202,208 |   |
| Gross Profit                                                                                  |       | 2,132,710                           |        | 291,611 |   | 57,607 |   | 134,184 |   | 244,380 |   |
| Operating  expenses:                                                                          |       |                                |        |   |   |   |   |   |   |   |   |
| Selling, general and administrative                                                           |       | 12,598,389                          |        | 11,560,039 |   | 12,255,427 |   | 12,698,682 |   | 19,188,046 |   |
| Research and development                                                                      |       | 8,486,368                           |        | 6,937,618 |   | 6,852,754 |   | 7,384,708 |   | 12,009,713 |   |
| Restructuring and other special charges                                                       |       | —                              |        | — |   | — |   | — |   | 726,280 |   |
| Inventory provision                                                                           |       | —                              |        | — |   | — |   | 1,114,442 |   | — |   |
| Write-off of intangible and other impaired assets                                             |       | —                              |        | — |   | 301,366 |   | — |   | 1,571,031 |   |
|                                                                                          |       | 21,084,757                          |        | 18,497,657 |   | 19,409,547 |   | 21,197,832 |   | 33,495,070 |   |
| Other income (expense):                                                                       |       |                                |        |   |   |   |   |   |   |   |   |
| Loss on other than temporary decline in equity  securities                                    |       | —                              |        | — |   | — |   | — |   | (11,513,099 | ) |
| Liquidated damages                                                                            |       | —                              |        | — |   | — |   | (155,716 | ) | — |   |
| Gain on decrease in value of warrant liability                                                |       | 2,794                               |        | 490,334 |   | 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                                                         |       | —                              |        | 80,971 |   | 4,330,248 |   | 234,759 |   | — |   |
| Net interest and other income (expense)                                                       |       | 163,980                             |        | 72,279 |   | 24,931 |   | 127,192 |   | 477,902 |   |
| Total Other Income / (expense)                                                                |       | 166,774                             |        | 643,584 |   | 4,853,902 |   | 1,468,850 |   | (10,216,715 | ) |
| Net loss                                                                                      |       | (18,785,273                         | )           | (17,562,462 | ) | (14,498,038 | ) | (19,594,798 | ) | (43,467,405 | ) |
| Accrued dividends on preferred stock (including  $5,485,000 of accretion of discount in 2003) |       | —                              |        | — |   | — |   | 5,697,518 |   | — |   |
| Net loss to common stockholders                                                               |       | $                                   | (18,785,273 | ) | $ | (17,562,462 | ) | $ | (14,498,038 | ) | $ | (25,292,316 | ) | $ | (43,467,405 | ) |
| Weighted average number of common shares outstanding  during the period                       |       | 36,735,059                          |        | 27,726,221 |   | 23,013,554 |   | 18,629,128 |   | 17,045,183 |   |
| Loss per common share-basic and  diluted                                                      |       | $                                   | (0.51       | ) | $ | (0.63 | ) | $ | (0.63 | ) | $ | (1.36 | ) | $ | (2.55 | ) |
| Cash dividends  declared per common share                                                     |       | -0-                                 |        | -0- |   | -0- |   | -0- |   | -0- |   |

 

**ConsolidatedBalance Sheet Data**

| ** **                                    | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                    | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Working capital                               |       | $                                     | 5,369,273  |   | $ | (1,112,413 | ) | $ | 3,549,095 |   | $ | 12,406,861 |   | $ | 8,754,620 |   |
| Total assets                                  |       | 9,359,677                             |       | 3,429,765 |   | 8,454,582 |   | 18,160,430 |   | 18,209,372 |   |
| Long-term  liabilities                        |       | —                                |       | 2,794 |   | 493,128 |   | 991,851 |   | — |   |
| Total liabilities                             |       | 3,439,408                             |       | 3,595,574 |   | 3,744,382 |   | 4,145,794 |   | 3,667,533 |   |
| Total stockholders’  equity (deficiency) |       | $                                     | 5,920,269  |   | $ | (165,809 | ) | $ | 4,710,200 |   | $ | 14,014,636 |   | $ | 14,541,839 |   |

 

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

On July 24, 2006, ourBoard of Directors approved a reverse stock split of our common stock at aratio of one-for-three, causing each three outstanding shares of Class Acommon stock and Class B common stock to convert automatically into oneshare of Class A common stock or Class B common stock, respectively. Thepar value of Class A common stock and Class B common stock remains$0.01 per share. The reverse split became effective at the close of business onJuly 25, 2006. In lieu of fractional shares, stockholders received a cashpayment based on an average trading price of the Class A common stockprior to the effectiveness of the reverse split. Stockholders’ equity has beenrestated to give retroactive recognition to the reverse split for all periodspresented by reclassifying the excess par value resulting from the reducednumber of shares from common stock to paid-in capital. Except as otherwisenoted, all references to common share and per common share amounts (includingwarrant shares, shares reserved for issuance and applicable exercise prices)for all periods presented have been retroactively restated to reflect thisreverse split.

**Overview**

In 2005 and 2006, Wave’s management focused itsactivities and resources on the continued development and marketing of theTCG-compliant software products known as the EMBASSY Trust Suite andEMBASSY Trust Server Applications. In 2003, these were the first commercialproducts introduced to the marketplace as specifically designed to support thefirst emerging products that included TPMs. These are products designedand built around the TCG specifications, known as Trusted Platforms, which arebeing adopted into the Information security services marketplace. Throughout 2005 and 2006, Wave continued todevelop enhancements to its existing products and has developed additionalproducts in support of the emerging TCG-specifications.

As the market for TPM-enabled products developed, withcomputing devices being shipped in volume by leaders in the PC industry, Wavehas developed its products to support security hardware, based on the TCGspecifications. Wave’s products are unique because they support cross platforminteroperability for the currently available TPM chips from Winbond ElectronicsCorp. (“WEC”), Broadcom, Atmel, Infineon and ST Microsystems, and have beencertified and/or approved for usage on TPM-based platforms shipped by Dell,Intel, Gateway, IBM and HP.

Wave is devotingits resources to capitalize on the opportunities, and overcome the specificchallenges, presented by this developing market as it continues to pursue astrategy of educating the marketplace on the benefits that trusted computinghas to offer, while continuing to develop the basic software applicationsdesigned to enable this emerging technology. The market trends andopportunities that management focused the company’s activities during the yearended December 31, 2006 included the following:

·       Astudy by Infonetics in early 2006 forecasts sharp rises in end-point security.The study predicts that in the coming years, endpoint security will require arange of new types of software and hardware to be effective, includingendpoint-security appliances and improved network-infrastructure equipment.Accordingly, the study forecasts the overall network access control (NAC)enforcement market will grow to $3.9 billion by 2008, up from just $323 millionin 2005, an 1101% increase. More information is available from the ITCompliance Institute.

·       Adoptionof TPMs and Trusted Computing technology is also growing—according to industryanalyst, IDC, shipments of TPMs are expected to grow from under 25 millionunits in 2005 to over 250 million units in 2010.

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

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·       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.

·       Inits *Windows Vista Logo Program for Systems, Version 3.0,Draft Revision 0.7*, Microsoft has required TPM version 1.2 in itsdraft operating system hardware requirements specification for logo compliancefor “Gold” level business PCs. Wave believes that a significant percentage ofthe approximately 150-million unit PC market could include TPMs by January 2007,which is Microsoft’s launch date for Vista.

·       Theemergence of additional trusted PC components in the marketplace, such asSeagate’s Momentus 5400 Full Disc Encryption drive which was announced in Q3 of2005, represent additional opportunities for Wave’s products to support andintegrate these devices with the TPM elements in the PC.

·       TheU.S. Army, in the new Consolidated Buy-2 (CB2) Desktop and Notebookminimum specifications for Army customers as published by the Army SmallComputer Program, specifies the requirement for desktop and laptop personalcomputers to be equipped with new open security chip hardware called theTrusted Platform Module (TPM).

In pursuing theseopportunities, we recognize many significant challenges that must 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.

·       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 2006).

·       Ahighly competitive landscape that includes competitors and potentialcompetitors having substantially greater name recognition, customer bases, andfinancial, technical, and marketing resources than do we.

As more PC and chip OEMs have begun introducing theirTrusted Platform offerings, management has focused on entering into licensingcontracts pursuant to which the OEM licenses our applications and distributesthem as part of their offering, paying Wave a royalty for each unit shipped.Wave currently has signed such bundling agreements with seven separate OEMpartners. Revenue recognized on these contracts for the years ended December 31,2006 and 2005 was approximately $2,598,000 and $757,000, respectively.

In addition, we have sought to develop our products sothat they operate on all of the Trusted Platforms of the major chip and PC OEMscurrently shipping product in the marketplace. Our applications 

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have been approved to workwith the Trusted Platforms of Dell, Intel, Gateway, IBM, HP, WEC, Atmel, Broadcom, Infineon,ST Microsystems and others. 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.

In February, 2005, Dell Computers Inc began offeringWave’s ETS Software as an option for purchase on select models through theirwebsite at Dell.com and in December 2005 Wave signed a distributionlicense agreement with Dell pursuant to which Dell is permitted to ship aversion of Wave’s EMBASSY Trust Suite software with select Dell PC models.Wave is paid royalties on each unit that ships with Wave software; and a fullyfeatured version of ETS is also being offered to Dell customers as an upgradewhich generates additional license revenue for Wave when a customer elects topurchase the upgrade. Wave hopes to capitalize on this association with Dellproducts and the wider distribution of TPM-equipped personal computers that aDell TPM offering represents. However, there are no minimum royalty or shippedquantity requirements under our arrangement with Dell.

Management is also focused on developing the clientand server-side applications and tools that will enable enterprises to managean IT infrastructure that relies on products built using TCG specifications. Waveis devoting 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 license agreements in 2005 and2006 for Wave’s TCG-Enabled Toolkit, EAS and EKMS.

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. Asan example of our channel partner relationship strategy, in July 2006 Wavesigned a reseller agreement with NTT Data Corporation (“NTT”), a Japaneseinformation technology systems integrator, pursuant to which NTT is authorizedto resell Wave’s products and solutions and to provide support services to NTTscustomers in an effort to introduce those products and solutions to theJapanese enterprise market.

Management is also focused on opportunities for itseTMS product suite to provide digital signing and document management solutionsto the financial services and other vertical markets in which there is a clearand identifiable value proposition in implementing these solutions. Although wehave met significant implementation challenges and long sales cycles with thiseffort, we have also entered into contracts with a la mode, inc. in the realestate industry in 2004 and with Efficient Forms, LLC in the financial servicessector in 2005 and 2006. We continue to pursue additional opportunities for theeTMS product line.

Wavexpress is focused onbuilding a sustainable revenue stream by establishing partnerships withbranded content providers to provide primarily advertising supported videoentertainment services. Wavexpress’ TVTonic service offers hundreds of videofeeds, a significant number of which are signed to revenue sharing agreementsfor ad placements. The service is designed to support any video channeldistributed via RSS. RSS is the standard format for blogs and podcasts and isbeing increasingly used for open video distribution on the Internet. TVTonic ispromoted by Microsoft with all installations of their Media Center software. MediaCenter is standard with Microsoft Vista Premium and Vista Ultimate, as well asXP Media Center Edition. In addition, Wavexpress is extending its technology sothat its subscriber management system can leverage the added security of a TPMand is preparing back-office systems for standalone deployment into enterpriseinstallations. Management plans to devote ongoing development resources towardenhancing the TVTonic client software and services.

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*Operating ExpenseTrends*

While research and development expenses increased from2005 to 2006 as shown in Item I—business; selling, general and administrativeexpenses (“SG&A”) have been trending downward or have flattened over thethree years ended December 31, 2006, net of allocated non-cash, share-basedcompensation expenses incurred during 2006 in accordance with SFAS 123(R). Forthe years ended December 31, 2006, 2005 and 2004, we have incurredapproximately $12.6 million, $11.6 million and $12.3 million, in SG&Aexpenses, respectively. Non-cash, share-based compensation expenses allocatedto SG&A for the year ended December 31, 2006 were approximately $1.1million. This expense was not incurred during the years ended December 31,2005 and 2004 since Wave did not adopt SFAS 123(R) until its effective dateof January 1, 2006.

The activities supported by these expenditures includebusiness development, sales, marketing (including product management),corporate communications and public relations, information technology andmanagement information systems, human resources, accounting, executivemanagement, corporate governance and general administrative functions.

Given the early stage nature of the****markets for products that use our technology, we haveexpended and 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 2006, withresearch and development expected to increase compared to 2006. (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 AccountingPolicies**

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 assets and liabilities and thedisclosure of contingent assets and liabilities at the date of the financialstatements, as well as the reported revenues and expenses during the reportingperiods. On an ongoing basis, management evaluates its estimates and judgments,including those related to revenue recognition, accounts receivable reserves,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.

*Researchand Development and Software Development Costs—**Research*anddevelopment 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 isestablished and the product has achieved commercial marketability, alldevelopment costs should be 

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capitalized until theproduct is available for general release to customers. We considertechnological feasibility to be established upon completion of a detail programdesign, or in the absence of a detail program design, upon completion of aworking model of the software as defined in SFAS No. 86. Judgment isrequired in determining when the technological feasibility of a product isestablished, if the product has achieved commercial marketability and inestimating the life of the product for which the capitalized costs will beamortized.

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

Wave follows theprovisions of statement of position SOP 97-2, *SoftwareRevenue Recognition* as amended by SOP 98-9, Modification ofSOP 97-2, *Software Revenue Recognition, with Respectto Certain Transactions*. Generally, Wave recognizes revenue when itis realized or realizable and earned. Wave considers revenue realized orrealizable and earned when persuasive evidence of an arrangement exists,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*

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 customers rights to any future upgrades at no additionalcharge or future maintenance that is provided within the overall price. Therevenue that is deferred for any contract element is recognized when all of therevenue recognition criteria have been met for that element.

Prepaid royalty feesreceived pursuant to distribution software licenses with OEMs in which Waveearns a royalty, based upon units shipped by the OEM to end customers, aredeferred when received, and recognized as revenue as units are shipped by theOEM.

*SERVICES*

Revenue from time and material service contracts isrecognized as the services are provided. Revenue from fixed price, long-termservice or development contracts is recognized over the contract term based onthe percentage of services that are provided during the period compared withthe total estimated services to be provided over the entire contract. Losses onfixed price contracts are recognized during the period in which the loss firstbecomes apparent. Payment terms vary by contract.

*Share-basedCompensation**—*On January 1,2006, Wave adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment,” (“SFAS No. 123(R)”), which requires themeasurement and recognition of compensation expense for all stock-based paymentawards made to employees and directors including employee stock options andemployee stock purchases based on estimated fair values. In March 2005,the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107

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(“SAB 107”) relatingto SFAS No. 123(R). The Company has applied the provisions of SAB 107 inits adoption of SFAS No. 123(R).

SFAS No. 123(R) requires companies toestimate the fair value of stock-based payment awards on the date of grantusing an option-pricing model. The value of the portion of the award that isultimately expected to vest is recognized as expense over the requisite serviceperiods in the Company’s consolidated statement of operations. SFAS No. 123(R) supersedesWave’s previous accounting under the provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation.” As permitted by SFAS No. 123, Wave measuredcompensation cost for options granted prior to January 1, 2006, inaccordance with Accounting Principles Board Opinion (APB) No. 25, “Accountingfor Stock Issued to Employees” and related interpretations. Accordingly, noaccounting recognition was given to stock options granted at fair market valueuntil they were exercised. Upon exercise, net proceeds, including tax benefitsrealized, were credited to equity.

Wave adopted SFAS No. 123(R) usingthe modified prospective transition method, which requires the application ofthe accounting standard as of January 1, 2006. In accordance with themodified prospective transition method, Wave’s consolidated financial statementsfor prior periods have not been restated to reflect, and do not include, theimpact of SFAS No. 123(R).

**Results ofOperations**

*Comparison of theyears ended December 31, 2006 and 2005*

Wave had revenues of $3,116,381 and $1,018,464 for theyear ended December 31, 2006, and 2005, respectively. Licensing revenuesincreased by $1,698,103, due to higher volume of shipments of Wave’s OEMcustomer products for which Wave receives royalty income. Services revenueincreased by $399,814 due to revenue from government time-and-materialscontracts that were signed during the first quarter of 2006, and completed inthe 2nd quarter of 2006.

Thetable below sets forth the components that make up the revenue for the yearended December 31, 2006, and 2005:

| ** **          | ** ** | **2006**         | ** ** | **2005**             | ** ** | **Increase/  (Decrease)** | ** ** | **Change** | ** ** |
|---------------------|------------|------------------|------------|----------------------|------------|---------------------------|------------|------------|------------|
| Licensing           |       | $ 2,672,161 |       | $  974,058 |       | $ 1,698,103          |       |       | 174        | % |   |
| Services            |       | 444,220          |       | 44,406               |       | 399,814                   |       |       | 900        | % |   |
| Total  Net Revenues |       | $ 3,116,381 |       | $ 1,018,464     |       | $ 2,097,917          |       |       | 206        | % |   |

 

Cost of sales for the year ended December 31,2006, was $983,671, compared with $726,853 for the same period in 2005. Theincrease in costs of sales was due primarily to costs associated with theincrease in services revenue during the year ended December 31, 2006versus the prior year.

SG&A expenses for the year ended December 31,2006, were $12,598,389, as compared to $11,560,039 for the comparable period of2005, an increase of approximately 9%. The increase was due mainly to non-cash,share-based compensation expense totaling approximately $953,000 for Wave and$103,000 for Wavexpress that was incurred in the year ended December 31,2006, in accordance with SFAS 123(R). This expense was not incurred in the yearended December 31, 2005, because Wave did not adoptSFAS 123(R) until its effective date of January 1, 2006. Inaddition, trade show and conference expense increased by approximately $81,000due to Wave participating in a greater number of events in 2006 versus 2005.Advertising & outside corporate marketing expenses also increased dueto an increased level of activity in these areas as well. These expenseincreases were offset by lower director & officer liability insurancepremiums incurred by Wave of approximately $64,000 and a decrease in rent andother facilities-related expense of approximately $141,000 resulting fromWavexpress entering into a new, lower cost lease 

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for its headquarters.Included in the SG&A expenses listed above are Wavexpress’ selling, generaland administrative expenses, which were $1,059,405 and $1,096,335 for the yearsended December 31, 2006, and 2005, respectively. This 3% decrease was dueto the reasons set forth above.

The activities supported by SG&A expenses includebusiness development, sales, marketing (including product development andproduct management), corporate communications and public relations, informationtechnology and management information systems, human resources, accounting,executive management, corporate governance and general administrativefunctions. Given the early stage nature of the****marketsfor products that use our technology, we have expended and will continue toexpend considerable resources, in the sales, marketing, business developmentand support activities referred to above that will be necessary for us to besuccessful in developing products and markets for our technology. We expectSG&A expenses to remain approximately at the same level as the yearDecember 31, 2006 for the foreseeable future, although actual expendituresmay vary depending upon the future business needs of Wave.

Research and development expenses for the year endedDecember 31, 2006, were $8,486,368, as compared to $6,937,618 for thecomparable period of 2005, an increase of 22%. This increase was primarilyattributable to increased salaries, fringe and benefit expenditures ofapproximately $1,053,000 associated with salary rate increases and headcountadditions to accommodate additional research and development efforts that wereundertaken since December 31, 2005. In addition, non-cash, share-basedcompensation expense was approximately $408,000 at Wave and $66,000 atWavexpress in connection with the adoption of SFAS 123(R) onJanuary 1, 2006. Wavexpress’ research and development expendituresincluded in the above were approximately $1,343,748 and $1,127,004 for the yearsended December 31, 2006, and 2005, respectively, for an increase of 19%.The increase in Wavexpress R&D expense was due to the share-basedcompensation referred to above and additional consultant & productdevelopment expenses of approximately $102,000 associated with an increase inresearch and development efforts during 2006.

Interest income for the year ended December 31,2006, was $163,980 as compared to $70,779 for the comparable period of 2005.The increase in interest income is primarily attributable to a higher averagebalance in interest bearing cash and an increase in interest rates earned onWave’s money market accounts for the year ended December 31, 2006,compared with the same period in 2005.

Wave sold 259,670 shares of Saflink common stock fortotal proceeds of $336,309, during the year ended December 31, 2005, at anaverage selling price of $1.295 per share, realizing an aggregate gain from thesales of $80,971. Wave did not hold any marketable securities during the yearended December 31, 2006.

For the year ended December 31, 2006, Waverecorded a gain, in connection with the value of the outstanding warrantscontaining net cash settlement features of $2,794, versus a gain of $490,334for the year ended December 31, 2005. These warrants were granted inconnection with a private placement of Class A Common Stock completed onNovember 18, 2003. The liability, calculated using the Black-Scholesoption pricing model, was valued at $2,794 as of December 31, 2005, and $-0-as of December 31, 2006. The gain was primarily the result of the decreasein the quoted closing price on the Nasdaq National Exchange of Wave’sClass A Common Stock from December 31, 2005 to December 31,2006. Because the price of Wave’s Class A Common Stock declined, the fairvalue of the warrant liability decreased as well, resulting in the gain. Thesewarrants expired on November 24, 2006.

