UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


                                    FORM 10-K


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

                   For the fiscal year ended December 31, 1997

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

        For the transition period from . . . . . . . . to . . . . . . . .

                         Commission File Number 0-24752

                               Wave Systems Corp.
             (Exact name 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
              Lee, Massachusetts                       01238
    (Address of principal executive offices)         (Zip Code)

                                  413-243-1600
              (Registrant's telephone number, including area code)

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

                                      None

           Securities registered pursuant to Section 12(g) of the Act:

                      Class A Common Stock, $.01 par value
                                (Title of Class)

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

         Indicate by check mark if disclosure of delinquent  filers  pursuant to
Item 405 of Regulation S-K is not contained  herein,  and will not be contained,
to the best of  registrant's  knowledge,  in  definitive  proxy  or  information
statements  incorporated  by  reference  in Part  III of this  Form  10-K or any
amendment to this Form 10-K. [ ]

         The  aggregate  market  value  of the  shares  of  Common  Stock of the
registrant  held by  non-affiliates  as of March 25, 1998 was  $32,900,789  (For
purposes  of this  calculation,  the  market  value of a share of Class B Common
Stock was assumed to be the same as a share of Class A Common Stock,  into which
it is convertible.)

         As of March 25, 1998, there were 22,223,683  shares of the registrant's
Class A Common Stock and  4,241,125  shares of the  registrant's  Class B Common
Stock outstanding.



<PAGE>







                                       -2-

EXCEPT FOR  HISTORICAL  INFORMATION  CONTAINED  HEREIN,  THIS FORM 10-K CONTAINS
FORWARD-LOOKING  STATEMENTS WITHIN THE MEANING OF THE U.S. SECURITIES LITIGATION
REFORM  ACT OF 1995.  THESE  STATEMENTS  INVOLVE  KNOWN  AND  UNKNOWN  RISKS AND
UNCERTAINTIES  THAT MAY CAUSE THE  COMPANY'S  ACTUAL  RESULTS OR  OUTCOMES TO BE
MATERIALLY  DIFFERENT FROM THOSE ANTICIPATED AND DISCUSSED HEREIN.  FURTHER, THE
COMPANY OPERATES IN AN INDUSTRY SECTOR WHERE  SECURITIES  VALUES MAY BE VOLATILE
AND MAY BE  INFLUENCED  BY  REGULATORY  AND OTHER  FACTORS  BEYOND THE COMPANY'S
CONTROL.   IMPORTANT   FACTORS  THAT  THE  COMPANY  BELIEVES  MIGHT  CAUSE  SUCH
DIFFERENCES  ARE  DISCUSSED  IN  THE  CAUTIONARY  STATEMENTS   ACCOMPANYING  THE
FORWARD-LOOKING  STATEMENTS  AND IN THE RISK FACTORS  DETAILED IN THE  COMPANY'S
OTHER  FILINGS  WITH THE  COMMISSION  DURING  THE PAST 12 MONTHS.  IN  ASSESSING
FORWARD-LOOKING STATEMENTS CONTAINED HEREIN, READERS ARE URGED TO READ CAREFULLY
ALL RISK FACTORS AND  CAUTIONARY  STATEMENTS  CONTAINED IN THIS FORM 10-K AND IN
THOSE OTHER FILINGS WITH THE COMMISSION.




<PAGE>





                                                      PART I
Item 1.           Business

Overview


     Wave Systems  Corp.  ("Wave" or the  "Company")  has completed a transition
from a company focused principally on research and development of new technology
to a  company  focused  on  the  commercialization  of  its  technology  through
licensing  and product  sales.  Since its  inception  in  February of 1988,  the
Company has devoted  substantially all of its efforts and resources to research,
feasibility studies,  design,  development,  and market testing of a system that
meters the usage of electronic  content (the "Wave System").  Electronic content
refers  to any  data,  graphic  software,  video or audio  sequence  that can be
digitally  transmitted.  As its research and development activities matured, the
Company  was able to  devote  increased  resources  to market  research,  market
development and other related  activities.  The Company has completed a shift in
business focus that began in June 1996 toward  development of the commercial and
technical relationships required to establish an electronic content distribution
network.

     The  Company  believes  that the Wave System can  fundamentally  change how
electronic content is consumed by providing more efficient and flexible pricing,
greater protection against unauthorized usage and secure, low-cost, and accurate
data on the  usage of the  electronic  content.  The  Wave  System  enables  the
merchandising of electronic content at the point of purchase.  This may increase
the interest of consumers to sample electronic content that they are considering
purchasing.   The  Wave  System  accurately  and  securely  records  information
pertaining to the usage of the electronic  content.  The Wave System facilitates
the payment of royalties to content providers and allows customized distribution
of content to customers.