Due to the reasons setforth above, our net loss for the year ended December 31, 2006 was$18,785,273 as compared to $17,562,462 for year ended December 31, 2005.

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*Comparison of theyears ended December 31, 2005 and 2004*

Wave had revenues of $1,018,464 and $209,311 for theyears ended December 31, 2005 and 2004, respectively, which were primarilyderived from license contracts in both periods. The increase was the result ofincreased shipments of Wave’s OEM customers’ products that include Wavesoftware, for which Wave is paid royalties.

Thetable below sets forth the components that make up the revenue for the yearsended December 31, 2005 and 2004:

| ** **         | ** ** | **2005** | ** ** | **2004** | ** ** | **Increase/  (Decrease)** | ** ** | **Change** | ** ** |
|--------------------|------------|----------|------------|----------|------------|---------------------------|------------|------------|------------|
| Licensing          |       | $        | 974,058    |     | $          | 183,318                   |       | $          | 790,740    |   |   | 431 | % |   |
| Services           |       | 44,406   |       | 18,833   |       | 25,573                    |       |       | 136        | % |   |
| Hardware Products  |       | —   |       | 7,160    |       | (7,160                    | )          |       | (100       | )% |   |
| Total Net Revenues |       | $        | 1,018,464  |     | $          | 209,311                   |       | $          | 809,153    |   |   | 387 | % |   |

 

Cost of sales for the year ended December 31,2005, was $726,853 compared with $151,704 for the same period in 2004. Theincrease in costs of sales was due primarily to additional amortization ofcapitalized software associated with products licensed during the year endedDecember 31, 2005 versus the prior year. In addition, service andlicensing costs increased resulting from the increase in revenues for theseline items.

SG&A expenses on a consolidated basis for the yearended December 31, 2005 were $11,560,039, as compared to $12,255,427 forthe comparable period of 2004, a decrease of approximately 6%. The decrease wasdue in large part to decreases in salary and benefit costs totalingapproximately $363,000 on a consolidated basis, associated with headcountreductions of four SG&A positions at Wavexpress which were made in thefourth quarter of 2004. In addition, depreciation and amortization expense waslower by approximately $637,000, because amortization that was previouslyincluded in SG&A for the year ended December 31, 2004, related torevenue and was therefore included in cost of sales for the year endedDecember 31, 2005. These expense decreases were offset by increases intravel & entertainment expenses of $107,200 at Wave; due to increasedinternational sales and marketing activities; and increases in bonuses andcommissions of $167,200 in connection with the higher sales volume for the yearended December 31, 2004 versus the prior year. Included in theconsolidated SG&A expense totals listed above are Wavexpress’ SG&Aexpenses, which were $1,096,335 and $1,789,997 for the years endedDecember 31, 2005 and 2004, respectively. This 39% decrease was dueprimarily to decreased salary, benefit, travel and other employee-relatedexpenses which accounted for approximately $481,000 of the decrease in theconsolidated salary and benefit expenses referred to above. In addition,Wavexpress’ facility, broadband and telecommunications expenses were reduced byapproximately $50,000, consultant and professional fees were reduced byapproximately $33,000, depreciation expenses decreased by approximately$43,000, and general office and supplies expenses were reduced by $35,000.

R&D expenses for the year ended December 31,2005 were $6,937,618, as compared to $6,852,754, for year endedDecember 31, 2004, an increase of 1%. This change was primarilyattributable to increased salary, fringe and benefit expenditures ofapproximately $311,000 at Wave where R&D headcount was greater by anaverage of three positions in the year ended December 31, 2005 versus2004. In addition, outside consulting and development expenses increased byapproximately $291,000 at Wave as Wave increased the use of outsourcedengineering services primarily in connection with its eTMS products and services.Wavexpress’ total R&D expenditures included in the above consolidatedR&D expenses were $1,127,004 and $1,657,376, for the year endedDecember 31, 2005 and 2004, respectively, for a decrease of approximately32%. This decrease related primarily to salary and fringe benefit costreductions of 

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approximately $475,000 dueto a reduction in headcount of six positions on average, for the year endedDecember 31, 2006 versus the prior year.

In the year ended December 31, 2004, Wave took acharge of $301,366 to write-off developed software that had been capitalized.The software that was written off was developed for a distribution agreementthat was entered into with NSC, whereby NSC was to distribute it with itstrusted platform model chip. The write-off was the result of the termination ofthe agreement and because the version of the software that was written off wasdiscontinued and superseded by a new version. Consequently, the value of thesoftware became impaired because it had no alternative uses. No such impairmentcharges were incurred in the year ended December 31, 2005. Wave continuesto maintain a license agreement with NSC’s successor, Winbond, whereby Wave ispaid royalties based on Wave intellectual property that is included inWinbond’s chip design.

Interest income for the years ended December 31,2005 was $70,779 as compared to $24,931, for the comparable period of 2004. Theincrease in interest income is primarily attributable to an increase ininterest rates earned on Wave’s money market accounts for the year endedDecember 31, 2005 compared with the same period in 2004.

Wave sold the remaining 259,670 shares of its holdingsof Saflink common stock during the year ended December 31, 2005 for totalproceeds of $336,309, recording a realized gain of $80,971 on the sales. Wavesold 2,507,300 shares of its holdings of SSP Solutions, Inc., common stockand 966,300 shares of Saflink common stock during the year endedDecember 31, 2004, for total proceeds of $6,759,751, recording a realizedgain of $4,330,248 on the sales. (In August 2004, SSP Solutions, Inc.merged with and became a wholly-owned subsidiary of Saflink Corporation.)

For the year ended December 31, 2005, Waverecorded a gain, representing the decrease in the value of the liability foroutstanding warrants containing net cash settlement features, of $490,334,versus a gain of $498,723 for the twelve-month period ended December 31,2004. These warrants were granted in connection with a private placement ofWave’s Class A Common Stock completed on November 18, 2003. Theliability, calculated using the Black-Scholes option pricing model, was valuedat $493,128 as of December 31, 2004, and $2,794 as of December 31,2005. The decrease was primarily the result of the decrease in the quoted closingprice on the Nasdaq National Exchange of Wave’s Class A Common Stock fromDecember 31, 2004 to December 31, 2005. Because the price of Wave’sClass A Common Stock declined, the fair value of the warrant liabilitydecreased as well, resulting in the gain.

Due to the reasons setforth above, our net loss to common stockholders for the year December 31,2005 was $17,562,462 as compared to $14,498,038, for the comparable period of2004.

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**Liquidity andcapital resources**

We have experienced netlosses and negative cash flow from operations since our inception and, as ofDecember 31, 2006, had a deficit accumulated during the development stageof $303,532,099. Total stockholders’ equity as of December 31, 2006 was$5,920,269.

*Sources and Uses ofCash*

At December 31, 2006, we had $7,965,994 in cashand cash equivalents versus $2,006,022 as of December 31, 2005, resultingin a net increase in cash of $5,959,972 for the year ended December 31,2006. The table below shows the year-to-year comparison of the significantelements of cash used in or provided by operating, investing and financingactivities and a reconciliation of each year’s operating results reported inthe statement of operations to the total increase in cash in the year endedDecember 31, 2006 and the total decrease in cash in the two years endedDecember 31, 2005 & 2004.

As shown below, the totalnet change in cash over the last three years has fluctuated significantly froma net cash decrease for the year ended December 31, 2004 of $3,012,393 toa net cash decrease for the year ended December 31, 2005 of $3,799,890 toa net cash increase for the year ended December 31, 2006 of $5,959,972.

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**ConsolidatedStatement of Cash Flow Data**

| ** **                                                                    | ** ** | **For the years ended December 31,** | ** **  |
|-------------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                                    | ** ** | **2006**                                                      | ** **  | **2005** | ** ** | **2004** | ** ** |
| Cash used in operating activities:                                            |       |                                                          |        |   |   |   |   |
| Net loss                                                                      |       | $                                                             | (18,785,273 | ) | $ | (17,562,462 | ) | $ | (14,498,038 | ) |
| Realized gain from the  sale of marketable securities                         |       | —                                                        |        | (80,971 | ) | (4,330,248 | ) |
| Share-based compensation  expense                                             |       | 1,556,042                                                     |        | — |   | — |   |
| Gain on decrease in  value of warrant liability                               |       | (2,794                                                        | )           | (490,334 | ) | (498,723 | ) |
| Write off intangible and  other assets that became impaired                   |       | —                                                        |        | — |   | 301,366 |   |
| Depreciation and  amortization                                                |       | 663,033                                                       |        | 841,729 |   | 854,629 |   |
| Compensation paid in the  form of stock options & warrants           |       | —                                                        |        | 7,294 |   | 80,609 |   |
| Total adjustments to  reconcile net loss to cash used in operating activities |       | 2,216,281                                                     |        | 277,718 |   | (3,592,367 | ) |
| Proceeds from  liquidation of other assets                                    |       | 63,973                                                        |        | 23,935 |   | 93,570 |   |
| Increase in prepaid  expenses and receivables                                 |       | (368,342                                                      | )           | (201,788 | ) | (67,085 | ) |
| (Reduction) increase in  deferred revenue                                     |       | (99,571                                                       | )           | 152,440 |   | 276,968 |   |
| (Reduction) increase in  accounts payable and accrued expenses                |       | (53,801                                                       | )           | 189,086 |   | 63,540 |   |
| Changes in  assets & liabilities                                     |       | (457,741                                                      | )           | 163,673 |   | 366,993 |   |
| Other accrual to cash  adjustments, net                                       |       | —                                                        |        | — |   | (31,480 | ) |
| Net cash used in  operating activities                                        |       | (17,026,733                                                   | )           | (17,121,071 | ) | (17,754,892 | ) |
| Cash flows from investing activities:                                         |       |                                                          |        |   |   |   |   |
| Disbursements for  capital expenditures                                       |       | (328,604                                                      | )           | (160,829 | ) | (304,172 | ) |
| Proceeds provided by sales  of marketable equity  securities                  |       | —                                                        |        | 336,309 |   | 6,759,751 |   |
| Net cash (used in)  provided by investing activities                          |       | (328,604                                                      | )           | 175,480 |   | 6,455,579 |   |
| Cash flows from financing activities:                                         |       |                                                          |        |   |   |   |   |
| Proceeds from sale of  common stock                                           |       | 22,428,249                                                    |        | 10,622,054 |   | 8,252,625 |   |
| Proceeds from employee  stock purchase plan                                   |       | 287,834                                                       |        | 354,047 |   | — |   |
| Proceeds from exercise  of employee stock options                             |       | —                                                        |        | — |   | 34,295 |   |
| Cash paid in lieu of  fractional shares                                       |       | (774                                                          | )           | — |   | — |   |
| Proceeds from the  exercise of warrants                                       |       | 600,000                                                       |        | 2,169,600 |   | — |   |
| Net cash provided by  financing activities                                    |       | 23,315,309                                                    |        | 13,145,701 |   | 8,286,920 |   |
| Net increase (decrease)  in cash                                              |       | $                                                             | 5,959,972   |   | ($3,799,890 | ) | ($3,012,393 | ) |
|                                                                               |            |                                                               |             |  |  |  |  |  |  |  |

 

*Cash used inoperations*

The amount of cash used inoperations decreased to $17,026,733 for the year ended December 31, 2006from $17,121,071 used for the year ended December 31, 2005, whichdecreased from $17,754,892 used for the year ended December 31, 2004. Asshown above, the decreases in cash used in operations were the result of thechanges in the Net Losses in each of the three years ended December 31,2006, as discussed in detail in the previous *Results ofOperations* section, adjusted for non-cash items of the net lossessuch as realized gains on sales of marketable securities, non-cash share-basedcompensation and changes to assets and liabilities for net cash outlays and/orreceipts which under generally accepted accounting principles, are not reportedin the Statement of Operations.

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*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,under generally accepted accounting principals. These items in the aggregatemake up a significant portion of the differences between Wave’s reported NetLoss year over year, versus the differences in the amount of cash used byWave’s operations over each of the periods. These items resulted in a net add-backto net loss of $2,216,281 for the year ended December 31, 2006 versus$277,718 for the year ended December 31, 2005 compared with a netsubtraction of $3,592,367 for the year ended December 31, 2004. Theindividual items that make up these adjustments are listed in the table aboveand described in greater detail in the *Results of Operations*and *Other Income and Expense* sections above.In addition, changes in asset and liability accounts, as shown above, representadditional sources or uses of cash in each of the three years. Accordingly,while the overall net loss increased by $1,222,811 (to $18,785,273 from$17,562,462) for the year ended December 31, 2006 versus the year endedDecember 31, 2005, cash used in operating activities decreased by $94,338(to $17,026,733 from $17,121,071). This was due in large part to theshare-based compensation expense included in the 2006 loss, of $1,556,042 whichis not a use of cash, and is therefore added back to the net loss to arrive atcash used in operating activities. In comparing the year endedDecember 31, 2005 to 2004, while the overall Net Loss increased by$3,064,424 (to $17,562,462 from $14,498,038) for the year endedDecember 31, 2005 versus the year ended December 31, 2004, cash usedin operating activities decreased by $633,821 (to $17,121,071 from$17,754,892.) This was due in large part to the gain realized on the sales ofavailable-for-sale securities of $80,971 in 2005 versus $4,330,248 in 2004.These gains must be subtracted from the reported net loss to arrive at cashused by operating activities because sales of marketable securities are aninvesting activity, therefore the gross proceeds from these sales are includedin cash flows from investing activities.

*Cash Flows frominvesting activities*

As displayed in the table above, cash used ininvesting activities consisted of funds used to acquire capital assets totaling$328,603, $160,829 and $304,172 for the years ended December 31, 2006,2005 and 2004, respectively. Such amounts included the cost of internallydeveloped capitalized software in the amount of $-0-, $-0-and $73,000 for each of the three years ended December 31, 2006, 2005 and2004, respectively. Wave expects to continue to acquire fixed assets primarilyto replace computer equipment to be used internally. These expenditures areexpected to continue at approximately the same level as the 2006 expenditures.

During the year ended December 31, 2005, Wavesold 259,670 shares of Saflink, in a series of separate sales, for totalproceeds of $336,309. For the year ended December 31, 2004, Wave sold2,507,300 shares of the common stock of SSP and 966,330 shares of Saflink fortotal proceeds of $6,759,751.

Net cash generated frominvesting activities decreased by $504,083 for the year ended December 31,2006 versus the year ended December 31, 2005 and decreased by $6,280,099for the year ended December 31, 2005 versus the year endedDecember 31, 2004. The cash generated from the sale of marketablesecurities was a much more significant source of cash for Wave in 2004, versusthe years ended December 31, 2006 and 2005, which made up for much of thedifferences described herein, combined with lower capital expenditures in theyear ended December 31, 2005 versus 2004 and 2006.

*Cash Flows from financingactivities*

Because Wave did not havesufficient cash on hand, nor did it generate sufficient revenues to fund theamount of cash used for operations and acquisition of capital assets for theyears ended December 31, 2006, 2005 and 2004, we needed to finance much ofour operations through the sale of newly issued common stock as describedbelow.

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*Proceeds fromIssuance of Newly Issued Equity Securities*

*Sales of CommonStock*

On October 30, 2006, Wave entered intosubscription agreements, pursuant to which Wave agreed to sell and issue3,517,230 shares of Class A Common Stock, par value $0.01 per share, tocertain purchasers for an aggregate purchase price of $9,602,038. These shareswere priced at $2.73 per share. Securities Research Associates, Inc. (“SRA”)entered into a placement agency agreement with Wave in which they agreed to actas placement agent in connection with the offering. Wave agreed to pay SRA afee equal to 5.0% of the gross proceeds of this offering. Wave also agreed toissue a warrant to SRA to purchase up to 175,861 shares of Class A commonstock at an exercise price of $2.73 per share. The Warrant expires onNovember 30, 2007. Wave realized net proceeds of approximately $9,101,224after deducting the placement agent fees of $484,000 and additional legal andother fees associated with the issuance of these securities which totaled$16,814. The shares sold on October 30, 2006 were offered and issuedpursuant to a shelf registration statement which was filed by Wave onDecember 16, 2005 and declared effective by the Commission onJanuary 13, 2006.

On August 4, 2006, Wave entered into subscriptionagreements, pursuant to which Wave agreed to sell and issue 2,336,752 shares ofClass A Common Stock, par value $.01 per share, to certain purchasers for anaggregate purchase price of $4,790,342. These shares were priced at $2.05 pershare. Securities Research Associates, Inc. (“SRA”) entered into aplacement agency agreement with Wave in which they agreed to act as placementagent in connection with the offering. Wave agreed to pay SRA a fee equal to5.0% of the gross proceeds of this offering. Wave also agreed to issue awarrant to SRA to purchase up to 116,837 shares of Class A common stock atan exercise price of $2.05 per share. The Warrant expires on September 3,2007. Wave realized net proceeds of approximately $4,528,376 after deductingthe placement agent fees of $239,517 and additional legal and other feesassociated with the issuance of these securities which totaled $22,449. Theshares sold on August 4, 2006 were offered and issued pursuant to a shelfregistration statement which was filed by Wave on December 16, 2005 anddeclared effective by the Commission on January 13, 2006.

On May 3, 2006, Wave entered into subscriptionagreements, pursuant to which Wave agreed to sell and issue 2,012,500 shares ofClass A Common Stock to certain purchasers for an aggregate purchase priceof $4,830,000. The shares were priced at $2.40 per share. SRA entered into aplacement agency agreement with Wave in which they agreed to act as placementagent in connection with the offering. Wave agreed to pay SRA a fee equal to5.0% of the gross proceeds of this offering. Wave also agreed to issue awarrant to SRA to purchase up to 100,625 shares of Class A common stock atan exercise price of $2.40. The Warrant will be exercisable for a period ofthirteen months following the date of the transaction. Wave realized netproceeds of approximately $4,548,439 after deducting the placement agent feesof $241,500 and additional legal and other fees associated with the issuance ofthese securities of $40,061. The shares were offered and issued pursuant to theshelf registration statement referred to above.

On February 15, 2006, Wave entered into asecurities purchase agreement, pursuant to which Wave agreed to sell and issue2,782,866 shares of Class A Common Stock for $1.605 per share, to certainpurchasers for an aggregate purchase price of $4,466,500. The purchasers werealso granted warrants (the “Warrants”) to purchase up to 516,956 shares ofClass A common stock at an exercise price of $2.16. The Warrants wereexercisable for a period of six months following the date of issuance. Allunexercised warrants granted in connection with the February 15, 2006securities purchase agreement expired on August 16, 2006. Each Warrant wassubject to cancellation if the closing bid price of Wave’s common stockexceeded $2.58 for 10 out of 20 consecutive trading days and the Warrant hadnot been exercised by the close of business on the trading day after the 10thtrading day on which the closing bid price exceeded $2.58. The placement agent,JPC Capital Partners, Inc. (formerly Corpfin, Inc.) (the “PlacementAgent”) had entered into a placement agency agreement with Wave in which theyagreed to act as placement agent 

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in connection with theoffering. Wave agreed to pay the Placement Agent a fee equal to 4.0% of thegross proceeds of this offering. Wave realized net proceeds of $4,250,212 afterdeducting the placement agent fees of $216,289 and additional legal and otherfees associated with the issuance of these securities. The shares were issuedpursuant to the shelf registration statement referred to above.

On December 5, 2005, Wave sold and issued1,994,302 shares of Class A Common Stock for $1.755 per share, for grossproceeds of $3,500,000, for which it received net proceeds of $3,340,890 afterpaying underwriter and other fees, which totaled $159,110. The purchasers werealso issued warrants to purchase 364,583 shares of Common Shares within sixmonths at an exercise price of $2.40 per share. All of these warrants expiredunexercised on May 5, 2006.

On August 5, 2005, Wave sold and issued 1,333,333shares of Class A Common Stock for $2.70 per share, for gross proceeds of$3,600,000, for which it received net proceeds of $3,389,205 after payingunderwriter and other fees, which totaled $210,795.

On March 15, 2005, Wave sold 1,553,030 shares ofClass A Common Stock for $2.64 per share, for gross proceeds of$4,100,000, for which it received $3,891,959, after paying underwriter andother fees.

On December 16, 2004, Wave sold and issued1,828,263 shares of Class A Common Stock for an aggregate purchase priceof $5,759,030. The Common Shares were priced at $3.15. Wave realized netproceeds of $5,474,728 after deducting placement agent and other feesassociated with the issuance of these securities.