     The  Wave  System  consists  of many  individually  distributed  processors
("WaveMeters") that decrypt content on demand from end users. The WaveMeter is a
proprietary  application-specific  integrated  circuit,  mounted  on  a  printed
circuit  board,  or  which  may  become  available  as  an  add-in  device  in a
stand-alone PC. The WaveMeter  allows  transactions to occur without the expense
of a real-time network connection for every transaction.  The WaveMeter securely
stores  electronic funds and batched  information  about the usage of electronic
content to be securely  transmitted to a central  transaction  processing center
("WaveNet").  WaveNet manages  encryption and decryption keys,  processes credit
and  usage  charges,  automatically  obtains  credit  authorization,  calculates
royalty distributions, and can provide user and usage data to electronic content
owners.  The Wave System is  designed to be  compatible  with  existing  content
delivery systems such as CD-ROM,  the internet and Direct  Broadcast  Satellite.
The Company views the  acceptance by developers,  distributors  and consumers of
entertainment and educational software as an important factor in the development
of a broad installed base of WaveMeters.  The Company further believes that once
there is a broad  installed base of WaveMeters,  electronic  content owners from
other market segments are likely to be attracted to the Wave System.

     In  1996  the  Company  developed  a  production  software  version  of the
WaveMeter  that offers a subset of the features of the  hardware  version of the
WaveMeter and has been  implemented as part of the Company's  internet  commerce
server (the  "WaveMeter  server").  The WaveMeter  server  supports a publishing
service called WINPublish and a purchasing function called WINPurchase.  Through
WINPublish, an electronic content owner can sell encrypted content from its site
on the Web to purchasers using the WINPurchase function.

     In order to achieve broad market acceptance of the Wave System, the Company
pursues strategic  relationships with major personal computer  manufacturers and
promotes the use of the Wave System to electronic  content owners,  particularly
developers and  distributors  of  entertainment  and educational  software.  The
compatibility with internet  transmission  provides the foundation for the broad
acceptance  of the Wave  System.  Specifically,  the Company  believes  that the
WaveMeter can be the foundation for a "client-side subscriber management system"
that is  independent  of a delivery  network.  This means  that  content  can be
delivered on CD-ROM, Data Broadcast, Broadband and other forms of transmission.

     The Company believes it has a sound strategy to achieve broad market
acceptance of the Wave System as a standard  platform for commerce in electronic
content. During 1997 the Company established  relationships with IBM and Aladdin
Knowledge  Systems,  Ltd.  ("Aladdin"),  as well as electronic content companies
such as Psygnosis,  GT Interactive  Software  Corp. and Red Storm  Entertainment
Corp.  The  Company  also  received a payment of $1 million  pursuant to a joint
venture agreement with Internet  Technology Group, PLC ("ITG"), a United Kingdom
company.

     Through  a number  of  strategic  relationships  established  in 1997,  the
Company  enhanced  the Wave System and  furthered  its goal of  achieving  broad
market  acceptance.  The Company and Aladdin entered into a licensing  agreement
whereby  in  return  for an  equity  position  in  Wave,  Aladdin  licensed  its
proprietary  persistent encryption technology (the "Hasp technology").  The Hasp
technology provided the Company with three distinct advantages.  First, the Hasp
technology  provides  a  turn-key  execution   protection  system  for  software
applications  that  permits  the option of  software  rental,  which the Company
believes will facilitate  commerce in electronic content on a pay-per-use basis.
Second, it allows the addition of execution-secure applette operations, allowing
a  WaveMeter  to  function  as a general  purpose  security  chip in a  personal
computer  and provide  basic  operations  in  hardware.  And third,  it provides
commercial  enhancements  to the  performance  and  security  of the Great Stuff
Network (the Company's internet commerce website).

     Under  the  terms  and  the  Aladdin  license  agreement,  the  company  is
prohibited from using any other encryption  technology for the first five years.
This  technology  will be  incorporated  into  the  Wave  System  to  facilitate
pay-per-view content distribution.

     The  Company  acquired  the  license for this  technology  in exchange  for
$950,000 plus two warrants to purchase the Company's Class A common stock valued
at approximately $2.9 million. The cost of this license was expensed as research
and development costs. Aladdin also is provided a royalty payment of 5% to 9% of
the Company's net content revenues.

     In connection with this agreement,  Aladdin  acquired an equity position in
the Company by purchasing  500,000 shares of the Company's  Class A common stock
for $900,000, which approximated the fair market value of the shares on the date
of purchase.

     The Company  also has set the  groundwork  for the  acceptance  of the Wave
System in Europe.  In July, the Company entered into a joint venture with ITG to
promote the use of the Wave System in Europe.

     The  Company  intends to continue to pursue  strategic  relationships  with
additional hardware  manufacturers,  including personal computer  manufacturers,
and  companies  involved in the  commerce of  electronic  content  both in North
America and overseas. The Company also seeks to expand the role of the WaveMeter
as a general security device in personal computers.

     Significant  uncertainty  currently  exists with respect to the adequacy of
current  funds to  support  the  Company's  activities.  This  uncertainty  will
continue   until  a  positive  cash  flow  from   operations  can  be  achieved.
Additionally,  the Company is uncertain as to the availability of financing from
other sources to fund any cash  deficiencies.  These  uncertainties  raise doubt
about the Company's ability to continue as a going concern.

     In order to reduce these uncertainties, the Company is currently evaluating
additional financing options and may therefore elect to raise capital, from time
to time,  through  equity or debt  financings in order to capitalize on business
opportunities and market conditions and insure the continued  development of the
Company's technology,  products and services. However, there can be no assurance
that the Company can raise the additional financing.

     As of  October  19,  1997,  the  Company  became  obligated  to redeem  for
approximately  $465,000 all of the outstanding shares of the Series A Redeemable
Preferred  Stock  issued to a certain  individual  pursuant  to the terms of the
Restated  Certificate of  Incorporation.  As of December 31, 1997, the Company's
total  obligation  (principal  plus interest)  under the Series A redemption was
$471,601, and it continues to accrue dividends and interest. The Company has not
redeemed  such shares as of March 25,  1998,  nor has any demand for  redemption
been made.

     The Company presently has no material commitments for capital expenditures.
However,  in order to bring the Wave System to market,  the Company  anticipates
spending  additional  amounts  on  inventory  items such as  computer  chips and
boards,  additional  hardware,  and related  materials.  Such spending will vary
based on the Company's performance.

     Effective  from the close of trading on October  24,  1997 the  Company was
delisted from The Nasdaq SmallCap Market.  As a result,  shares of the Company's
Class A Common Stock are now traded on the OTC Bulletin Board.  Until October 3,
1997 the  Company  had been listed on The Nasdaq  National  Market.  Because the
Company was unable to meet the minimum net tangible  assets  requirement  of The
Nasdaq  National  Market,  the Company  was  delisted  from The Nasdaq  National
Market.  From October 3, 1997 to October 24, 1997,  the Company was  temporarily
listed on The Nasdaq SmallCap Market.  Continued  listing on The Nasdaq SmallCap
Market was dependent upon the Company meeting certain commercial objectives. The
Company was unable to meet these  objectives  within the prescribed time period.
The Company  believes that not being listed on a national  exchange or quotation
system will have a material  adverse  effect on the price and  liquidity  of its
securities and consequently its ability to raise capital in the future.

     The Company was  incorporated  in Delaware  under the name Indata Corp.  on
August 12, 1988.  The Company  changed its name to  Cryptologics  International,
Inc. on December 4, 1989. The Company  further  changed its name to Wave Systems
Corp. on January 22, 1993. The Company's principal executive offices are located
at 480 Pleasant Street, Lee, Massachusetts 01238 and the telephone number of the
Company is (413) 243-1600.

     The  Company  is a  development  stage  company  and has  realized  minimal
operating revenues since its inception. At December 31, 1997, the Company had an
accumulated deficit of approximately $45 million. There can be no assurance that
the Company will be  successful in achieving  commercial  acceptance of the Wave
System.

The Wave System

     The Wave System is  designed  to create new  revenue  streams for owners of
electronic  content  by  improving  upon  existing   distribution   systems  for
electronic content.  Using existing  distribution systems such as CD-ROM and the
Internet,  electronic  content owners  distribute their products to customers in
segmented  and  encrypted  ("Wave-enabled")  form so it can be offered  for sale
through the Wave  System.  Customers  are then able to purchase  and decrypt the
electronic  content on an as-needed  basis.  The Company  believes that the Wave
System allows  electronic  content  owners to deliver their products to a larger
market because the efficient and secure metering technology  facilitates greater
flexibility  in content  distribution  and pricing.  The Company  believes  that
greater flexibility in electronic distribution and pricing makes the Wave System
particularly   attractive   to   developers,   distributors   and  consumers  of
entertainment and educational software.

     The Wave System  consists of the  WaveMeter,  a subsystem  that records and
communicates the usage of electronic content, and WaveNet, a central transaction
processing network. The WaveMeter controls and monitors the customer's access to
encrypted  electronic  information  and  software.  Because the Wave System uses
asynchronous  communication,  it is well suited to low-cost processing of micro,
rental and  rent-to-own  transactions.  The  Company  has  completed a prototype
incorporating  the rental and  rent-to-own  functionality  into the Wave System.
Transactions  are  executed  locally  against  a source  of funds  stored in the
WaveMeter.  The WaveMeter  retains pricing and tax information,  downloaded from
WaveNet,  for use in the  execution  of  these  transactions.  Transactions  are
securely  stored in the usage log of the  WaveMeter  for  eventual  reporting to
WaveNet.  The WaveMeters and WaveNet communicate using Wave's proprietary secure
communications protocol.