On July 30, 2004,Wave sold and issued 1,176,471 shares of Class A Common Stock for anaggregate purchase price of $3,000,000. The shares of Class A Common Stockwere priced at $2.55. Wave realized net proceeds of $2,777,897 after deductingplacement agent and other fees associated with the issuance of thesesecurities. In addition, a total of 1,176,471 shares were offered in connectionwith this sale and issuance of these shares, in the form of an additionalinvestment right with an exercise price of $3.00 per share and warrants for1,470,588 shares at exercise prices ranging from $3.4284 to $3.846 per share.The additional investment right expired on November 2, 2004. All of thewarrants expired unexercised during the period January 30, 2005 throughJanuary 30, 2006

*Exercise ofWarrants to Purchase Class A Common Stock*

On May 8, 2006, Wave received gross proceeds of$625,000 less placement agent fees of $25,000 for net proceeds of $600,000, inconnection with the issuance of 276,620 shares of Class A Common Stockupon the exercise of two warrants that were granted to an investor as part ofWave’s December 5, 2005 financing and February 15, 2006 financing.The warrant issued to this investor in connection with the December 5,2005 financing was exercised in full for 114,583 shares of Class A CommonStock at an exercise price of $2.40 per share. The warrant issued to theinvestor in connection with the February 15, 2006 financing was exercisedin full for 162,037 shares of Class A Common Stock at an exercise price of$2.16 per share.

On August 1, 2005,Wave received gross proceeds of $2,260,000 less placement agent fees of $90,400for net proceeds of $2,169,600, for the issuance of 666,667 shares of Class A Common Stock uponpartial exercise of a warrant that was granted to an accredited investor aspart of a securities purchase agreement with the accredited investor, datedJuly 30, 2004. The warrants were exercised at a price of $3.39 per share.

*Exercise ofemployee stock options*

On December 1, 2006 Wave issued 62,269 shares ofClass A Common Stock to Wave and Wavexpress employees for $2.01 per share,pursuant to the Wave 2004 Employee Stock Purchase Plan. Wave received proceedsof $125,441, from the sale of these shares.

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On June 1, 2006 Wave issued 82,706 shares ofClass A Common Stock to Wave and Wavexpress employees for $1.96 per share,pursuant to the Wave 2004 Employee Stock Purchase Plan. Wave received proceedsof $162,393, from the sale of these shares.

On December 1, 2005 Wave issued 79,555 shares ofClass A Common Stock to Wave and Wavexpress employees for $2.04 per share,pursuant to the Wave 2004 Employee Stock Purchase Plan. Wave received proceedsof $162,293, from the sale of these shares.

On June 1, 2005 Wave issued 84,492 shares ofClass A Common Stock to Wave and Wavexpress employees for $2.29 per share,pursuant to the Wave 2004 Employee Stock Purchase Plan. Wave received proceedsof $191,754, from the sale of these shares.

During 2004, employeesexercised stock options resulting in the issuance of 11,770 shares of WaveClass A Common Stock for proceeds of $34,295, at an average price of $2.91per share.

*Summary analysis ofhistorical cash flows and future outlook*

It is evident from thetable above that Wave’s use of cash to fund operations has fluctuatedsignificantly 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.

*LiquidityRequirements and Future Sources of Capital*

Wave estimates that its total expenditures to fundoperations for the year ending December 31, 2007 will be approximately$22,400,000, including research and development, acquisition of capital assets,sales and marketing, general corporate expenses and overhead.

Expected sources ofcapital include the following:

·       cashon hand of $7,965,994 as of December 31, 2006

·       grossmargin contribution from sales and licensing of products

·       additionalfinancings

Given Wave’s capital requirements for the year endingDecember 31, 2007 as indicated above, and our cash balance as ofDecember 31, 2006, Wave will likely be required to raise additionalcapital to continue to fund its operations.

We may obtain additional funding as needed, fromfurther sales of newly issued shares of Class A Common Stock, includingthe sale of Class A Common Stock under the remaining availability of our$25,000,000 shelf registration statement that we filed on April 15, 2004that the SEC declared effective on May 10, 2004.

There remains approximately$2,506,000 in gross proceeds available under the April 15, 2004 shelfregistration statement, which may be utilized for future financings. We canprovide no assurances as to whether we will be successful in raising the neededcapital to continue as a going concern.

*Revenue outlook*

Wave receives revenue from licensing its EMBASSY TrustSuite software through distribution arrangements with OEM partners asdescribed below. In addition, Wave received revenues from software developmentand other services. Total cash received from all revenue sources in 2006 wasapproximately $2,633,000 versus approximately $961,000 for 2005.

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In November of 2005, Wave signed a new OEMdistribution agreement with Dell that permits Dell to distribute Wave softwareon certain Dell TPM-equipped business PCs. Wave is being paid a per unitroyalty fee for each Dell product shipment which includes Wave’s software. Inaddition, pursuant to this same agreement, Dell is offering an upgrade packageof Wave’s software that purchasers of certain models of TPM-equipped computersmay buy. Wave is paid a license fee for each copy of the upgrade package that ispurchased. We are working with Dell to market our products in an effort todrive volume of purchases of the upgrade package. However, we have no reliablebasis to predict how many upgrade packages will be purchased, and what theresultant revenue to Wave might be from this program. There are no minimumroyalty or shipped quantity requirements.

In January of 2006, Wave signed a distributionagreement with Gateway, which permits Gateway to distribute Wave software onGateway TPM-equipped models. Wave is being paid a per unit royalty fee for eachGateway shipment which includes Wave’s software. In addition, pursuant to thissame agreement, it is expected that Gateway is offering an upgrade package ofWave’s software that purchasers of certain models of TPM-equipped computers maybuy. Wave will be paid a license fee, for each copy of the upgrade package thatis purchased. We are working with Gateway to market our products, in an effortto drive volume of purchases of the upgrade package. However, we have no reliablebasis to predict how many upgrade packages will be purchased, and what theresultant revenue to Wave might be from this program. There are no minimumroyalty or shipped quantity requirements in this agreement.

In March of 2006, Wave signed a distributionagreement with Broadcom Corporation (“Broadcom”) that permits Broadcom todistribute Wave software on Broadcom TPM-equipped hardware devices. Wave isbeing paid a per unit royalty fee for each Broadcom shipment, which includesWave’s software. We are working with Broadcom to market our products in aneffort to drive volume of shipments of their TPM-equipped products. There areno minimum royalty or shipped quantity requirements in this agreement.

In April of 2006, Wave signed a software licenseagreement with Winbond Electronics Corporation (“WEC”) that permits WEC todistribute Wave software on WEC TPM-equipped hardware devices. Wave will bepaid a per unit royalty fee for each WEC shipment which includes Wave’ssoftware. We are working with WEC to market our products in an effort to drivevolume of shipments of their TPM-equipped products. However, we have noreliable basis to predict how many of WEC’s TPM-equipped products will bepurchased, and what the resultant revenue to Wave might be from this program.Although we received a prepaid royalty, there are no minimum royalty or shippedquantity requirements. This software license agreement is in addition to thetechnology license agreement that Wave and WEC are a party to and royaltiesunder this new software license agreement are in addition to the previouslyexisting technology license agreement.

Wave also continues to work with all of its partnersand customers to introduce and promote its existing software products and newsoftware products which are under development, in an effort to expand themarket for TPM-based secure computing and thereby increase its market share andrevenues. However, it should be noted that because of the early stage of Wave’smarket and other factors, a high level of uncertainty exists with respect tothe ability to forecast future revenues. Although there has been a substantialincrease in the volume of shipments of TPM chips (TPM hardware security thatmeets the TCG industry standard), which our business model depends upon, thisremains a new and developing category within the computer security market, andthe ultimate size of this market and the timeframe for its development areunknown and difficult to predict.

The license anddistribution agreements referred to above began to generate royalty revenue inthe second quarter of 2006. The aggregate amount of royalty revenue from thesearrangements in 2006 was a significant contributor to Wave’s revenue growthover the prior year. Revenue from these contracts in future years may also bematerial. We expect to continue to generate cash flow from these agreements aslong as the agreements remain in effect and our software continues to ship withthese products. Enterprise 

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customersare also expressing interest in the upgrade packages offered in connection withthese distribution agreements. We recorded modest initial revenues from thesale of license upgrade packages in 2006.

*Known Trends andUncertainties affecting future cash flows*

Because Wave does not have sufficient cash to fundoperations for the year ending December 31, 2007, and there is uncertaintyas to whether Wave will generate sufficient revenues to fund its operationsover this time period, Wave has been, and will likely continue to be, activelyengaged in financing activities in order to generate additional funding tocover its operating costs for the year ending December 31, 2007. Theseactivities have included the filing of a $25,000,000 S-3 shelfregistration with the SEC on December 16, 2005, which was declared effectiveon January 13, 2006; and the sale of 2,782,866 shares of common stock at$1.605 per share for gross proceeds of $4,466,500 in an initial round offinancing under this shelf registration on February 15, 2006, for which wereceived approximately $4,250,000 in net proceeds. We also granted warrants aspart of the February 15 financing that allowed the purchasers to acquirean additional 516,956 shares of Wave common stock for $2.16 per share. OnMay 8, 2006 an investor exercised one of these warrants for 162,037shares, at an exercise price of $2.16 per share. Wave received $336,000 fromthis warrant exercise after subtracting the 4% placement agent fee. Theremaining warrants granted in connection with the February 16, 2006financing, expired on August 15, 2006.

Pursuant to a financing entered into on May 3,2006 under the same shelf registration statement, we also sold 2,012,500 sharesof Wave’s Class A common stock at $2.40 per share for gross proceeds of$4,830,000, for which we received approximately $4,548,439 in net proceeds. Inconnection with that financing, we also agreed to issue a warrant to theplacement agent (as part of the fees paid to the placement agent) that willallow the placement agent to acquire 100,625 shares of Wave Class A commonstock for $2.40 per share. The warrant expires on June 3, 2007.

On May 8, 2006, an investor also exercised awarrant issued by Wave to that investor in connection with Wave’sDecember 5, 2005 financing. The warrant was exercised in full for 114,583shares of Wave Class A Common Stock, at an exercise price of $2.40 pershare. Wave received $264,000 from the exercise of this warrant aftersubtracting the 4% placement agent fee.

Also, pursuant to a financing entered into onAugust 4, 2006, under the same shelf registration statement, we sold2,336,752 shares of Wave’s Class A common stock at $2.05 per share forgross proceeds of $4,790,342, for which we have received $4,528,375 in netproceeds. In connection with that financing, we also agreed to issue a warrant tothe placement agent (as part of the fees paid to the placement agent) that willallow the placement agent to acquire 116,837 shares of Wave Class A commonstock for $2.05 per share. The warrant expires on September 3, 2007.

In addition, under the same shelf registrationstatement, on October 30, 2006, we sold and issued 3,517,240 shares ofWave’s Class A common stock for $2.73 per share. We received grossproceeds from the sales of these shares of $9,602,038. We expect to realize netproceeds of $9,101,224 after paying all transaction costs. In connection withthat financing, we also agreed to issue a warrant to the placement agent (aspart of the fees paid to the placement agent) that will allow the placementagent to acquire 175,861 shares of Wave Class A common stock for $2.73 pershare. The warrant expires on November 30, 2007.

It is likely that we willbe required to sell additional shares of common stock, preferred stock, obtaindebt financing or engage in a combination of these financing alternatives, toraise additional capital to continue to fund our operations for the year endingDecember 31, 2007. The availability and amount of any such financings areunknown at this time. Wave may also be required to reduce expenses which maysignificantly impede its ability to meet its sales, marketing and developmentobjectives. Given the available cash currently on hand and our expenditureforecast for the year ending December 31, 2007, we estimate 

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that wewill need to generate at least $11,500,000, in order to continue as a goingconcern for the next twelve months ending December 31, 2007

*Other uncertaintiesthat may impact the future business outlook*

Uncertainty exists with respect to the formal SECinvestigation described in Item 3, including uncertainty as to the amount oflegal costs that Wave may incur in addressing this matter. In addition, theextent of any impact due to negative publicity or perceived negative publicityis unknown.

Because the information security services market andthe TCG hardware security category in particular are in early stages ofdevelopment, customer requirements may change or new competitive pressures canemerge which could require a shift in product development and/or marketstrategy. Should such shifts occur, they may require development, marketing andsales strategies to re-start or expand, which would likely increase operatingcosts, requiring additional capital. Such shifts have occurred several timesthroughout Wave’s history, requiring significant changes in strategy and businessplan.

Furthermore, theachievement of sufficient revenue is dependent upon continued significantexpenditures, which will likely be required for research and development andsales and marketing to increase market awareness for our products. Therefore,if Wave is not able to begin to generate significant revenues byDecember 31, 2007 to cover its operating costs, it will need to generatecapital from other sources, including raising funds through the issuance ofadditional common stock, preferred stock and/or debt to fund its operationsbeyond December 31, 2007.

*Commitments*

Wave has no significant long-term contractualobligations other than with respect to operating leases for its facilities,which are listed below: 

| ** **                    | ** ** | **Within one  year** | ** ** | **Years two  and three** | ** ** | **Years four  and five** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|-------------------------------|------------|---------------------------|------------|------------------------------------|------------|------------------------------------|------------|----------------|------------|-----------|------------|
| Operating leases  commitments |       |                      | $          | 855,992                            |       |                               | $          | 970,796        |       | $         | 125,542    |   |   | $ | -0- |   |   | $ | 1,952,330 |   |
|                               |            |                           |            |                                    |            |                                    |            |                |            |           |            |  |  |  |  |  |  |  |  |  |

 

*Net Operating andCapital Loss Carryforwards*

As of December 31,2006, Wave had available net operating and capital loss carryforwards forFederal income tax purposes of approximately $268.2 million, which expirebeginning in 2007 through 2026. 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 been suchcumulative changes in ownership or the impact on the utilization of the losscarryforwards if such changes have occurred. However, in consideringSection 382 of the Internal Revenue Code, we believe that it is likelythat such a change in ownership occurred prior to or following the completionof our initial public offering in September 1994 and, potentially, inperiods following. As a result, all of the utilization of our net operatinglosses is likely to be subject to annual limitations.

*Going ConcernOpinion*

Wave’s consolidatedfinancial statements as of December 31, 2006 have been prepared under theassumption that we will continue as a going concern. Wave’s independentregistered public accounting firm, KPMG LLP, have issued a report datedMarch 15, 2007, that includes an explanatory paragraph referring to oursignificant operating losses and substantial doubt of our ability to continueas a going concern. (See Note 2 to Wave’s consolidated financial statements.)

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**Recent AccountingPronouncements**

In June 2006, the FASB issued InterpretationNo. 48, “Accounting for Uncertainty in Income Taxes (as amended)—aninterpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with SFAS No. 109, “Accounting forIncome Taxes,” and prescribes a recognition threshold and measurement attributefor the financial statement recognition and measurement of a tax position takenor expected to be taken in a tax return. FIN 48 also provides guidance onde-recognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006. We are in the process of analyzing theimpact of FIN 48, which is required to be adopted by the first quarter of 2007.

In September 2006,the FASB issued SFAS No. 157, “Accounting for Fair Value Measurements”.SFAS No. 157 defines fair value, and establishes a framework for measuringfair value in generally accepted accounting principles and expands disclosureabout fair value measurements. SFAS No. 157 is effective for the Companyfor financial statements issued subsequent to November 15, 2007. Wave doesnot expect the new standard to have any material impact on the financialposition and results of operations.

**Item 7A.**                Quantitativeand Qualitative Disclosures about Market Risk

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

**Item 8.**                        FinancialStatements 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 arehereby incorporated by reference into this Item 8. The quarterly financialinformation required by this Item 8 is included in the Notes to ConsolidatedFinancial Statements.

**Item 9.***                       *Changesin and Disagreements with Accountant on Accounting and Financial Disclosure

None.

**Item 9A.**                Controlsand Procedures

*Evaluation ofdisclosure controls and procedures*

Our CEO and CFO haveevaluated the effectiveness of our disclosure controls and procedures as ofDecember 31, 2006. Based on their evaluation, our CEO and CFO haveconcluded, as of the date of such evaluation, that our disclosure controls andprocedures are effective.

*Management’s AnnualReport on Internal Control Over Financial Reporting*

Wave’s management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as defined in Rule 13a-15(f) promulgated underthe 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 ofDecember 31, 2006. In making its assessment, Wave’s management used thecriteria set forth by the Committee of Sponsoring Organizations of the TreadwayCommission in “Internal Control Integrated Framework”. Based on thisassessment, Wave’s management concluded that, as of 

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December 31,2006, its internal control over financial reporting is effective based on thosecriteria. Wave’s Independent Registered Public Accounting Firm, KPMG LLP, hasissued an attestation report on management’s assessment of Wave’s internalcontrol over financial reporting, which is included following this report.

| Dated: March 16, 2007 |                   |                                    |
|----------------------------|------------------------|-----------------------------------------|
| 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 Officer* |   | Title: | *Senior Vice President of Finance and Administration,  Chief Financial Officer* |
|                            |                        |                                         |  |  |  |  |  |

 

*Report ofIndependent Registered Public Accounting Firm*

The Board of Directors and StockholdersWave Systems Corp.:

We have audited management’s assessment, included inthe accompanying ***Management’s Annual Report on InternalControl Over Financial Reporting,*****that Wave Systems Corp. maintained effective internal control overfinancial reporting as of December 31, 2006, based on criteria establishedin Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission*.*WaveSystems Corp’s management is responsible for maintaining effective internalcontrol over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of WaveSystems Corp’s internal control 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 operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

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. Acompany’s internal 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 

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that controls may becomeinadequate because of changes in conditions, or that the degree of compliancewith the policies or procedures may deteriorate.

In our opinion, management’s assessment that WaveSystems Corp. maintained effective internal control over financial reporting asof December 31, 2006, 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. Also, in ouropinion, Wave Systems Corp. maintained, in all material respects, effectiveinternal control over financial reporting as of December 31, 2005, basedon criteria established in Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of Wave Systems Corp. andsubsidiaries as of December 31, 2006 and 2005, and the relatedconsolidated statements of operations, stockholders’ equity (deficiency) andcomprehensive income (loss), and cash flows for each of the years in thethree-year period ended December 31, 2006, and our report datedMarch 15, 2007 expressed an unqualified opinion on those consolidatedfinancial statements. Our report dated March 15, 2007 contains anexplanatory paragraph that states that the Company has suffered recurringlosses from operations and has an accumulated deficit that raises substantialdoubt about its ability to continue as a going concern. The consolidatedfinancial statements do not include any adjustments that might result from theoutcome of that uncertainty. Our report also contains an explanatory paragraphregarding the adoption of Statement of Financial Accounting StandardsNo. 123(R) “Share-Based Payments.”

| /s/ KPMG LLP           |
|------------------------|
|                   |
| Boston,  Massachusetts |
| March 15,  2007   |

 

*Changes in internalcontrols*

There have been no changesin Wave’s internal controls over financial reporting that occurred duringWave’s fourth fiscal quarter that have materially affected, or are reasonablylikely to affect, Wave’s internal control over financial reporting.

**Item 9B.***              *OtherInformation

Not Applicable.

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**PART III**

**Item 10.**                 Directorsand Executive Officers and Corporate Governance of the Registrant

Information concerning Wave’s directors, executiveofficers, promoters and control persons will appear in Wave’s Proxy Statementfor the 2007 Annual Meeting of Stockholders, to be filed pursuant to Regulation14A on or before April 30, 2007, under the caption “Election of Directors.”Such information is incorporated herein by reference.

Information concerning compliance with Section 16(a) ofthe Securities Exchange Act will appear in Wave’s Proxy Statement for the 2007Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A onor before April 30, 2007, 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 2007 Annual Meeting of Stockholders,to be filed pursuant to Regulation 14A on or before April 30, 2007, 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 anamendment to, or waiver from, a provision of the Code of Ethics that relates toa substantive 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.**                 ExecutiveCompensation

Information regardingexecutive compensation will appear in Wave’s Proxy Statement for the 2007 AnnualMeeting of Stockholders, to be filed pursuant to Regulation 14A on or before April 30,2007, under the caption “Executive Compensation.”  Such information is incorporated herein byreference.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

Information regardingsecurity ownership of certain beneficial owners and management and relatedstockholder matters will appear in Wave’s Proxy Statement for the 2007 AnnualMeeting of Stockholders, to be filed pursuant to Regulation 14A on or before April 30,2007, under the caption “Security Ownership of Certain Beneficial Owners andManagement.”  Such information isincorporated herein by reference.

**Item 13.**                 CertainRelationships and Related Transactions, and Director Independence

Information regardingcertain relationships and related transactions and director independencewillappear in Wave’s Proxy Statement for the 2007 Annual Meeting of Stockholders,to be filed pursuant to Regulation 14A on or before April 30, 2007, underthe caption “Certain Relationships and Related Transactions.”  Such information is incorporated herein byreference.

**Item 14.**                 PrincipalAccountant Fees and Services

**Information regarding Wave’sprincipal accountant’s fees will appear in Wave’s Proxy Statement for the 2007Annual Meeting of Stockholders, to be filed pursuant to Regulation 14A on orbefore April 30, 2007, under the caption “Certain Relationships andRelated Transactions.”  Such informationis incorporated herein by reference.**

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**PART IV**

**Item 15.**                 Exhibitsand Financial Statement Schedules

(a) (1)    Financial Statements:

|                                                                                                                                                                       | ** ** | **Page(s)** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|
| Report of Independent  Registered Public Accounting Firm                                                                                                              |       | F-1         |
| Consolidated Balance Sheets as of  December 31, 2006 and 2005                                                                                                    |       | F-2         |
| Consolidated Statements of  Operations for each of the years ended  December 31, 2006, 2005 and 2004                                                             |       | F-3         |
| Consolidated  Statements of Stockholders’ Equity (Deficiency) and Comprehensive Income  (Loss) for each of the years ended December 31, 2006, 2005 and 2004 |       | F-4         |
| Consolidated Statements of Cash Flows for each of the years ended December 31, 2006,  2005 and 2004                                                              |       | F-6         |
| Notes to  Consolidated Financial Statements                                                                                                                           |       | F-7         |

 

(a) (2)    FinancialStatement 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, as  amended (incorporated by reference to Exhibit 3.1 of Wave’s Quarterly  Report on Form 10-Q, filed on August 9, 2006, File No. 0-24752)                                                                                              |
| 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)           |
| 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) |

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| 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*  |   | — |   | Wave Systems Corp. 2004 Employee Stock Purchase Plan  (incorporated by reference to Exhibit 4.1 of Wave’s Form S-8  Registration Statement, filed on May 24,2005)                                                                                                                       |
| 10.2*        |   | — |   | Form of Subscription Agreement dated as of  October 30, 2006 among Purchasers and Wave (incorporated by reference to  Exhibit 10.1 of Wave’s Current Report on Form 8-K, filed on  October 31, 2006, File # 0-24752)                                                          |
| 10.3*        |   | — |   | Form of Subscription Agreement dated as of  August 4, 2006 among Purchasers and Wave (incorporated by reference to  Exhibit 10.1 of Wave’s Current Report on Form 8-K, filed on  August 8, 2006, File # 0-24752)                                                              |
| 10.4*        |   | — |   | Form of Subscription Agreement dated as of  May 3, 2006 among Purchasers and Wave (incorporated by reference to  Exhibit 10.1 of Wave’s Current Report on Form 8-K, filed on  May 8, 2006, File # 0-24752)                                                                    |
| 10.5*        |   | — |   | Reserved                                                                                                                                                                                                                                                                                                    |
| 10.6*        |   | — |   | Securities Purchase Agreement dated as of  December 5, 2005 among Purchasers and Wave (includes form of warrant)  (incorporated by reference to Exhibit 10.1 of Wave’s Current Report on  Form 8-K, filed on December 7, 2005, File # 0-24752)                                     |
| 10.7*        |   | — |   | Securities Purchase Agreement dated as of  August 5, 2005 among Purchasers and Wave (includes form of warrant)  (incorporated by reference to Exhibit 10.1 of Wave’s Current Report on  Form 8-K, filed on August 8, 2005, File # 0-24752)                                         |
| 10.8*        |   | — |   | Securities Purchase Agreement dated as of  March 15, 2005 among Purchasers and Wave (includes form of warrant)  (incorporated by reference to Exhibit 10.1 of Wave’s Current Report on  Form 8-K, filed on March  17, 2005, File # 0-24752)                                        |
| †10.9*  |   | — |   | Wave’s Amended and Restated 1994 Stock Option Plan  (incorporated by reference to Wave’s Notice of Annual Meeting of Stockholders  on Schedule 14A filed on April 29, 2004,)                                                                                                                 |
| †10.10* |   | — |   | Wave Non-Employee Directors Stock Option Plan  (incorporated by reference to Wave’s Notice of Annual Meeting of Stockholders  on Schedule 14A filed on April 29, 2004)                                                                                                                            |
| †10.11* |   | — |   | 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)                                                                                                                      |
| †10.12* |   | — |   | 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).                                                                    |
| †10.13* |   | — |   | 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).                                                                 |
| 10.14*       |   | — |   | 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)                                                    |
| 10.15*       |   | — |   | 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)                                                            |

49

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| 10.16* |   | — |   | 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)                                                                                        |
|--------|--------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.17* |   | — |   | 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)                                                                                  |
| 10.18* |   | — |   | 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) |
| 10.19* |   | — |   | 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) |
| 10.20* |   | — |   | 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)               |
| 10.21* |   | — |   | 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)                                       |
| 10.22* |   | — |   | 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)                                                                                                 |
| 10.23* |   | — |   | 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)                                                                                                   |
| 10.24* |   | — |   | 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)                                                                                                      |
| 10.25* |   | — |   | 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)                                                                                              |
| 10.26* |   | — |   | 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)                                                                 |
| 10.27* |   | — |   | 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)                                                                  |
| 10.28* |   | — |   | 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)                                                                                                                                    |
| 10.29* |   | — |   | Subscription Agreement (incorporated by reference to  Exhibit 10.1 of Wave’s Current Report on Form 8-K, filed on  May 5, 2006, File #0-24752)                                                                                                                                                                          |
| 10.30* |   | — |   | Subscription Agreement (incorporated by reference to  Exhibit 10.1 of Wave’s Current Report on Form 8-K, filed on  August 8, 2006, File #0-24752)                                                                                                                                                                       |
| 10.31* |   | — |   | Subscription Agreement (incorporated by reference to  Exhibit 10.1 of Wave’s Current Report on Form 8-K, filed on  October 31, 2006, File #0-24752)                                                                                                                                                                     |

50

----

 

| 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 Registered Public Accounting  Firm—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.))                            |
| 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)                                                                                                              |

51

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| 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

52

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

Dated: March 16, 2007

|   | 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, 2007 |
| Steven K. Sprague                 |          | and Director                                                         |       |                |
| /s/ JOHN E. BAGALAY, JR.     |          | Chairman                                                             |       | March 16, 2007 |
| John E. Bagalay, Jr.         |          |                                                                 |       |                |
| /s/ GEORGE GILDER                 |          | Director                                                             |       | March 16, 2007 |
| George Gilder                     |          |                                                                 |       |                |
| /s/ JOHN E. MCCONNAUGHY, JR. |          | Director                                                             |       | March 16, 2007 |
| John E. McConnaughy, Jr.     |          |                                                                 |       |                |
| /s/ NOLAN BUSHNELL                |          | Director                                                             |       | March 16, 2007 |
| Nolan Bushnell                    |          |                                                                 |       |                |
| /s/ GERARD T. FEENEY              |          | Senior Vice President,  Finance and  Administration, Chief Financial |       | March 16, 2007 |
| Gerard T. Feeney                  |          | Officer and Secretary (Principal                                     |       |                |
|                              |          | Financial Officer and Duly Authorized                                |       |                |
|                              |          | Officer of the  Registrant)                                          |       |                |

 

53

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and StockholdersWave Systems Corp.:

We have audited the accompanying consolidated balancesheets of Wave Systems Corp. and subsidiaries as of December 31, 2006 and2005, and the related consolidated statements of operations, stockholders’equity (deficiency) and comprehensive income (loss), and cash flows for each ofthe years in the three-year period ended December 31, 2006. Theseconsolidated financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements 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, 2006and 2005, and the results of their operations and their cash flows for each ofthe years in the three-year period ended December 31, 2006 in conformitywith accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statementshave been prepared assuming that the Company will continue as a going concern.As discussed in Note 2 to the consolidated financial statements, the Companyhas suffered recurring losses from operations and has an accumulated deficitthat raises substantial doubt about its ability to continue as a going concern.Management’s plans in regard to these matters are also described in Note 2. Theconsolidated financial statements do not include any adjustments that mightresult from the outcome of this uncertainty.

As discussed in Note 3 to the consolidated financialstatements, Wave Systems Corp. adopted Statement of Financial AccountingStandards No. 123(R), “Share-Based Payment” effective January 1,2006, utilizing the modified prospective application transition method.

We also have audited, inaccordance with standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Wave Systems Corp.’s internal controlover financial reporting as of December 31, 2006, based on criteriaestablished in Internal Control-Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO) and our report datedMarch 15, 2007, expressed an unqualified opinion on management’sassessment of, and the effective operation of, internal control over financialreporting.

/s/ KPMG

Boston, MassachusettsMarch 15, 2007

F-1

----

**WAVE SYSTEMS CORP. AND SUBSIDIARIESConsolidated Balance SheetsDecember 31, 2006 and 2005**

| ** **                                                                                                                                             | ** ** | **2006**                                 | ** ** | **2005**                                 | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| **Assets**                                                                                                                                             |       |                                     |       |                                     |       |
| Current assets:                                                                                                                                        |       |                                     |       |                                     |       |
| Cash and cash  equivalents                                                                                                                             |       | $     7,965,994 |       | $     2,006,022 |       |
| Accounts Receivable, net  of allowance for doubtful accounts of $40,547 and $14,087 at  December 31, 2006 and 2005, respectively                  |       | 635,852                                  |       | 334,659                                  |       |
| Prepaid expenses                                                                                                                                       |       | 206,835                                  |       | 139,686                                  |       |
| Total current assets                                                                                                                                   |       | 8,808,681                                |       | 2,480,367                                |       |
| Property and equipment,  net                                                                                                                           |       | 419,724                                  |       | 754,153                                  |       |
| Other assets                                                                                                                                           |       | 131,272                                  |       | 195,245                                  |       |
| Total Assets                                                                                                                                           |       | 9,359,677                                |       | 3,429,765                                |       |
| **Liabilities and Stockholders’ Equity**                                                                                                          | ** ** | ** **                               | ** ** | ** **                               | ** ** |
| Current liabilities:                                                                                                                                   |       |                                     |       |                                     |       |
| Accounts payable and  accrued expenses                                                                                                                 |       | 3,035,349                                |       | 3,089,150                                |       |
| Deferred revenue                                                                                                                                       |       | 404,059                                  |       | 503,630                                  |       |
| Total current  liabilities                                                                                                                             |       | 3,439,408                                |       | 3,592,780                                |       |
| Liability for warrants containing cash settlement  provisions                                                                                          |       | —                                   |       | 2,794                                    |       |
| Total liabilities                                                                                                                                      |       | 3,439,408                                |       | 3,595,574                                |       |
| Stockholders’  Equity (Deficiency):                                                                                                               |       |                                     |       |                                     |       |
| Common Stock, $.01 par  value. Authorized 150,000,000 shares as Class A; 42,203,773 shares  issued and outstanding in 2006 and 31,113,918 in 2005 |       | 422,038                                  |       | 311,139                                  |       |
| Common Stock, $.01 par  value. Authorized 13,000,000 shares as Class B; 39,232 shares issued and  outstanding in 2006 and 58,575 in 2005     |       | 392                                      |       | 586                                      |       |
| Capital in excess of par  value                                                                                                                        |       | 309,029,938                              |       | 284,269,292                              |       |
| Accumulated deficit                                                                                                                                    |       | (303,532,099                             | )          | (284,746,826                             | )          |
| Total Stockholders’  Equity (Deficiency)                                                                                                          |       | 5,920,269                                |       | (165,809                                 | )          |
| Total Liabilities and Stockholders’ Equity                                                                                                        |       | $     9,359,677 |       | $     3,429,765 |       |

 

See accompanying notes to consolidated financial statements.

F-2

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**WAVE SYSTEMS CORP. AND SUBSIDIARIESConsolidated Statements of OperationsYears ended December 31, 2006, 2005, 2004**

| ** **                                                           | ** ** | **2006**                                                                 | ** ** | **2005**                                                                 | ** ** | **2004**                                                                 | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Net revenues:                                                        |       |                                                                     |       |                                                                     |       |                                                                     |       |
| Licensing                                                            |       | $  2,672,161                                                   |       | $      974,058                             |       | $      183,318                             |       |
| Services                                                             |       | 444,220                                                                  |       | 44,406                                                                   |       | 18,833                                                                   |       |
| Hardware products                                                    |       | —                                                                   |       | —                                                                   |       | 7,160                                                                    |       |
| Total net revenues                                                   |       | 3,116,381                                                                |       | 1,018,464                                                                |       | 209,311                                                                  |       |
| Cost of sales:                                                       |       |                                                                     |       |                                                                     |       |                                                                     |       |
| Licensing                                                            |       | 700,766                                                                  |       | 682,179                                                                  |       | 133,468                                                                  |       |
| Services                                                             |       | 282,905                                                                  |       | 44,674                                                                   |       | 13,589                                                                   |       |
| Hardware Products                                                    |       | —                                                                   |       | —                                                                   |       | 4,647                                                                    |       |
| Total cost of sales                                                  |       | 983,671                                                                  |       | 726,853                                                                  |       | 151,704                                                                  |       |
| Gross profit                                                         |       | 2,132,710                                                                |       | 291,611                                                                  |       | 57,607                                                                   |       |
| Operating expenses:                                                  |       |                                                                     |       |                                                                     |       |                                                                     |       |
| Selling, general and  administrative                                 |       | 12,598,389                                                               |       | 11,560,039                                                               |       | 12,255,427                                                               |       |
| Research and development                                             |       | 8,486,368                                                                |       | 6,937,618                                                                |       | 6,852,754                                                                |       |
| Write-off of intangibles  and other impaired assets                  |       | —                                                                   |       | —                                                                   |       | 301,366                                                                  |       |
| Total operating expenses                                             |       | 21,084,757                                                               |       | 18,497,657                                                               |       | 19,409,547                                                               |       |
| Operating loss                                                       |       | (18,952,047                                                              | )          | (18,206,046                                                              | )          | (19,351,940                                                              | )          |
| Other income:                                                        |       |                                                                     |       |                                                                     |       |                                                                     |       |
| Interest income                                                      |       | 163,980                                                                  |       | 70,779                                                                   |       | 24,931                                                                   |       |
| Gain on sale of  marketable securities                               |       | —                                                                   |       | 80,971                                                                   |       | 4,330,248                                                                |       |
| Unrealized gain on  decrease in value of warrant   liability         |       | 2,794                                                                    |       | 490,334                                                                  |       | 498,723                                                                  |       |
| Other income                                                         |       | —                                                                   |       | 1,500                                                                    |       | —                                                                   |       |
| Total other income                                                   |       | 166,774                                                                  |       | 643,584                                                                  |       | 4,853,902                                                                |       |
| Net loss                                                             |       | (18,785,273                                                              | )          | (17,562,462                                                              | )          | (14,498,038                                                              | )          |
| Loss per common  share—basic and diluted                        |       | $           (0.51 | )          | $           (0.63 | )          | $           (0.63 | )          |
| Weighted average number  of common sharesoutstanding during the year |       | 36,735,059                                                               |       | 27,726,221                                                               |       | 23,013,554                                                               |       |

 

See accompanying notes to consolidated financial statements.

F-3

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**WAVE SYSTEMS CORP. AND SUBSIDIARIESConsolidated Statements of Stockholders’ Equity (Deficiency) And ComprehensiveIncome (Loss)**

| ** **                                                                                                        | ** ** | **Class A  Common Stock** | ** ** | **Class B  Common Stock** | ** ** | **Capital in Excess ** | ** ** | **Accumulated ** | ** ** | **Accumulated  Other   Comprehensive** | ** ** | ** **  | ** **         |
|-------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|---------------------------------------|------------|-----------------------|------------|---------------------------------------------|------------|-------------|--------------------|
| ** **                                                                                                        | ** ** | **Shares**                          | ** ** | **Amount**                          | ** ** | **Shares**                            | ** ** | **Amount**            | ** ** | **of Par Value**                  | ** ** | **Deficit** | ** **         | **Income** | ** ** | **Total** | ** ** |
| Balance at December 31, 2003                                                                                 |       | 22,376,035                          |       | $ 223,759                      |       | 68,575                                |       |                  | $ 686 |                                        |       |        | $ 262,836,048 |   |   | $ (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 $2.55 per  share, net of issuance costs of $222,101                      |       | 1,176,471                           |       | 11,765                              |       | —                                |       |                  | —     |                                        |       |        | 2,766,132          |   |   | — |   |   | — |   |   | 2,777,897 |   |
| Issuance of Class A Common Stock at $3.15 per  share, net of issuance costs of $284,300                      |       | 1,828,263                           |       | 18,283                              |       | —                                |       |                  | —     |                                        |       |        | 5,456,445          |   |   | — |   |   | — |   |   | 5,474,728 |   |
| Issuance of Class A Common Stock upon exercise  of  employee stock options                                   |       | 11,770                              |       | 118                                 |       | —                                |       |                  | —     |                                        |       |        | 34,177             |   |   | — |   |   | — |   |   | 34,295 |   |
| Issuance of warrants to purchase Class A Common  Stock for services                                          |       | —                              |       | —                              |       | —                                |       |                  | —     |                                        |       |        | 80,609             |   |   | — |   |   | — |   |   | 80,609 |   |
| Balance as of December 31, 2004                                                                              |       | 25,392,539                          |       | $ 253,925                      |       | 68,575                                |       |                  | $ 686 |                                        |       |        | $ 271,173,411 |   |   | $ (267,184,364 | ) |   | $ 466,542 |   |   | $ 4,710,200 |   |
| Net loss                                                                                                          |       | —                              |       | —                              |       | —                                |       |                  | —     |                                        |       |        | —             |   |   | (17,562,462 | ) |   | — |   |   | (17,562,462 | ) |
| Unrealized loss on  marketable securities:                                                                        |       |                                |       |                                |       |                                  |       |                  |       |                                        |       |        |               |   |   |   |   |   |   |   |   |   |   |
| Unrealized holding losses during the period                                                                       |       | —                              |       | —                              |       | —                                |       |                  | —     |                                        |       |        | —             |   |   | — |   |   | (385,571 | ) |   |   |   |
| Less: reclassification adjustment for gain included  in net income                                                |       | —                              |       | —                              |       | —                                |       |                  | —     |                                        |       |        | —             |   |   | — |   |   | (80,971 | ) |   | (466,542 | ) |
| Comprehensive loss                                                                                                |       | —                              |       | —                              |       | —                                |       |                  | —     |                                        |       |        | —             |   |   | — |   |   | — |   |   | (18,029,004 | ) |
| Issuance of Class A Common Stock at $2.64 per  share, less issuance cost of $208,041                         |       | 1,553,030                           |       | 15,530                              |       | —                                |       |                  | —     |                                        |       |        | 3,876,429          |   |   | — |   |   | — |   |   | 3,891,959 |   |
| Issuance of Class A Common Stock at $2.70 per  share, less issuance cost of $210,975                         |       | 1,333,333                           |       | 13,333                              |       | —                                |       |                  | —     |                                        |       |        | 3,375,872          |   |   | — |   |   | — |   |   | 3,389,205 |   |
| Issuance of Class A Common Stock at $1.755 per  share, less issuance cost of $159,110                        |       | 1,994,302                           |       | 19,943                              |       | —                                |       |                  | —     |                                        |       |        | 3,320,947          |   |   | — |   |   | — |   |   | 3,340,890 |   |
| Warrants Exercised at $3.39 per share, less issuance  cost of $90,400                                             |       | 666,667                             |       | 6,667                               |       | —                                |       |                  | —     |                                        |       |        | 2,162,933          |   |   | — |   |   | — |   |   | 2,169,600 |   |
| Shares of Class A Common Stock Issued pursuant  to the  Wave Employee Stock Purchase Plan at $2.26 per share |       | 84,492                              |       | 845                                 |       | —                                |       |                  | —     |                                        |       |        | 190,909            |   |   | — |   |   | — |   |   | 191,754 |   |
| Shares of Class A Common Stock Issued pursuant  to the  Wave Employee Stock Purchase Plan at $2.04 per share |       | 79,555                              |       | 796                                 |       | —                                |       |                  | —     |                                        |       |        | 161,497            |   |   | — |   |   | — |   |   | 162,293 |   |
| Compensation cost for stock options granted to  consultant                                                        |       | —                              |       | —                              |       | —                                |       |                  | —     |                                        |       |        | 7,294              |   |   | — |   |   | — |   |   | 7,294 |   |
| Exchange of Class B Common Stock for  Class A Common Stock                                              |       | 10,000                              |       | 100                                 |       | (10,000                               | )          |                  | (100       | )                                           |       |        | —             |   |   | — |   |   | — |   |   | — |   |
| Balance  as of December 31, 2005                                                                             |       | 31,113,918                          |       | $ 311,139                      |       | 58,575                                |       |                  | $ 586 |                                        |       |        | $ 284,269,292 |   |   | $ (284,746,826 | ) |   | $           — |   |   | $  (165,809 | ) |
|                                                                                                              |       |                                |       |                                |       |                                  |       |                  |       |                                        |       |        |               |   |   |   |   |   |   |   |   |   |   |

 

See accompanying notes to consolidated financial statements.

F-4

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**WAVE SYSTEMS CORP. AND SUBSIDIARIESConsolidated Statements of Stockholders’ Equity (Deficiency) And ComprehensiveIncome (Loss)—(Continued)**

| ** **                                                                                                               | ** ** | **Class A  Common Stock** | ** ** | **Class B  Common Stock** | ** ** | **Capital in Excess** | ** ** | **Accumulated** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | ** **  | ** **         |
|--------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|---------------------------------|------------|-----------------|------------|---------------------------------------|------------|-------------|--------------------|
| ** **                                                                                                               | ** ** | **Shares**                          | ** ** | **Amount**                          | ** ** | **Shares**                      | ** ** | **Amount**      | ** ** | **of Par Value**            | ** ** | **Deficit** | ** **         | **Income** | ** ** | **Total** | ** ** |
| Balance  at December 31, 2005                                                                                       |       | 31,113,918                          |       | $ 311,139                      | ** ** | 58,575                          |       |            | $ 586 |                                  |       |        | $ 284,269,292 |   |   | $ (284,746,826 | ) |   | $ — |   |   | $ (165,809 | ) |
| Net  loss                                                                                                                |       | —                              |       | —                              |       | —                          |       |            | —     |                                  |       |        | —             |   |   | (18,785,273 | ) |   | — |   |   | (18,785,273 | ) |
| Issuance  of Class A Common Stock at $1.605 per share, less issuance cost of  $216,291                              |       | 2,782,866                           |       | 27,829                              |       | —                          |       |            | —     |                                  |       |        | 4,222,383          |   |   | — |   |   | — |   |   | 4,250,212 |   |
| Issuance  of Class A Common Stock at $2.40 per share, less issuance cost of  $281,561                               |       | 2,012,500                           |       | 20,125                              |       | —                          |       |            | —     |                                  |       |        | 4,528,314          |   |   | — |   |   | — |   |   | 4,548,439 |   |
| Issuance  of Class A Common Stock at $2.05 per share, less issuance cost of  $261,968                               |       | 2,336,752                           |       | 23,367                              |       | —                          |       |            | —     |                                  |       |        | 4,505,007          |   |   | — |   |   | — |   |   | 4,528,374 |   |
| Issuance  of Class A Common Stock at $2.73 per share, less issuance cost of  $500,814                               |       | 3,517,230                           |       | 35,172                              |       | —                          |       |            | —     |                                  |       |        | 9,066,052          |   |   | — |   |   | — |   |   | 9,101,224 |   |
| Shares  of Class A Common Stock Issued pursuant to the Wave Employee Stock  Purchase Plan at $1.9635 per share |       | 82,706                              |       | 827                                 |       | —                          |       |            | —     |                                  |       |        | 161,566            |   |   | — |   |   | — |   |   | 162,393 |   |
| Shares  of Class A Common Stock Issued pursuant to the Wave Employee Stock  Purchase Plan at $2.0145 per share |       | 62,269                              |       | 623                                 |       | —                          |       |            | —     |                                  |       |        | 124,818            |   |   | — |   |   | — |   |   | 125,441 |   |
| Warrants  Exercised at $2.16 per share, less issuance cost of $14,000                                                    |       | 162,037                             |       | 1,620                               |       | —                          |       |            | —     |                                  |       |        | 334,380            |   |   | — |   |   | — |   |   | 336,000 |   |
| Warrants  Exercised at $2.40 per share, less issuance cost of $11,000                                                    |       | 114,583                             |       | 1,146                               |       | —                          |       |            | —     |                                  |       |        | 262,854            |   |   | — |   |   | — |   |   | 264,000 |   |
| Cash  paid for fractional shares in reverse stock split                                                                  |       | (431                                | )          | (4                                  | )          | —                          |       |            | —     |                                  |       |        | (770               | ) |   | — |   |   | — |   |   | (774 | ) |
| Stock-based  compensation                                                                                                |       | —                              |       | —                              |       | —                          |       |            | —     |                                  |       |        | 1,556,042          |   |   | — |   |   | — |   |   | 1,556,042 |   |
| Exchange  of Class B Common Stock for Class A Common Stock                                                     |       | 19,343                              |       | 194                                 |       | (19,343                         | )          |            | (194       | )                                     |       |        | —             |   |   | — |   |   | — |   |   | — |   |
| Balance as of  December 31, 2006                                                                                    |       | 42,203,773                          |       | $ 422,038                      |       | 39,232                          |       |            | $ 392 |                                  |       |        | $ 309,029,938 |   |   | $ (303,532,099 | ) |   | $ — |   |   | $ 5,920,269 |   |

 

See accompanying notes to consolidated financial statements.

F-5

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**WAVE SYSTEMS CORP. AND SUBSIDIARIESConsolidated Statements of Cash FlowsYears ended December 31, 2006, 2005, 2004**

| ** **                                                                  | ** ** | **2006**    | ** **  | **2005**    | ** ** | **2004**    | ** ** |
|-----------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|
| Cash flows from  operating activities:                                      |       |        |        |        |       |        |       |
| Net  loss                                                                   |       | $           | (18,785,273 | )           | $          | (17,562,462 | )          | $ | (14,498,038 | ) |
| Adjustments to reconcile  net loss to net cashused in operating activities: |       |        |        |        |       |        |       |
| Depreciation and amortization                                               |       | 663,033     |        | 841,729     |       | 854,629     |       |
| Realized gain on marketable securities                                      |       | —      |        | (80,971     | )          | (4,330,248  | )          |
| Warrants issued as compensation for services                                |       | —      |        | —      |       | 80,609      |       |
| Write-off of impaired assets                                                |       | —      |        | —      |       | 301,366     |       |
| Gain on decrease in value of warrant liability                              |       | (2,794      | )           | (490,334    | )          | (498,723    | )          |
| Compensation associated with issuance of stock  options                     |       | 1,556,042   |        | 7,294       |       | —      |       |
| Changes in assets  and liabilities:                                         |       |        |        |        |       |        |       |
| (Decrease) increase in deferred revenue                                     |       | (99,571     | )           | 152,440     |       | 276,968     |       |
| (Increase) decrease in accounts receivable                                  |       | (301,193    | )           | (236,018    | )          | 9,633       |       |
| (Increase) decrease in prepaid expenses                                     |       | (67,149     | )           | 34,230      |       | (76,718     | )          |
| Decrease (increase) in other assets                                         |       | 63,973      |        | 23,935      |       | 93,570      |       |
| (Decrease) increase in accounts payable and accrued  expenses               |       | (53,801     | )           | 189,086     |       | 63,540      |       |
| Decrease in amounts due to charities                                        |       | —      |        | —      |       | (243,197    | )          |
| Decrease in cash collected on behalf of charities                           |       | —      |        | —      |       | 211,717     |       |
| Net cash used in operating activities                                       |       | (17,026,733 | )           | (17,121,071 | )          | (17,754,892 | )          |
| Cash flows from  investing activities:                                      |       |        |        |        |       |        |       |
| Acquisition of property and equipment                                       |       | (328,604    | )           | (160,829    | )          | (304,172    | )          |
| Proceeds provided by sale of marketable equity  securities                  |       | —      |        | 336,309     |       | 6,759,751   |       |
| Net cash provided by (used in) investing activities                         |       | (328,604    | )           | 175,480     |       | 6,455,579   |       |
| Cash flows from  financing activities:                                      |       |        |        |        |       |        |       |
| Net proceeds from issuance of common stock                                  |       | 22,428,249  |        | 10,622,054  |       | 8,252,625   |       |
| Proceeds  from employee stock purchase plan                                 |       | 287,834     |        | 354,047     |       | —      |       |
| Proceeds from employee options under stock plans                            |       | —      |        | —      |       | 34,295      |       |
| Proceeds from exercise of warrants                                          |       | 600,000     |        | 2,169,600   |       | —      |       |
| Payment in lieu of fractional shares in reverse  stock split                |       | (774        | )           | —      |       | —      |       |
| Net cash provided by financing activities                                   |       | 23,315,309  |        | 13,145,701  |       | 8,286,920   |       |
| Net increase (decrease) in cash and cash equivalents                        |       | 5,959,972   |        | (3,799,890  | )          | (3,012,393  | )          |
| Cash and cash equivalents at beginning of year                              |       | 2,006,022   |        | 5,805,912   |       | 8,818,305   |       |
| Cash  and cash equivalents at end of year                                   |       | $           | 7,965,994   |        | $          | 2,006,022   |       | $ | 5,805,912 |   |

 

See accompanying notes to consolidated financial statements.

F-6

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**(1)Business of the Company**

Wave Systems Corp. develops, produces and marketsproducts for hardware-based digital security including security applicationsand services that are complementary to and compliant with the specifications ofthe Trusted Computing Group, www.trustedcomputinggroup.org (“TCG”). Specificationsdeveloped by the TCG are designed to address a broad range of current andevolving digital security issues facing the industry. These issues include thefollowing: identity protection, data security, digital signatures, electronictransaction integrity, platform trustworthiness, network security, andregulatory compliance. Wave’s products are designed to solve many of thesedigital security issues.

Prior to January 1, 2006, the financial statementsof Wave were presented in the development stage format as prescribed byStatement of Financial Accounting Standards No. 7—“Accounting andReporting by Development Stage Enterprises.”

On July 24, 2006, ourBoard of Directors approved a reverse stock split of our common stock at aratio of one-for-three, causing each three outstanding shares of Class Acommon stock and Class B common stock to convert automatically into oneshare of Class A common stock or Class B common stock, respectively. Thepar value of Class A common stock and Class B common stock remains$0.01 per share. The reverse split became effective at the close of business onJuly 25, 2006. In lieu of fractional shares, stockholders received a cashpayment based on an average trading price of the Class A common stockprior to the effectiveness of the reverse split. Stockholders’ equity has beenrestated to give retroactive recognition to the reverse split for all periodspresented by reclassifying the excess par value resulting from the reduced numberof shares from common stock to paid-in capital. Except as otherwise noted, allreferences to common share and per common share amounts (including warrantshares, shares reserved for issuance and applicable exercise prices) for allperiods presented have been retroactively restated to reflect this reversesplit.

**(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 31,2006, has an accumulated deficit of $303,532,099. We also expect Wave willincur an operating loss for the calendar year of 2007. As of December 31,2006, we had working capital of $5,369,273.

Wave has begun market introduction of its security andbroadband media distribution software products and has signed initialdistribution contracts for these applications. However, due to the early stagenature of this market, it is unlikely that Wave will generate sufficient revenueto cover all of its cash flow needs to fund its operating requirements for theyear ending December 31, 2007.

Because Wave does not have sufficient cash to fundoperations for the year ending December 31, 2007; and given theuncertainties described above with respect to Wave’s revenue outlook for 2007,Wave has been and will continue to be actively engaged in financing activitiesin order to generate additional funding to cover its operating costs for theyear ending December 31, 2007. These activities included the filing of asecond $25,000,000 S-3 shelf registration with the SEC on December 16,2005, which was declared effective on January 31, 2006; and the subsequentsale of 10,811,385 shares of common stock pursuant to this shelf registrationstatement, for gross proceeds of $24,038,881 during 2006. Wave received netproceeds of $22,428,249 from these sales of common stock and $336,000 from theexercise of a warrant granted to an investor as part of this financing afterpaying underwriter and other issuance costs totaling $1,274,632 in connectionwith the sale and issuance of these shares. The remaining $961,119 of grossproceeds under this shelf, are reserved for warrants for the issuance of393,323 shares of common stock at exercise prices ranging from between $2.05and $2.73 per share. These warrants expire June 3, 2007 through November 30,2007.

F-7

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**(2)Liquidity (Continued)**

On May 8, 2006, an investor also exercised awarrant issued by Wave to that investor in connection with Wave’s December 5,2005 financing. The warrant was exercised in full for 114,583 shares of

Wave Class A Common Stock, at an exercise priceof $2.40 per share. Wave received $264,000 from the exercise of this warrantafter subtracting the 4% placement agent fee.

Also, previously, on April 15, 2004 Wave filed a$25,000,000 registration statement with the SEC, under which Wave has drawndown a total of $22,494,000 in gross proceeds, through various sales of commonstock and issuances of Warrants (See footnote 8). There remains approximately$2,506,000 in gross proceeds available under the April 15, 2004 shelfregistration statement, which may be used for future financings.

It is likely that we will be required to selladditional shares of common stock, preferred stock, obtain debt financing orengage in a combination of these financing alternatives, to raise additionalcapital to continue to fund our operations for the twelve months ending December 31,2007.

Considering our current cash balance, we project thatwe have enough liquid assets to continue operating into May 2007. Weestimate we will need a minimum of $11,500,000 of additional cash from acombination of revenue growth and additional financings, to fund operatingexpenses and capital expenditures for the year ending December 31, 2007.

If Wave is not successfulin raising the needed capital referred to above, or is not successful inexecuting its business plan, we could be forced to reduce expenses which may significantlyimpede our ability to meet our sales, marketing and development objectives,cease operations or merge with another company. No assurance can be providedthat any of these initiatives will be successful. Due to our current cashposition, our capital needs over the next year and beyond, the fact that wehave not at this time secured enough financing to fund our operations through December 31,2007 and beyond, and the uncertainty as to whether we will achieve our salesforecast for our products and services, substantial doubt exists with respectto our ability to continue as a going concern.

**(3) Significant AccountingPolicies**

*(a) Basis of Consolidation*

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 of Estimates***

The preparation offinancial statements and related disclosures in conformity with accountingprinciples generally accepted in the United States requires management to makeestimates and assumptions that affect amounts reported in the ConsolidatedFinancial Statements and accompanying notes. Estimates are used for, but notlimited to, depreciation and amortization, charges for other than temporarydeclines in value of marketable equity securities and other special charges,inventory allowances and contingencies. Actual results could differ from thoseestimates.

***(c)Method of Accounting for Joint Ventures***

Wave accounts for its investmentsin joint ventures using the equity method of accounting when its ownershipinterest 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 

F-8

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

financialstatements of joint ventures in which Wave owns greater than a fifty percentinterest are consolidated with Wave’s financial statements (see note 10).

***(d)Cash and Cash 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. Wave held no marketable securities as of December 31,2005 and 2006.

***(f)Allowance For Doubtful Accounts***

The determination of theallowance for doubtful accounts is based on management’s estimate ofuncollectible accounts receivable. Management records specific reserves forreceivable balances that are considered high risk due to known facts regardingthe customer.

*(g) Concentrationsof Credit Risks*

Sales to our largestcustomer in 2006, Dell, Inc., were approximately 35% of revenue. Accountsreceivable at December 31, 2006 included receivables from Dell, Inc.of $272,825. Sales to our largest customer in 2005, ST Microelectronics, wereapproximately 44% of revenue. Accounts receivable at December 31, 2005included receivables from ST Microelectronics of $144,373. Sales to our largestcustomer in 2004, the US Government, were approximately 39% of revenue. Therewere no outstanding receivables due from this customer at December 31,2004.

*(h) Property andEquipment*

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 shorter of the useful life or remaining lease term.

F-9

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

*(i) Income Taxes*

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. At December 31,2006 and 2005, a full valuation allowance has been recorded against the grossdeferred tax asset since management believes that, after considering all theavailable objective evidence, both positive and negative, historical andprospective, with greater weight given to historical evidence, it is morelikely than not that these assets will not be realized.

*(j) Share-basedPayments*

On January 1, 2006, Wave adopted Statement ofFinancial Accounting Standards No. 123(R), “Share-Based Payment,” (“SFAS No. 123(R)”),which requires the measurement and recognition of compensation expense for allstock-based payment awards made to employees and directors including employeestock options and employee stock purchases based on estimated fair values. In March 2005,the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107(“SAB 107”) relating to SFAS No. 123(R). The Company has applied theprovisions of SAB 107 in its adoption of SFAS No. 123(R).

SFAS No. 123(R) requires companies to estimatethe fair value of stock-based payment awards on the date of grant using anoption-pricing model. The value of the portion of the award that is ultimatelyexpected to vest is recognized as expense over the requisite service periods inthe Company’s consolidated statement of operations. SFAS No. 123(R) supersedesWave’s previous accounting under the provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation.” As permitted by SFAS No. 123, Wave measuredcompensation cost for options granted prior to January 1, 2006, inaccordance with Accounting Principles Board Opinion (APB) No. 25, “Accountingfor Stock Issued to Employees” and related interpretations. Accordingly, noaccounting recognition was given to stock options granted at fair market valueuntil they were exercised. Upon exercise, net proceeds, including tax benefitsrealized, were credited to equity.

Wave adopted SFAS No. 123(R) usingthe modified prospective transition method, which requires the application ofthe accounting standard as of January 1, 2006. In accordance with themodified prospective transition method, Wave’s consolidated financialstatements for prior periods have not been restated to reflect, and do notinclude, the impact of SFAS No. 123(R) (See footnote 8).

*(k) Research andDevelopment 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 did not capitalize any software development costs for 2006 or2005. Amortization of capitalized software costs for the years ended December 31,2006, 2005 and 2004 was $382,287, $621,419 and $538,781, respectively

F-10

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

*(l) 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 optionsand stock warrants. Diluted net loss per share is equal to basic net loss pershare and is therefore not presented separately in the financial statements. Theweighted average number of potential common shares that would have beenincluded in diluted loss per share had their effect not been anti-dilutive foreach of the years ended December 31, 2006, 2005 and 2004 wereapproximately 121,000 shares, 67,000 shares and 87,000 shares, respectively. Employeestock options and other stock warrants to purchase a weighted average ofapproximately 5,577,000, 5,515,000 and 4,753,000 shares were outstanding forthe years ended December 31, 2006, 2005 and 2004 respectively, but wouldnot have been included in the computation of diluted loss per share becausetheir exercise price was greater than the average share price of Wave’s commonshares and, therefore, their effect would have been anti-dilutive.

*(m) Impairment ofLong-Lived Assets and Long-Lived Assets to Be Disposed Of*

Wave reviews thevaluation of long-lived assets, including property and equipment and capitalizedsoftware, under the provisions of SFAS No. 144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets”* (“SFAS No. 144”)and SFAS No.86, *“Accounting for the Costs of ComputerSoftware to Be Sold, Leased, or Otherwise Marketed”* (“SFAS No. 86”),respectively. Wave is required to assess the recoverability of long-livedassets and capitalized software development costs whenever events andcircumstances indicate that the carrying value may not be recoverable. Factorswe consider important that could trigger an impairment review include thefollowing:

·       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 be recoverablebased upon the existence of one or more of the above indicators of impairment,we evaluate whether the carrying amount of the asset exceeds the sum of theundiscounted 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 currentbusiness model. In accordance with SFAS No. 86, when we determine that thecarrying value of capitalized software development costs may not be recoverable,we evaluate 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.Changes in judgments on any of these factors could impact the value of theasset being evaluated.

F-11

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**(3) Significant AccountingPolicies (Continued)**

*(n)   RevenueRecognition*

Wave’s business model targets revenues from varioussources including: licensing of EMBASSY Trust Suite, Wavexpress’ broadbandmedia distribution and eTMS software products and development contracts. Manyof our sales arrangements include multiple-elements, and/or requiredsignificant modification or customization of our software.

Wave follows theprovisions of statement of position “SOP” 97-2, *SoftwareRevenue Recognition* as amended by SOP 98-9, Modification ofSOP 97-2, *Software Revenue Recognition, with Respectto Certain Transactions*. Generally, Wave recognizes revenue when itis realized or realizable and earned. Wave considers revenue realized orrealizable and earned when persuasive evidence of an arrangement exists,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 be estimated.When these amounts cannot be estimated Wave defers revenue until the product issold to the end-user. Revenue from software license agreements that havesignificant customizations and modification of the software product is deferredand recognized in a manner that approximates the percentage of completionmethod. In addition to the aforementioned general policy, the following are thespecific revenue recognition policies for each major category of revenue.

**PRODUCTS—SOFTWARE**

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 customers rights to any future upgrades at no additionalcharge or future maintenance that is provided within the overall price. Therevenue that is deferred for any contract element is recognized when all of therevenue recognition criteria have been met for that element.

Prepaid royalty feesreceived pursuant to distribution software licenses with OEMs in which Waveearns a royalty, based upon units shipped by the OEM to end customers, aredeferred when received, and recognized as revenue as units are shipped by theOEM.

**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.

*(o)   Accountingfor Warrants Containing Cash Settlement Provisions*

Wave follows the FASB’sEmerging Issues Task Force pronouncement No. 00-19 (“EITF 00-19”)to account for derivative financial instruments indexed to, and settled in ourown stock. These would include financial instruments such as options orwarrants to purchase Wave stock, but does not include employee stock options.EITF 00-19 requires that freestanding financial instruments of thisnature be classified as an asset or liability at fair value, in the event thatthe contract underlying any such financial instruments includes a net cashsettlement provision. In addition, EITF 00-19 requires any such asset orliability to be 

F-12

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

markedto market at the end of each period, with any resulting difference in fair value to be recorded asincome or loss, through the company’s statement of operations, depending uponwhether the difference results in a gain or loss.

On November 18, 2003,Wave granted warrants to purchase 310,436 shares of Wave common stock at anexercise price of $7.86 per share, in connection with a private placement ofcommon stock with a group of accredited investors. The warrants had athree-year term. The contract underlying the warrants included a provision thatwould require Wave to pay liquidated damages in cash to the warrant holders ifthe warrants are “in the money” and the registration statement underlying suchshares ceases to remain continuously effective. Because of this provision, thecontract is considered to contain a net cash settlement provision as defined inEITF 00-19. Accordingly, Wave recorded a liability in its balance sheetthat was valued at $-0- as of December 31, 2006, and $2,794 asof December 31, 2005. The decreases in fair value of the liabilityassociated with the warrants of $2,794, $490,334 and $498,723 were recorded asan unrealized gain in Wave’s statement of operations in the years endedDecember 31, 2006, 2005 and 2004 respectively, in accordance with EITF 00-19.These warrants expired unexercised on November 24, 2006.

***(p)   Recent AccountingPronouncements***

***In June 2006, the FASB issued InterpretationNo. 48, “Accounting for Uncertainty in Income Taxes (as amended)—aninterpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with SFAS No. 109, “Accounting forIncome Taxes,” and prescribes a recognition threshold and measurement attributefor the financial statement recognition and measurement of a tax position takenor expected to be taken in a tax return. FIN 48 also provides guidance onde-recognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. FIN 48 is effective for fiscal years beginningafter December 15, 2006. We are in the process of analyzing the impact ofFIN 48, which is required to be adopted by the first quarter of 2007.***

***In September 2006, the FASB issued SFASNo. 157, “Accounting for Fair Value Measurements”. SFAS No. 157 definesfair value, and establishes a framework for measuring fair value in generallyaccepted accounting principles and expands disclosure about fair value measurements.SFAS No. 157 is effective for the Company for financial statements issued subsequentto November 15, 2007. Wave does not expect the new standard to have any materialimpact on the financial position and results of operations.***

**(4) Related PartyTransactions**

In March 2003, Mr. Peter Sprague, who is theformer Chairman of Wave, was appointed Chairman and Chief Executive Officer ofWavexpress. Mr. Sprague was paid $129,000 for each of the years endedDecember 31, 2006, 2005 and 2004, respectively in salary as an officer ofWavexpress. Mr. Peter Sprague is the father of Wave’s President and ChiefExecutive Officer, Steven Sprague.

On August 1, 1997,Michael Sprague became an employee of Wave and was paid a salary of $150,000,$150,000 and $150,000 for the years ended December 31, 2006, 2005 and2004, respectively. In addition, lease payments were made to Michael Sprague inthe amount of $48,750 for the year ended December 31, 2006. These paymentswere for property occupied by Wavexpress and owned by Michael Sprague. Thislease agreement was in effect for the period of April 15, 2006 throughOctober 31, 2006. This lease agreement has since been terminated. MichaelSprague is the brother of Steven Sprague and the son of Wave’s former Chairman,Peter Sprague.

F-13

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**(5) Property and Equipment**

Propertyand equipment as of December 31 consisted of the following:

| ** **                                       | ** ** | **2006**  | ** ** | **2005**   | ** ** |
|--------------------------------------------------|------------|-----------|------------|------------|------------|
| Computer  equipment                              |       | $         | 3,308,529  |       | $          | 6,003,899 |   |
| Furniture,  fixtures and improvements            |       | 231,162   |       | 887,843    |       |
| Computer software                                |       | 2,502,054 |       | 4,821,247  |       |
|                                             |       | 6,041,745 |       | 11,712,989 |       |
| Less: Accumulated  depreciation and amortization |       | 5,622,021 |       | 10,958,836 |       |
| Total                                            |       | $         | 419,724    |       | $          | 754,153 |   |

 

The decrease in the value of the historical cost andaccumulated depreciation balances reflected above resulted from the retirementof fully depreciated assets totaling approximately $5,983,000 for the yearended December 31, 2006.

Computer software includes $1,864,256 of capitalizedsoftware development costs pursuant to SFAS 86 as of December 31,2006 and 2005. Capitalized software pursuant to SFAS 86 is amortized over athree-year life using the straight-line method, once the product is ready tobring to market.

Depreciation andamortization expense on property and equipment amounted to approximately$663,000, $842,000 and $855,000 for the years ended December 31, 2006,2005, 2004, respectively.

**(6) Accounts Payable andAccrued Expenses**

Accountspayable and accrued expenses as of December 31 consisted of the following:

| ** **                                   | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|----------------------------------------------|------------|-----------|------------|-----------|------------|
| Accounts payable                             |       | $         | 910,935    |      | $          | 993,926 |   |
| Accrued  consulting and professional fees    |       | 351,083   |       | 472,290   |       |
| Accrued payroll  and related costs           |       | 1,232,924 |       | 1,139,814 |       |
| State & local  taxes payable             |       | 173,539   |       | 92,397    |       |
| Accrued software  licenses                   |       | 162,500   |       | 162,500   |       |
| Other accrued  expenses                      |       | 204,368   |       | 228,223   |       |
| Total accounts payable  and accrued expenses |       | $         | 3,035,349  |      | $          | 3,089,150 |   |

 

**(7) Common Stock**

On October 30, 2006, Wave entered intosubscription agreements, pursuant to which Wave agreed to sell and issue3,517,230 shares of Class A Common Stock, par value $.01 per share, tocertain purchasers for an aggregate purchase price of $9,602,038. These shareswere priced at $2.73 per share. Securities Research Associates, Inc.(“SRA”) entered into a placement agency agreement with Wave in which theyagreed to act as placement agent in connection with the offering. Wave agreedto pay SRA a fee equal to 5.0% of the gross proceeds of this offering. Wavealso agreed to issue a warrant to SRA to purchase up to 175,861 shares ofClass A common stock at an exercise price of $2.73. The Warrant expires onNovember 30, 2007. Wave realized net proceeds of $9,101,224 after deductingthe placement agent fees of $484,000 and additional legal and other feesassociated with the issuance of the securities which totaled $16,814. Theshares sold on October 30, 2006 were offered and issued pursuant to ashelf registration statement which was filed by Wave on December 16, 2005and declared effective by the Commission on January 13, 2006.

F-14

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**(7)Common Stock (Continued)**

On August 4, 2006, Wave entered into subscriptionagreements, pursuant to which Wave agreed to sell and issue 2,336,752 shares ofClass A Common Stock, par value $.01 per share, to certain purchasers foran aggregate purchase price of $4,790,342. These shares were priced at $2.05per share. Securities Research Associates, Inc. (“SRA”) entered into aplacement agency agreement with Wave in which they agreed to act as placementagent in connection with the offering. Wave agreed to pay SRA a fee equal to5.0% of the gross proceeds of this offering. Wave also agreed to issue awarrant to SRA to purchase up to 116,837 shares of Class A common stock atan exercise price of $2.05. The Warrant expires on September 3, 2007. Waverealized net proceeds of $4,528,374 after deducting the placement agent fees of$239,517 and additional legal and other fees associated with the issuance ofthese securities which totaled $22,451. The shares sold on August 4, 2006were offered and issued pursuant to a shelf registration statement which wasfiled by Wave on December 16, 2005 and declared effective by theCommission on January 13, 2006.

On May 8, 2006, Wave received gross proceeds of$625,000 less placement agent fees of $25,000 for net proceeds of $600,000, inconnection with the issuance of 276,620 shares of Class A Common Stockupon the exercise of two warrants that were granted to an investor as part ofWave’s December 5, 2005 financing and February 15, 2006 financing.The warrant issued to this investor in connection with the December 5,2005 financing was exercised in full for 114,583 shares of Class A CommonStock at an exercise price of $2.40 per share. The warrant issued to theinvestor in connection with the February 15, 2006 financing was exercisedin full for 162,037 shares of Class A Common Stock at an exercise price of$2.16 per share.

On May 3, 2006, Waveentered into subscription agreements, pursuant to which Wave agreed to sell andissue 2,012,500 shares of Class A Common Stock to certain purchasers foran aggregate purchase price of $4,830,000. The shares were priced at $2.40 pershare. SRA entered into a placement agency agreement with Wave in which theyagreed to act as placement agent in connection with the offering. Wave agreedto pay SRA a fee equal to 5.0% of the gross proceeds of this offering. Wavealso agreed to issue awarrant to SRA to purchase up to 100,625 shares of Class A common stock atan exercise price of $2.40. The Warrant is exercisable for a period of thirteenmonths following the date of the transaction. Wave realized net proceeds of$4,548,439 after deducting the placement agent fees of $241,500 and additionallegal and other fees associated with the issuance of these securities, whichwere $40,061. The shares were offered and issued pursuant to the shelfregistration statement referred to above.

OnFebruary 15, 2006, Wave entered into a securities purchase agreement,pursuant to which Wave agreed to sell and issue 2,782,866 shares ofClass A Common Stock for $1.605 per share, to certain purchasers for anaggregate purchase price of $4,466,500. The purchasers were also grantedwarrants (the “Warrants”) to purchase up to 516,956 shares of Class Acommon stock at an exercise price of $2.16. The Warrants were exercisable for aperiod of six months following the date of issuance. Warrants to purchase162,037 shares were exercised on May 8, 2006, as described above. The remainingwarrants to purchase 354,919 shares expired unexercised on August 16,2006. Each Warrant was subject to cancellation if the closing bid price ofWave’s common stock exceeded $2.58 for 10 out of 20 consecutive trading daysand the Warrant had not been exercised by the close of business on the tradingday after the 10th trading day on which the closing bid price exceeded $2.58.The placement agent, JPC Capital Partners, Inc. (formerlyCorpfin, Inc.) (the “Placement Agent”) had entered into a placement agencyagreement with Wave in which they agreed to act as placement agent inconnection with the offering. Wave agreed to pay the Placement Agent a feeequal to 4.0% of the gross proceeds of this offering. Wave realized netproceeds of $4,250,212 after deducting the placement agent fees of $216,291 andadditional legal and other fees associated with the issuance of thesesecurities. The shares were issued pursuant to the shelf registration statementreferred to above.

F-15

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**(7)Common Stock (Continued)**

On December 5, 2005, Wave entered into aSecurities Purchase Agreement, pursuant to which Wave sold and issued 1,994,302shares of Class A Common Stock, par value $.01 per share, to certainpurchasers who are parties to the Purchase Agreement for an aggregate purchaseprice of $3,500,000. The Common Shares were priced at $1.755 per share. JPCCapital Partners, Inc. (formerly Corpfin Inc.) (the “Placement Agent”),had entered into a placement agency agreement with Wave in which they agreed toact as placement agent in connection with the offering. Wave paid the PlacementAgent a fee equal to 4.0% of the gross proceeds of this offering. Wave realizednet proceeds of $3,340,890 after deducting placement agent and other feesassociated with the issuance of these securities.

On August 5, 2005, Wave entered into a securitiespurchase agreement, pursuant to which Wave agreed to sell and issue 1,333,333shares of Class A Common Stock, par value $.01 per share, for $2.70 pershare, to certain purchasers who are parties to the Purchase Agreement for anaggregate purchase price of $3,600,000. The Placement Agent had entered into aplacement agency agreement with Wave in which they agreed to act as a placementagent in connection with the offering. Wave has agreed to pay the PlacementAgent a fee equal to 4.0% of the gross proceeds of this offering. Wave realizednet proceeds of $3,389,205 after deducting the placement agent fees of $144,000and additional legal and other fees associated with the issuance of thesesecurities of $66,795.

On August 1, 2005, Wave received gross proceedsof $2,260,000 less placement agent fees of $90,400 for net proceeds of$2,169,600, for the issuance of 666,667 shares of Class A Common Stockupon partial exercise of a warrant that was granted to an accredited investoras part of a securities purchase agreement with the accredited investor, datedJuly 30, 2004. The warrants were exercised at a price of $3.39 per share.

On March 15, 2005,Wave entered into a securities purchase agreement, pursuant to which Wave soldand issued 1,553,030 shares of Class A Common Stock, par value $.01 pershare for an aggregate purchase price of $4,100,000. The shares of Class ACommon Stock were priced at $2.64. The Placement Agent, had entered into aplacement agency agreement with Wave in which they agreed to act as placement agent in connection with theoffering. Wave paid the placement agent a fee equal to 4% of the gross proceedsof this offering. Wave realized net proceeds of $3,891,959 after deductingplacement agent and other fees associated with the issuance of thesesecurities, which totaled $208,041.

On December 16, 2004, Wave entered into aSecurities Purchase Agreement, pursuant to which Wave sold and issued 1,828,263shares of Class A Common Stock, par value $.01 per share, to certainpurchasers who are parties to this purchase agreement for an aggregate purchaseprice of $5,759,030. The Common Shares were priced at $3.15. The PlacementAgent had entered into a placement agency agreement with Wave in which they agreedto act as placement agent in connection with the offering. Wave paid thePlacement 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 andother fees associated with the issuance of these securities.

On July 30,2004, Wave entered into a securities purchase agreement, pursuant to which Wavesold and issued 1,176,471 shares of Class A Common Stock, par value $.01per share for an aggregate purchase price of $3,000,000. The shares ofClass A Common Stock were priced at $2.55. Wave realized net proceeds of$2,777,897 after deducting placement agent and other fees associated with theissuance of these securities. Wave also granted warrants to purchase up to 1,470,588 shares ofClass A Common Stock, in connection with this securities purchaseagreement.

The warrants granted in this transaction were made upof two different series, Series A and Series B. The Series Awarrants were exercisable for up to 1,176,471 shares of Class A CommonStock at an exercise price of $3.45 per share. The Series A warrants wereexercisable from January 30, 2005, until August 1, 2005. TheSeries B warrants were exercisable for up to 294,118 shares ofClass A Common Stock at an exercise price of $3.90 per share. TheSeries B warrants were exercisable from July 30, 2005, until 

F-16

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**(7)Common Stock (Continued)**

January 30, 2006. TheSeries A and Series B warrants issued in this transaction carried asubsequent equity clause that required Wave to adjust the initial exerciseprice, pro-rata, for any subsequent equity sales that were made at a price thatwas lower than the initial exercise price. As a result of several sales ofcommon stock subsequent to the July 30, 2004 securities purchase agreement,the exercise prices of the Series A and Series B warrants wereadjusted to $3.39 and $3.60, respectively, in accordance with the formulapursuant to the warrant agreements. On August 1, 2005 a Series AWarrant holder exercised a portion of the Series A Warrant for a total of666,667 shares at an exercise price of $3.39 per share, for aggregate grossproceeds of $2,260,000, less placement agent fees of $90,400, for net proceedsof $2,169,600. The remaining Series A warrants for 509,804 shares expiredon August 1, 2005. All of the Series B Warrants granted in connectionwith the July 30, 2004 securities purchase agreement expired unexercisedon January 30, 2006.

Wave also granted the purchaser a 90-dayadditional investment right. The additional investment right granted in thistransaction allowed the purchaser to purchase up to 1,176,471 additional sharesof Class A Common Stock at a price of $3.00 per share, and expired onNovember 2, 2004 unexercised. These shares would have been drawn-down offof the shelf registration statement, had the investment right been exercised.

The Placement Agent entered into a placement agencyagreement with Wave in which they have agreed to act as placement agent inconnection with the offering. Wave has agreed to pay the Placement Agent a feeequal to 4.0% of the actual gross proceeds from the sale of the shares andexercise of the investment rights and warrants referred to above.

All of the above 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”) onMay 10, 2004.

On December 1, 2006Wave issued 62,269 shares of Class A Common Stock to Wave and Wavexpressemployees for $2.01 per share, pursuant to the Wave 2004 Employee StockPurchase Plan. Wave received proceeds of $125,441, from the sale of theseshares.

On June 1,2006 Wave issued 82,706 shares of Class A Common Stock to Wave andWavexpress employees for $1.96 per share, pursuant to the Wave 2004 Employee StockPurchase Plan. Wave received proceeds of $162,393, from the sale of theseshares.

On December 1, 2005 Wave sold 79,555 shares ofClass A Common Stock to Wave and Wavexpress employees for $2.04 per share,pursuant to the Wave 2004 Employee Stock Purchase Plan. Wave received proceedsof $162,293, from the sale of these shares.

On June 1, 2005 Wavesold 84,492 shares of Class A Common Stock to Wave and Wavexpressemployees for $2.26 per share, pursuant to the Wave 2004 Employee StockPurchase Plan. Wave received proceeds of $191,754, from the sale of theseshares.

**(8) Share-basedCompensation**

In January 1994, Wave adopted the 1994 EmployeeStock Option Plan (the “1994 Plan”). The total number of shares of Class ACommon Stock reserved for issuance under the 1994 Plan, as amended is 6,833,333shares. The 1994 Plan Expires on January 1, 2009. In September 1996,Wave adopted the 1996 Performance Stock Option Plan (the “1996 Plan”). Thenumber of shares of Class A Common Stock subject to the 1996 Plan was266,666. Under 1994 and 1996 Plans, both incentive stock options andnon-qualified stock options may be granted to officers, key employees and otherpersons providing services to Wave. Options granted under the plans generallyvest over three years and expire ten years from the date 

F-17

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**(8) Share-basedCompensation (Continued)**

of grant. InJanuary 1994, Wave adopted the Non-Employee Directors Stock Option Plan(the “Directors’ Plan”). The total number of shares of Class A CommonStock reserved for issuance under the Directors’ Plan, as amended is 333,333shares. Under the Directors’ Plan, each director who is not an employee of Wavereceives an initial grant of options to purchase 4,000 shares of Class ACommon Stock; and an additional annual grant to purchase 3,333 shares on the dayimmediately following each of the dates on which an incumbent director isreelected. The options granted to non-employee directors vest on the dayfollowing the grant and expire ten years from the date of grant. Under all ofWave’s stock option plans, options are granted with exercise prices thatapproximate fair market value at the date of grant. All of Wave’s stock optionplans and amendments thereto have been approved by shareholder vote.

In November 2004 Waveadopted the 2004 Employee Stock Purchase Plan (the “Purchase Plan”) pursuant towhich a total of 1,000,000 shares of Wave’s Common Stock may be sold toeligible employees at a 15% discount from the market value of the shares. ThePurchase Plan was approved by a vote of Wave’s shareholders. Under the terms ofthe Purchase Plan, employees may elect to have withheld up to 15% of their baseearnings to purchase these shares during each offering period, up to a maximumof $25,000 in market value of Wave Common Stock. Offering periods commence on May 1stand December 1st and are for a period of six months. The purchase priceunder the Purchase Plan is 85% of the lesser of the market price on thebeginning or the ending of the offering period.

On January 1, 2006,Wave adopted Statement of Financial Accounting Standards No. 123(R), “Share-BasedPayment,” (“SFAS No. 123(R)”), which requires the measurement andrecognition of compensation expense for all stock-based payment awards made toemployees and directors including employee stock options and employee stock purchasesbased on estimated fair values. In March 2005, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relatingto SFAS No. 123(R). The Company has applied the provisions of SAB 107in its adoption of SFAS No. 123(R).

SFAS No. 123(R) requirescompanies to estimate the fair value of stock-based payment awards on the dateof grant using an option-pricing model. The value of the portion of the awardthat is ultimately expected to vest is recognized as expense over the requisiteservice periods in the Company’s consolidated statement of operations. SFAS No. 123(R) supersedesWave’s previous accounting under the provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation.” As permitted by SFAS No. 123, Wave measuredcompensation cost for options granted prior to January 1, 2006, inaccordance with Accounting Principles Board Opinion (APB) No. 25, “Accountingfor Stock Issued to Employees” (“APB No. 25”) and related interpretations.Accordingly, no accounting recognition was given to stock options granted atfair market value until they were exercised. Upon exercise, net proceeds,including tax benefits realized, were credited to equity.

Wave adopted SFAS No. 123(R) usingthe modified prospective transition method, which requires the application ofthe accounting standard as of January 1, 2006. In accordance with themodified prospective transition method, Wave’s consolidated financialstatements for prior periods have not been restated to reflect, and do notinclude, the impact of SFAS No. 123(R). Stock-based compensation expenserecognized under SFAS No. 123(R) for the year ended December 31,2006, was $1,556,042. Stock-based compensation expense for the year ended December 31,2005 under APB No. 25 and the related interpretations was $7,294. Therewas no stock-based compensation expense recognized for the year ended December 31,2004. SFAS 123(R) requires that the classification of the cost of sharebased compensation, in the 

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**(8)Share-based Compensation (Continued)**

statement of operations,is consistent with the nature of the services being rendered in exchange forthe share based payment.  The followingtable summarizes the effect of share based compensation in Wave’s statement ofoperations, year ended December 31, 2006:

| Cost of Sales                         |   | $     25,577 |   |
|---------------------------------------|--------|---------------------------------------|--------|
| Selling, General & Administrative |   | 1,056,013                             |   |
| Research & Development            |   | 474,453                               |   |
| Total                                 |   | $ 1,556,043                      |   |

 

Waveuses the Black-Scholes-Merton option pricing model to value stock options. TheBlack-Scholes-Merton model requires the use of employee exercisebehavior data and the use of a number of assumptions including volatility ofthe company’s stock price, the weighted-average, risk-free interest rate andthe weighted-average expected term of the options. As Wave does not paydividends, the dividend rate variable in the Black-Scholes-Merton model iszero. The following values for the indicated variables were used to valueoptions granted during the year ended December 31, 2006.

| ** **                         | ** ** | **Stock Option  Plans** | ** ** | **Stock Purchase  Plan** | ** ** |
|------------------------------------|------------|------------------------------|------------|-------------------------------|------------|
| Expected Term (in years)           |       | 5 Years                      |       | 6 Months                      |       |
| Risk-free Rate—range          |       | 4.13% - 5.11                 | %          | 3.28% - 4.95                  | %          |
| Risk-free Rate—wt. avg.       |       | 4.68                         | %          | 4.49                          | %          |
| Expected Volatility—range     |       | 95.4% - 100.5                | %          | 55.4% - 71.31                 | %          |
| Expected Volatility—wt.  avg. |       | 99.72                        | %          | 58.89                         | %          |
| Dividend Yield                     |       | 0                            | %          | 0                             | %          |

 

The volatilityassumptions are based on the historical weekly price data of Wave’s stock overa period equivalent to the weighted average expected term of the options. Managementdid not identify any factors during that period which were unusual and whichwould distort the volatility figure if used to estimate future volatility.

The risk-free interest rate assumption is based uponthe implied yield available on U.S. Treasury zero-coupon issues with aremaining term equal to the expected term of the option granted.

The expected term of employee stock options representsthe weighted average period that the stock options are expected to remainoutstanding. For Wave’s stock option plans, it is based upon an analysis of thehistorical behavior of option holders during the period from January 1,2000 to December 31, 2005. Management believes historical data isrepresentative of future exercise behavior. For Wave’s Employee Stock PurchasePlan, the expected term of six months, is the length of each purchase period,pursuant to the plan.

As stock-based compensation expense recognized in theconsolidated statement of operations pursuant to SFAS No. 123(R) isbased on awards ultimately expected to vest, expense for grants beginning uponadoption of SFAS No. 123(R) on January 1, 2006 is reduced forestimated forfeitures. The estimated forfeiture rates used in the calculationof share-based compensation expense ranged from 17.74% to 19.41% for the yearended December 31, 2006. SFAS No. 123(R) requires forfeitures tobe estimated at the time of grant and revised, if necessary, in subsequentperiods if actual forfeitures differ from those estimates. Forfeitures areestimated based on historical experience.

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**(8)Share-based Compensation (Continued)**

A summary of optionactivity for all Wave option plans through December 31, 2006 follows:

| ** **                                           | ** ** | **2006**                   | ** ** | **2005**                               | ** **   | **2004**                   | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|----------------------------------------|--------------|----------------------------|------------|
| ** **                                           | ** ** | **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                        |       | 4,122,870                  |       |                                   | $ 11.46 |                       |       | 3,779,018 |   |   | $ 12.60 |   |   | 3,180,226 |   |   | $ 15.09 |   |   |
| Granted                                              |       | 1,048,517                  |       |                                   | 1.91         |                       |       | 503,208 |   |   | 3.00 |   |   | 781,513 |   |   | 3.66 |   |   |
| Forfeited                                            |       | (114,025                   | )          |                                   | 2.83         |                       |       | (88,310 | ) |   | 3.36 |   |   | (81,699 | ) |   | 5.09 |   |   |
| Expired                                              |       | (231,434                   | )          |                                   | 24.51        |                       |       | (71,046 | ) |   | 21.19 |   |   | (90,086 | ) |   | 30.80 |   |   |
| Exercised                                            |       | —                     |       |                                   |         |                       |       | — |   |   |   |   |   | (10,936 | ) |   | 3.12 |   |   |
| Balance at end of year                               |       | 4,825,928                  |       |                                   | 8.97         |                       |       | 4,122,870 |   |   | 11.46 |   |   | 3,779,018 |   |   | 12.60 |   |   |
| Exercisable at end of  year                          |       | 3,329,847                  |       |                                   | $ 11.94 |                       |       | 2,967,657 |   |   | $ 14.58 |   |   | 2,427,476 |   |   | $ 17.37 |   |   |
| Additional shares available for grant at end of year |       | 1,930,265                  |       |                                   |         |                       |       | 2,774,972 |   |   |   |   |   | 2,300,300 |   |   |   |   |   |

 

The weighted average grant date fair value of optionsgranted during the years ended December 31, 2006, 2005 and 2004 was $1.46,$2.43 and $3.09, respectively.

The weightedaverage remaining contractual term for options outstanding and optionsexercisable at December 31, 2006 were 5.8 and 4.5 years, respectively.

As of December 31, 2006, unrecognized stock-basedcompensation related to stock options was approximately $994,000. At December 31,2006, the weighted average period this cost is expected to be expensed is 2.0years. The total fair value of shares that vested during the years ended December 31,2006, 2005 and 2004 was approximately $1,788,000, $757,000 and $1,160,000,respectively.

As of December 31, 2006, the intrinsic value ofoutstanding, vested and currently exercisable share options was $41,000.

Thefollowing table summarizes information about stock options outstanding underthe Wave stock options plans as of December 31, 2006:

| ** **                         | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Exercise Price Range** | ** ** | ** **                   | ** ** | **Number  Outstanding**      | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $0 – $2.00                    |       |                         | 928,634    |                         |       |   | 9.0 |   |   |   | $ 1.87 |   |   | 13,332 |   |   | $ 1.65 |   |   |
| $2.01 – $3.00                 |       |                         | 821,029    |                         |       |   | 7.0 |   |   |   | 2.64 |   |   | 563,589 |   |   | 2.74 |   |   |
| $3.01 – $4.25                 |       |                         | 546,081    |                         |       |   | 5.8 |   |   |   | 3.31 |   |   | 322,520 |   |   | 3.42 |   |   |
| $4.26 – $5.50                 |       |                         | 629,998    |                         |       |   | 6.3 |   |   |   | 4.94 |   |   | 535,776 |   |   | 4.93 |   |   |
| $5.51 – $10.00                |       |                         | 356,811    |                         |       |   | 5.4 |   |   |   | 6.24 |   |   | 351,255 |   |   | 6.24 |   |   |
| $10.01 – $11.25               |       |                         | 502,292    |                         |       |   | 1.4 |   |   |   | 10.90 |   |   | 502,292 |   |   | 10.90 |   |   |
| $11.26 – $22.50               |       |                         | 552,225    |                         |       |   | 3.5 |   |   |   | 12.53 |   |   | 552,225 |   |   | 12.53 |   |   |
| $22.51 – $112.50              |       |                         | 488,858    |                         |       |   | 3.1 |   |   |   | 40.59 |   |   | 488,858 |   |   | 40.58 |   |   |
|                               |       |                         | 4,825,928  |                         |       |   | 5.7 |   |   |   | $ 8.97 |   |   | 3,329,847 |   |   | $ 11.94 |   |   |
|                                    |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-20

----

**(8)Share-based Compensation (Continued)**

*Pro formaInformation under SFAS No.123*

Thefollowing table shows the pro forma effect on net loss and net loss per shareif Wave had applied the fair value recognition provisions of SFAS 123 tostock-based employee awards.

| ** **                                              | ** ** | **For the year ended  December 31, 2005** | ** **                                                               | **For the year ended  December 31, 2004** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------------------------------|--------------------------------------------------------------------------|--------------------------------------------------------------------|------------|
| Net loss to common  shareholders—as reported       |       |                                                               | $ (17,562,462                                                       | )                                                                  |       |   | $ (14,498,038 | ) |   |
| Fair value compensation  cost under SFAS 123            |       |                                                               | (2,103,508                                                               | )                                                                  |       |   | (2,840,103 | ) |   |
| Net loss to common  shareholders—pro forma         |       |                                                               | (19,665,970                                                              | )                                                                  |       |   | (17,338,141 | ) |   |
| Loss per common share  (basic/diluted)—as reported |       |                                                               | (0.63                                                                    | )                                                                  |       |   | (0.63 | ) |   |
| Loss per common share (basic/diluted)—pro forma    |       |                                                               | $           (0.72 | )                                                                  |       |   | $           (0.75 | ) |   |

 

Thefollowing values for the indicated variables were used to value options grantedduring the years ended December 31, 2005 and 2004.

| ** **               | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Expected Term (in years) |       | 5 Years  |       | 5 Years  |       |
| Risk-free Rate           |       | 4.23     | %          | 3.68     | %          |
| Expected Volatility      |       | 104      | %          | 120      | %          |
| Dividend  Yield          |       | 0        | %          | 0        | %          |

 

*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 2006, 2005 and 2004 is as follows:

| ** **                                           | ** ** | **2006**                   | ** ** | **2005**                               | ** **  | **2004**                   | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|----------------------------------------|-------------|----------------------------|------------|
| ** **                                           | ** ** | **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                        |       | 691,896                    |       |                                   | $ 1.23 |                       |       | 1,302,829 |   |   | $ 1.21 |   |   | 1,315,062 |   |   | $ 1.21 |   |   |
| Granted                                              |       | —                     |       |                                   | —      |                       |       | — |   |   | — |   |   | 24,500 |   |   | 1.20 |   |   |
| Canceled                                             |       | (54,733                    | )          |                                   | 1.20        |                       |       | (610,933 | ) |   | 1.20 |   |   | (36,733 | ) |   | 1.20 |   |   |
| Balance at end of year                               |       | 637,163                    |       |                                   | 1.23        |                       |       | 691,896 |   |   | 1.23 |   |   | 1,302,829 |   |   | 1.21 |   |   |
| Exercisable at end of  year                          |       | 633,830                    |       |                                   | 1.23        |                       |       | 682,229 |   |   | 1.23 |   |   | 1,210,029 |   |   | 1.21 |   |   |
| Additional shares available for grant at end of year |       | 1,835,060                  |       |                                   |        |                       |       | 1,780,327 |   |   |   |   |   | 1,169,394 |   |   |   |   |   |

 

F-21

----

**(8)Share-based Compensation (Continued)**

The per shareweighted-average fair value of stock options granted during 2004 was $0.72, onthe date of grant using a Black-Scholes option-pricing model with the followingweighted-average assumptions:

| Expected Term (in years) |   | 3 Years |   |
|--------------------------|--------|---------|--------|
| Risk-free Rate           |   | 3.00    | %      |
| Expected Volatility      |   | 114     | %      |
| Dividend  Yield          |   | 0       | %      |

 

No options were granted under the Wavexpress stockoption plan during the years ended December 31, 2006 or December 31,2005.

 

Thefollowing table summarizes information about Wavexpress’ stock optionsoutstanding at December 31, 2006:

| ** **          | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**         | ** ** |
|---------------------|------------|------------------------------|------------|--------------------------------------|------------|
| ** **          | ** ** | ** **                   | ** ** | **Weighted**                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **          | ** ** | ** **                   | ** ** | **Average**                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **          | ** ** | **Number**                   | ** ** | **Remaining  Contractual Life** | ** ** | **Weighted  Average** | ** ** | **Number** | ** ** | **Weighted  Average** | ** ** |
| **Exercise  Price** | ** ** | ** **                   | ** ** | **Outstanding**                      | ** ** | **(in years)** | ** ** | **Exercise Price** | ** ** | **Exercisable** | ** ** | **Exercise Price** | ** ** |
| $1.20               |       |                         | 628,966    |                                 |       |   | 5.1 |   |   |   | $ 1.20 |   |   |   | 625,633 |   |   |   | $ 1.20 |   |   |
| $3.00-$4.50         |       |                         | 8,197      |                                 |       |   | 3.6 |   |   |   | $ 3.37 |   |   |   | 8,197 |   |   |   | $ 3.37 |   |   |
| $1.20-$4.50         |       |                         | 637,163    |                                 |       |   | 5.1 |   |   |   | $ 1.23 |   |   |   | 633,830 |   |   |   | $ 1.23 |   |   |
|                     |            |                              |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Employee StockPurchase Plan*

In November 2004,the Board of Directors adopted the Wave Systems Corp. 2004 Employee StockPurchase Plan (the “Purchase Plan”) pursuant to which a total of 1,000,000shares of Wave’s Common Stock may be sold to eligible employees at a 15%discount from the market value of the shares. The Purchase Plan was ratified bya shareholder vote at Wave’s 2005 annual shareholder meeting on May 23,2005. Under the terms of the Purchase Plan, employees may elect to havewithheld, up to 15% of their base earnings to purchase these shares during eachoffering period, up to a maximum of $25,000 in market value of Wave CommonStock. Offering periods commence on May 1st and December 1st and arefor a period of six months. The purchase price under the Purchase Plan is 85%of the lesser of the market price on the beginning or the ending of theoffering period. Approximately 37% and 49% of eligible employees participatedin the Purchase Plan for the years ended December 31, 2006 and 2005,respectively. For the year ended December 31, 2006 employees purchased144,975 shares of Wave Class A Common Stock at an average share price of$1.99 per share, for an aggregate of $287,834 in proceeds to Wave. For the yearended December 31, 2005 employees purchased 164,047 shares of Wave Class ACommon Stock at an average share price of $2.16 per share, for an aggregate of$354,047 in proceeds to Wave.

**(9) Warrants**

On October 30, 2006, Wave granted warrants topurchase up to 175,861 shares of Class A Common Stock, in connection witha securities purchase agreement, pursuant to which Wave sold and issued3,517,230 shares of Class A Common Stock, par value $.01 per share for anaggregate purchase price of $9,602,038. The warrants are exercisable at anexercise price of $2.73 per share and expire on November 30, 2007. Ifexercised in full, the warrants granted in connection with this financing willgenerate up to an additional $480,101, at the exercise price. The shares of Class ACommon Stock issuable upon exercise of theses warrants are to be drawn-down offof the shelf registration statement filed by Wave on 

F-22

----

**(9) Warrants  (Continued)**

December 16, 2005 anddeclared effective by the Commission on January 13, 2006, if the warrantsare exercised. All of the warrants granted in connection with theOctober 30, 2006 securities purchase agreement remain outstanding as ofDecember 31, 2006.

On August 4, 2006, Wave granted warrants topurchase up to 116,837 shares of Class A Common Stock, in connection witha securities purchase agreement, pursuant to which Wave sold and issued2,336,752 shares of Class A Common Stock, par value $.01 per share for anaggregate purchase price of $4,790,342. The warrants are exercisable at anexercise price of $2.05 per share and expire on September 3, 2007. Ifexercised in full, the warrants granted in connection with this financing willgenerate up to an additional $239,516, at the exercise price. The shares ofClass A Common Stock issuable upon exercise of theses warrants are to bedrawn-down off of the shelf registration statement referred to above, if thewarrants are exercised. All of the warrants granted in connection with theAugust 4, 2006 securities purchase agreement remain outstanding as ofDecember 31, 2006.

On May 3, 2006, Wave granted warrants to purchaseup to 100,625 shares of Class A Common Stock, in connection with a securitiespurchase agreement, pursuant to which Wave sold and issued 2,012,500 shares ofClass A Common Stock, par value $.01 per share for an aggregate purchaseprice of $4,830,000. The warrants are exercisable at an exercise price of $2.40per share and expire on June 3, 2007. If exercised in full, the warrantsgranted in connection with this financing will generate up to an additional$241,500, at the exercise price. The shares of Class A Common Stockissuable upon exercise of theses warrants are to be drawn-down off of the shelfregistration statement referred to above, if the warrants are exercised. All ofthe warrants granted in connection with the May 3, 2006 securitiespurchase agreement remain outstanding as of December 31, 2006.

On February 15, 2006, Wave granted warrants topurchase up to 516,956 shares of Class A common stock at an exercise priceof $2.16 in connection with a financing competed as of that date (See Footnote 7–CommonStock). The Warrants were exercisable for a period of six months following thedate of issuance. On May 8, 2006, warrants to purchase 162,037 shares wereexercised on May 8, 2006, at the exercise price of $2.16 per share. Wavereceived net proceeds of $336,000, after deducting placement agent fees of$14,000, for the exercise of these warrants.. The remaining warrants topurchase 354,919 shares expired unexercised on August 16, 2006. EachWarrant was subject to cancellation if the closing bid price of Wave’s commonstock exceeded $2.58 for 10 out of 20 consecutive trading days and the Warranthad not been exercised by the close of business on the trading day after the10th trading day on which the closing bid price exceeded $2.58.

On December 5, 2005, Wave granted warrants topurchase up to 364,583 shares of Class A Common Stock, in connection witha securities purchase agreement. The warrants were exercisable at an exerciseprice of $2.40 per share and were set to expire on June 5, 2006. Anyshares of Class A Common Stock issuable upon exercise of theses warrants wereto be drawn-down off of a shelf registration statement. On May 8, 2006, aninvestor exercised a warrant issued by Wave to that investor in connection withWave’s December 5, 2005 financing. The warrant was exercised in full for114,583 shares of Wave Class A Common Stock, at its exercise price of$2.40 per share. Wave received $264,000 from the exercise of this warrant aftersubtracting the 4% placement agent fee. The remaining warrants expired on theirexpiration date of June 5, 2006.

On July 30, 2004, Wave granted warrants topurchase up to 1,470,588 shares of Class A Common Stock, in connectionwith a securities purchase agreement that Wave entered into with certainpurchasers as of that date. The warrants granted in this transaction were madeup of two different series, Series A and Series B. The Series Awarrants were exercisable for up to 1,176,471 shares of Class A CommonStock at an exercise price of $3.45 per share. The Series A warrants wereexercisable from January 30, 2005, until August 1, 2005. The Series Bwarrants were exercisable for up to 294,118 shares of Class A Common Stock

F-23

----

**(9)Warrants  (Continued)**

at an exercise price of$3.90 per share. The Series B warrants were exercisable from July 30,2005, until January 30, 2006. Any shares of Class A Common Stockissuable upon exercise of the Series A warrants and Series B warrantswere also to be drawn-down off of a shelf registration statement. TheSeries A and Series B warrants issued in this transaction carried asubsequent equity clause that required Wave to adjust the initial exerciseprice, pro-rata, for any subsequent equity sales that were made at a lowerprice than the initial exercise price. As a result several sales of commonstock subsequent to the July 30, 2004 securities purchase agreement, theexercise prices of the Series A and Series B warrants were adjustedto $3.39 and $3.60, respectively, in accordance with the formula pursuant tothe warrant agreements. On August 1, 2005 a Series A Warrant holderexercised a portion of the Series A Warrant for a total of 666,667 sharesat an exercise price of $3.39 per share, for aggregate gross proceeds of$2,260,000, less placement agent fees of $90,400, for net proceeds of$2,169,600. The remaining warrants for 509,804 expired on August 1, 2005.All of the Series B Warrants granted in connection with the July 30,2004 securities purchase agreement expired unexercised on January 30,2006.

In connection with an agreement that Wave entered intowith an outside software development consultant, on January 2, 2004, Waveissued warrants to purchase 10,000 shares of Class A Common Stock at aprice of $3.00 per share, pursuant to an individual compensation plan with theconsultant. Also, in connection with the same agreement, on April 30, 2004an additional warrant was issued to to the consultant to purchase 11,667 sharesof Class A Common Stock at an exercise price of $3.00 per share. The fairmarket value of these warrants was approximately $81,000 and was recorded asconsultant expense in 2004. No additional warrants are required to be grantedpursuant 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 310,436 shares of Class A Common Stock at an exercise price of$7.86 per share in connection with a private placement to a group of accreditedinvestors. The warrants had a three year term. In addition, in connection with the transaction, Wave granted additionalwarrants to purchase 53,865 shares of Class A Common Stock as commissionsto placement agents in connection with the private placement. The warrantsgranted to the placement agents are also exercisable at a price of $7.86 pershare and had a 3 year life as well.   All of the warrants granted inconnection with the November 18, 2003 private placement expiredunexercised in November 2006.

On April 30, 2003, Wave granted the Series HWarrants to purchase shares of Class A Common Stock, with an initialexercise price of $3.39 per share and a five (5) year life. Initially, theSeries H Warrants were exercisable for a total of 1,202,852 shares ofClass A Common Stock on the trading day following the date of Wave’s 2003annual meeting of stockholders. During September 2003 the terms of theSeries H Purchase Agreement and other documents governing theSeries H Stock and the Series H Warrants were modified, as discussed in note 8(a), above. As ofDecember 31, 2003, 877,438 shares of Class A Common Stock were issuedin connection with the exercise of Series H Warrants for net proceeds of$2,565,167. Series H Warrants to acquire 21,930 shares of Class ACommon Stock remain outstanding as of December 31, 2006.

In connection with an agreement that Wave entered intowith an outside sales representative, Wave issued warrants to purchase 14,788shares of Class A Common Stock at prices ranging from $2.85 to $4.35 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 expireJanuary 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 16,667 shares of Wave 

F-24

----

**(9)Warrants  (Continued)**

Class A Common Stockat $10.44 per share. The warrant became exercisable on November 9, 2002,and expires on November 9, 2007.

A summary of warrants outstanding at December 31,2006, follows:

| ** **              | ** ** | **Warrants Outstanding** | ** ** | **Warrants Exercisable** | ** ** |
|-------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **              | ** ** | ** **                    | ** ** | **Weighted**                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Exercise Price** | ** ** | ** **                    | ** ** | **Number of  Shares**    | ** ** | **Average  Remaining  Contractual Life  (in years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $2.05 – $3.08      |       |                          | 421,866    |                          |       |   | 0.9 |   |   |   | $ | 2.48 |   |   |   | 129,168 |   |   |   | $ | 2.53 |   |   |
| $3.09 – $4.62      |       |                          | 29,843     |                          |       |   | 2.6 |   |   |   | $ | 3.50 |   |   |   | 29,843 |   |   |   | $ | 3.50 |   |   |
| $4.63 – $10.44     |       |                          | 16,667     |                          |       |   | 0.9 |   |   |   | $ | 10.44 |   |   |   | 16,667 |   |   |   | $ | 10.44 |   |   |
|                    |       |                          | 468,376    |                          |       |   | 1.0 |   |   |   | $ | 2.83 |   |   |   | 175,678 |   |   |   | $ | 3.44 |   |   |
|                         |            |                               |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**(10) Wavexpress**

In April 1999, Wave joined with SarnoffCorporation to form Wavexpress. Wavexpress develops secure broadband mediadistribution software products, infrastructure and content services. OnOctober 15, 1999, Wave and Sarnoff signed a Joint Venture Agreement, whichformally established Wavexpress. Under this agreement, Sarnoff and itsaffiliates received a 40% equity stake in Wavexpress. Wave received a 53%equity interest, and its affiliates, who purchased founders stock inApril 1999 for a nominal amount, owned the remaining 7% of the outstandingcapital stock. The affiliates of Wave include Peter Sprague, the formerChairman of Wave and Steven Sprague, the Chief Executive Officer of Wave,certain members of the Board of Directors of Wave and certain Wave employees.

Wave has funded Wavexpress through a series ofconvertible notes, some with attached warrants. The notes bear interest at therate 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. Through December 31, 2006, Wave has funded Wavexpresswith approximately $40,234,000 in cash, plus approximately $15,786,000 inaccrued interest. Such amounts include approximately $9,500,000 thatautomatically converted into 1,826,571 additional shares of Wavexpress at anaverage conversion price of $5.20 per share. These amounts are eliminated inconsolidation.

As of December 31,2006, Wave owned 69% of Wavexpress, while Sarnoff owned 25.6%. None of theminority shareholders have provided, or are obligated to provide, funding toWavexpress. Accordingly, the financial statements of Wavexpress have beenincluded in the consolidated financial statements of Wave for all periodspresented herein. 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 $2.4million, $2.2 million and $3.4 million, for the years ended December 31,2006, 2005 and 2004, respectively.

F-25

----

**(11) Commitments andContingencies**

*Leases*

Summarized below is a listing of properties leased byWave pursuant to non-cancelable operating leases. Our principal research anddevelopment activities are conducted at the Princeton and Cupertino facilities.

| **Location**    | ** ** | ** ** | ** **     | **Annual  Lease Cost** | ** ** | **Lease Expiration  Date** | ** **     |
|-----------------|------------|------------|----------------|-----------------------------|------------|---------------------------------|----------------|
| Lee, MA         |       |       | $ 143,374 |                        |       |                            | Jul. 2010 |   |   |
| Princeton, NJ   |       |       | 160,931        |                        |       |                            | Dec. 2009 |   |   |
| Cupertino, CA   |       |       | 416,592        |                        |       |                            | Aug. 2010 |   |   |
| Orvault, France |       |       | 67,260         |                        |       |                            | Sep. 2007 |   |   |
| New York, NY(1) |       |       | 93,600         |                        |       |                            | Oct. 2007 |   |   |
| Total           |       |       | $ 881,757 |                        |       |                            |           |   |   |

----

(1)          Wavexpressfacility

Future minimum lease payments under non-cancelableoperating leases (with initial or remaining lease terms in excess of one year)as of December 31, 2006 are as follows:

| 2007                         |   | $  855,992 |   |
|------------------------------|--------|----------------------|--------|
| 2008                         |   | 505,167              |   |
| 2009                         |   | 465,629              |   |
| 2010                         |   | 125,542              |   |
| Thereafter                   |   | —               |   |
| Total minimum lease payments |   | $ 1,952,330     |   |

 

Rent expense for the years ended December 31,2006, 2005, 2004 amounted to approximately $790,000, $957,000 and $940,000,respectively.

There were no capitallease obligations as of December 31, 2006 & 2005.

*Securities andExchange Commission Investigation*

On December 17, 2003,Wave received an Order by the Securities and Exchange Commission (the“Commission”) regarding a formal investigation. The focus of this investigationis on certain public statements made by Wave during and aroundAugust 2003, as well as certain trading in Wave’s securities during suchtime. Wave is cooperating fully with the Commission in this investigation. Waveis unable to predict the outcome of this investigation at this time.

*PurportedClass Actions*

A consolidated amended class action complaint ispending in the United States District Court for the District of Massachusetts,naming Wave, its Chief Executive Officer and its Chief Financial Officer asdefendants. Brumbaugh et al. v. Wave Systems Corp. et al., Civ. No. 04-30022(D. Mass.) (MAP).

F-26

----

**(11)Commitments and Contingencies (Continued)**

The purported class action was filed by allegedpurchasers of Wave’s Class A Common Stock during the purported classperiod July 31, 2003 through February 2, 2004. The complaint claimedthat Wave and the named individuals violated Section 10(b) of theSecurities Exchange Act of 1934 (the “1934 Act”), Rule 10(b)-5promulgated thereunder and Section 20(a) of the 1934 Act by publiclydisseminating materially false and misleading statements, relating to Wave’sagreements with Intel and IBM. The complaint did not specify the amount ofalleged damages plaintiffs sought to recover.

In January 2006, the Court granted in part anddenied in part defendants’ motion to dismiss. The court dismissed two but letstand seven alleged misrepresentations or omissions. This was not a finding offault or liability, it was a decision not entirely to dismiss plaintiffs’pleading.

Without admittingliability, the defendants recently reached a mediated settlement in principleof all claims asserted by the plaintiffs. On January 10, 2007, the Courtissued an Order and Final Judgment approving the settlement and dismissing theaction with prejudice. Wave’s insurer had agreed to pay the plaintiffs a totalof $1,750,000 in exchange for the dismissal with prejudice and release of theclaims against all defendants.

**(12) Income Taxes**

The Company did not provide for any income tax expenseor (benefit) for the years ending December 31, 2006, 2005 and 2004.

Thefollowing table summarizes the significant differences between the UnitedStates federal statutory tax rate and the Company’s effective tax rate forfinancial statement reporting purposes:

| ** **                              | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory tax rate                      |       |     | 34         | %        |       |     | 34         | % |   |   | 34 | % |   |
| Stock-based compensation  on ISO’s |       |     | (3         | )        |       |     | (0         | ) |   |   | (0 | ) |   |
| Gain on warrant  liability              |       |     | (0         | )        |       |     | (1         | ) |   |   | (1 | ) |   |
| Change in valuation  allowance          |       |     | (31        | )        |       |     | (33        | ) |   |   | (33 | ) |   |
| Total                                   |       |     | —     | %        |       |     | —     | % |   |   | — | % |   |

 

Thetax effects of temporary differences that give rise to the deferred tax assetat December 31, 2006 and 2005 are as follows:

| ** **                                    | ** ** | **2006**                                                                                                                  | ** ** | **2005**                                                                                                | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|
| Deferred tax  assets:                         |       |                                                                                                                      |       |                                                                                                    |       |
| Net operating and capital  loss carryforwards |       | $  97,946,000                                                                                                   |       | $ 91,503,000                                                                                       |       |
| Accrued expenses                              |       | 323,000                                                                                                                   |       | 480,000                                                                                                 |       |
| Intangibles                                   |       | 471,000                                                                                                                   |       | 534,000                                                                                                 |       |
| Reserves                                      |       | 917,000                                                                                                                   |       | 903,000                                                                                                 |       |
| Depreciation                                  |       | 552,000                                                                                                                   |       | 532,000                                                                                                 |       |
| Total gross deferred tax  assets              |       | 100,209,000                                                                                                               |       | 93,952,000                                                                                              |       |
| Less valuation allowance                      |       | (100,209,000                                                                                                              | )          | (93,952,000                                                                                             | )          |
| Net deferred tax asset                        |       | $                   — |       | $                — |       |

 

The valuation allowance increased by approximately$6.3 million and $7.2 million, during the years ended December 31, 2006and 2005, respectively.

F-27

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**(12)Income Taxes (Continued)**

Management has concludedthat it is more likely than not that Wave will not have sufficient taxableincome of an appropriate character within the carryback and carryforwardperiods permitted by current law to allow for the utilization of the deferredtax assets and, therefore, a valuation allowance has been established againstthe deferred tax assets of $100,209,000 as of December 31, 2006. Subsequentlyreported tax benefits relating to the valuation allowance for deferred taxassets as of December 31, 2006 will be allocated as follows: $99,469,000to continuing operations and $740,000 to additional paid-in capital for amountsattributable to exercise of employee stock options.

Wave has net operatingloss carryforwards for tax return purposes of approximately $259.6 million,which expire beginning in 2007 through 2026. Wave also has capital losscarryforwards for tax return purposes of approximately $8.6 million, whichexpire beginning in 2008 through 2010. Pursuant to Section 382 of theInternal Revenue Code, the annual utilization of Wave’s net operating andcapital loss carryforwards may be substantially limited if a cumulative changein ownership of more than 50% occurs within any three-year period. Wave has notdetermined whether there have been such cumulative changes in ownership or theimpact on the utilization of the loss carryforwards if such changes haveoccurred. However, in considering Section 382 of the Internal RevenueCode, Wave believes that it is likely that such a change in ownership hasoccurred thus raising the likelihood that such net operating and capital losscarryforwards are subject to annual limitations.

**(13) DefinedContribution 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 2006, 2005 or 2004

**(14) Disclosuresabout the Fair Value of Financial Instruments**

*Cashand Cash Equivalents, Marketable Securities, Prepaid Expenses and OtherReceivables, Accounts Payable and Accrued Expenses*

The carrying amounts ofthese instruments approximate fair value because of their short maturities.Marketable securities are valued based on the value of the securities as tradedon 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.

**(15) Impairment ofDeveloped Software**

In the quarter ended June 30,2004, Wave took a charge of $301,366 to write off developed software that hadbeen capitalized. The software that was written off was developed for adistribution agreement that was entered into with National Semiconductor Corp.(“NSC”) whereby NSC was to distribute it with their trusted platform modulechip. The write-off was the result of the termination of the agreement, andbecause the version of the software that was written off has been discontinuedand superseded by a new version. Consequently, the value of the software becameimpaired because it had no alternative uses. Wave  continues to maintain a license agreement withNSC, whereby Wave is paid royalties based on Wave Intellectual Property (“IP”)that is included in NSC’s chip design

F-28

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**(16) SegmentReporting**

Wave’s products includethe Wave EMBASSY® digital security products and services (“EMBASSY®”) andWavexpress broadband media distribution products and services. These productsand services constitute Wave’s reportable segments under Statement of FinancialAccounting Statement No. 131 - Disclosures about Segments of an Enterpriseand Related Information. Net losses for reportable segments exclude interestincome, unrealized gains on decrease in value of warrant liability, gain onsales of marketable securities and other income. These items are not reportedby segment since they are excluded from the measurement of segment performancereviewed by Wave’s management.

Thefollowing sets forth reportable segment data:

| ** **                                                          | ** ** | **For the years ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Operating Revenues:                                                 |       |                                                          |       |   |   |   |   |
| EMBASSY® digital  security products and services               |       | $  3,086,637                                        |       | $      976,807 |   | $      164,350 |   |
| Wavexpress broadband  media distribution products and services |       | 29,744                                                        |       | 41,657 |   | 44,961 |   |
| Total Operating Revenues                                            |       | 3,116,381                                                     |       | 1,018,464 |   | 209,311 |   |
| Net Loss:                                                           |       |                                                          |       |   |   |   |   |
| EMBASSY® digital  security products and services               |       | (16,562,112                                                   | )          | (15,986,692 | ) | (15,915,487 | ) |
| Wavexpress broadband  media distribution products and services |       | (2,389,935                                                    | )          | (2,219,354 | ) | (3,436,453 | ) |
| Total Segments Net Loss                                             |       | (18,952,047                                                   | )          | (18,206,046 | ) | (19,351,940 | ) |
| Interest Income                                                     |       | 163,980                                                       |       | 70,779 |   | 24,931 |   |
| Unrealized gain on  decrease in value of warrant   liability        |       | 2,794                                                         |       | 490,334 |   | 498,723 |   |
| Gain on sale of  marketable securities                              |       | —                                                        |       | 80,971 |   | 4,330,248 |   |
| Other Income                                                        |       | —                                                        |       | 1,500 |   | — |   |
| Net Loss                                                            |       | $ (18,785,273                                            | )          | $ (17,562,462 | ) | $ (14,498,038 | ) |
| Depreciation and Amortization Expense:                              |       |                                                          |       |   |   |   |   |
| EMBASSY® digital  security products and services               |       | 547,712                                                       |       | 746,536 |   | 703,137 |   |
| Wavexpress broadband  media distribution products and services |       | 115,321                                                       |       | 95,193 |   | 151,492 |   |
| Total Depreciation and  Amortization Expense                        |       | $      663,033                  |       | $      841,729 |   | $      854,629 |   |
| Capital Expenditures:                                               |       |                                                          |       |   |   |   |   |
| EMBASSY® digital  security products and services               |       | 275,834                                                       |       | 152,474 |   | 186,756 |   |
| Wavexpress broadband  media distribution products and services |       | 52,770                                                        |       | 8,355 |   | 117,416 |   |
| Total Capital  Expenditures                                         |       | $      328,604                  |       | $      160,829 |   | $      304,172 |   |

 

| ** **                                                          | ** ** | **As of**              | ** **       |
|---------------------------------------------------------------------|------------|-----------------------------|------------------|
| ** **                                                          | ** ** | **December 31,  2006** | ** **       | **December 31,   2005** | ** ** | **December 31,   2004** | ** ** |
| Assets:                                                             |       |                        |             |   |   |   |   |   |   |   |   |   |   |
| EMBASSY® digital  security products and services               |       |                        | 9,262,942        |   |   |   | 3,235,946 |   |   |   | 8,167,614 |   |   |
| Wavexpress broadband  media distribution products and services |       |                        | 96,735           |   |   |   | 193,819 |   |   |   | 286,968 |   |   |
| Total Assets                                                        |       |                        | $ 9,359,677 |   |   |   | $ 3,429,765 |   |   |   | $ 8,454,582 |   |   |

 

F-29

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**(16)Segment Reporting (Continued)**

The following tabledetails Wave’s sales by geographic area for the years ended December 31,2006, 2005 and 2004. Geographic area is based on the location of where theproducts were shipped or services rendered. 

| ** **                                                     | ** ** | **United States ** | ** **           | ** ** | ** ** | ** **     | ** ** | ** **                                                    | ** ** |
|----------------------------------------------------------------|------------|------------------------------|----------------------|------------|------------|----------------|------------|---------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **of America**          | ** **           | **Europe** | ** ** | **Asia**       | ** ** | **Total**                                                     | ** ** |
| 2006                                                           |       |                         |                 |       |       |           |       |                                                          |       |   |   |
| EMBASSY® digital  security products and services          |       |                         | $ 2,102,959     |       |       | $ 792,743 |       | $ 190,934                                                |       | $ 3,086,637 |   |
| Wavexpress broadband  media distribution products and services |       |                         | 29,744               |       |       | —         |       | —                                                        |       | 29,744 |   |
| Total                                                          |       |                         | 2,132,703            |       |       | 792,743        |       | 190,934                                                       |       | 3,116,381 |   |
| % of Total                                                     |       |                         | 68                   | %          |       | 26             | %          | 6                                                             | %          | 100 | % |
| 2005                                                           |       |                         |                 |       |       |           |       |                                                          |       |   |   |
| EMBASSY® digital  security products and services          |       |                         | 352,761              |       |       | 467,537        |       | 156,510                                                       |       | 976,808 |   |
| Wavexpress broadband media  distribution products and services |       |                         | 41,657               |       |       | —         |       | —                                                        |       | 41,657 |   |
| Total                                                          |       |                         | 394,418              |       |       | 467,537        |       | 156,510                                                       |       | 1,018,465 |   |
| % of Total                                                     |       |                         | 39                   | %          |       | 46             | %          | 15                                                            | %          | 100 | % |
| 2004                                                           |       |                         |                 |       |       |           |       |                                                          |       |   |   |
| EMBASSY® digital  security products and services          |       |                         | 152,690              |       |       | 11,660         |       | —                                                        |       | 164,350 |   |
| Wavexpress broadband  media distribution products and services |       |                         | 43,961               |       |       | 1,000          |       | —                                                        |       | 44,961 |   |
| Total                                                          |       |                         | $  196,651 |       |       | 12,660         |       | $         — |       | $  209,311 |   |
| % of Total                                                     |       |                         | 94                   | %          |       | 6              | %          | —                                                        |       | 100 | % |

 

**Substantially alllong-lived assets of Wave Systems Corp. are located within the United States ofAmerica.**

Customers, by segment,from which Wave derived revenue in excess of 10% for the years ended December 31st are as follows:

| ** **          | ** ** | ** **    | ** ** | **2006**         | ** ** | **2005**                                                      | ** ** | **2004**                                                      | ** ** |
|---------------------|------------|---------------|------------|------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| **Customer**        | ** ** | ** **    | ** ** | **Segment**      | ** ** | **Revenue**                                                   | ** ** |
| Dell, Inc.     |       | EMBASSY® |       | $ 1,094,041 |       | $         — |       | $         — |       |
| ST Microelectronics |       | EMBASSY® |       | 774,695          |       | 467,537                                                       |       | —                                                        |       |
| Broadcom            |       | EMBASSY® |       | 335,899          |       | —                                                        |       | —                                                        |       |
| US Government       |       | EMBASSY® |       | 319,877          |       | —                                                        |       | 81,760                                                        |       |
| Winbond             |       | EMBASSY® |       | —           |       | 156,510                                                       |       | —                                                        |       |
| Intel               |       | EMBASSY® |       | —           |       | 133,850                                                       |       | 36,346                                                        |       |
| Total               |       |          |       | $ 2,523,512 |       | $ 757,897                                                |       | $ 118,106                                                |       |
| % of Total          |       |          |       | 81               | %          | 71                                                            | %          | 56                                                            | %          |
|                     |            |               |            |                  |            |                                                               |            |                                                               |            |  |  |

 

F-30

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**(17) Selected Quarterly Financial Data(unaudited)**

| ** **                | ** ** | **Quarter-ended**                                            | ** ** |
|---------------------------|------------|--------------------------------------------------------------|------------|
| ** **                | ** ** | **December 31,**                                        | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** |
| ** **                | ** ** | **2006**                                                     | ** ** | **2006** | ** ** | **2006** | ** ** | **2006** | ** ** |
| Revenues                  |       | $   866,542                                   |       |   | $   846,280 |   |   | $   910,445 |   | $   493,114 |   |
| Gross Profit              |       | 656,775                                                      |       |   | 643,295 |   |   | 554,603 |   | 278,037 |   |
| Loss from Operations      |       | (4,851,786                                                   | )          |   | (4,518,142 | ) |   | (4,569,364 | ) | (5,012,755 | ) |
| Net loss                  |       | (4,766,989                                                   | )          |   | (4,487,270 | ) |   | (4,539,108 | ) | (4,991,906 | ) |
| Net loss per Common Share |       | $         (0.12 | )          |   | $         (0.12 | ) |   | $         (0.13 | ) | $         (0.14 | ) |

 

| ** **                 | ** ** | **Quarter-ended**                                            | ** ** |
|----------------------------|------------|--------------------------------------------------------------|------------|
| ** **                 | ** ** | **December 31,**                                        | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** |
| ** **                 | ** ** | **2005**                                                     | ** ** | **2005** | ** ** | **2005** | ** ** | **2005** | ** ** |
| Revenues                   |       | $   347,598                                   |       |   | $   335,335 |   |   | $   257,655 |   | $      77,876 |   |
| Gross Profit               |       | 151,663                                                      |       |   | 150,419 |   |   | 80,771 |   | (91,242 | ) |
| Loss from Operations       |       | (4,533,151                                                   | )          |   | (4,464,460 | ) |   | (4,526,144 | ) | (4,682,289 | ) |
| Net loss                   |       | (4,495,149                                                   | )          |   | (4,361,808 | ) |   | (4,159,925 | ) | (4,545,578 | ) |
| Net  loss per Common Share |       | $         (0.15 | )          |   | $         (0.15 | ) |   | $         (0.15 | ) | $         (0.18 | ) |

 

 

F-31

----