         WaveNet  is  composed  of the  WaveNet  Transaction  Processing  System
     ("TXP") and the WaveNet Information Clearing House ("ICH"). TXP acts as the
principal  interface with the WaveMeter and  accumulates  data pertaining to the
consumer's usage. ICH provides interfaces to the Wave System for partners,  such
as third-party  distributors  of WaveMeters and electronic  content  owners.  It
contains the WaveNet  security  server,  which  manages all the  encryption  and
decryption keys. ICH also does all the back-end  processing of usage information
from the WaveMeter,  calculating  royalties,  producing  billing  services,  and
ensuring that all content owners are properly compensated.  WaveNet is presently
in operation.

     The WaveMeter is installed into the customer's  stand-alone PC. It is based
on a semiconductor device that uses proprietary integrated circuit technology to
store  decryption  keys,  credit  information,  and usage data.  Presently,  the
WaveMeter  is packaged  on a half-size  ISA board with a battery and a clock and
can be installed  in the ISA slot of a PC. In 1996 the Company also  developed a
production  software  version of the WaveMeter  which has been  implemented as a
component of the WaveMeter  server.  The WaveMeter  server is currently  used to
facilitate  WINPublish and  WINPurchase  transactions on the Web. The use of the
software  version of the  WaveMeter is  compatible  with the use of the hardware
version of the WaveMeter.

     The Company believes that the hardware version of the WaveMeter is the most
secure form of metering technology available today. Tampering with the WaveMeter
is easily detected by both the WaveMeter and WaveNet. The keys are loaded at the
time of manufacture and are unique and specific to each  WaveMeter.  Every piece
of electronic  content is protected using a unique key. The value of breaking an
individual  WaveMeter  to  ascertain  the keys is low  since  the  keys  have no
system-wide use.

     Wave  supplies  the tools that  developers  need to build and  successfully
supply applications to end users.  Electronic content must be Wave-enabled to be
available  to end  users  on  the  Wave  System.  A data  preparation  tool  kit
structures data packages,  which are individual  elements of electronic  content
that are uniquely identified,  encrypted, priced and formatted to use within the
Wave System.  Once  Wave-enabled,  each data package can be delivered to the end
user in many electronic forms. Currently, the two primary mechanisms of delivery
of  electronic  content to the end user are the  Internet  and CD-ROM.  The Wave
System,  however,  will work with  point-to-multi-point  data  broadcasting  via
satellite or FM sideband, magnetic media, cable modem, DVD and broadband.

Markets and Business Strategy

     The Company's  long-term  strategy is to achieve broad market acceptance of
the Wave System as a platform for  commerce in  electronic  content.  To achieve
this  goal  the  Company   pursues   strategic   relationships   with   hardware
manufacturers  and  companies   involved  in  the  development  of  commerce  in
electronic  content.  In addition,  the Company  believes  that,  since the Wave
System permits  greater  flexibility in pricing and  distribution  of electronic
content,  it is particularly  well-suited for  merchandising  entertainment  and
educational software.  Therefore the Company is vigorously targeting this market
segment as a means of rapidly  achieving the broad  installed base of WaveMeters
and  acceptance  of the Wave System.  The Company  believes that once there is a
broad installed base of WaveMeters,  electronic content owners from other market
segments are likely to be attracted to the Wave System. However, there can be no
assurances that the Wave System will achieve any significant market acceptance.

     The Company has focused on forming  agreements with strategic partners that
will help the Company promote the broad-based acceptance of the Wave System as a
platform for commerce in  electronic  content.  Wave is currently in  discussion
with  original  equipment  manufacturers  regarding  the  incorporation  of  the
WaveMeter into their products.

     Wave has also focused on pursuing  strategic  relationships  with companies
seeking to distribute electronic content via the Internet.  The compatibility of
the Wave System with the Web has  provided  the Company  with a product that has
already  attracted  the  attention of leaders in the  development  of electronic
commerce solutions and particularly  commerce in electronic  content.  Wave will
continue to focus on developing other strategic relationships to seek to achieve
the broad acceptance of the Wave System as a platform for electronic commerce.

     As part of Wave's goal to achieve broad  acceptance of the Wave System as a
platform  for  commerce  in  electronic  content,  the Company has made the Wave
System available to users of the Web through the WaveMeter server. The WaveMeter
server  currently   supports  both  WINPublish,   a  publishing   service,   and
WINPurchase, the purchasing component. WINPublish provides an easy-to-use system
so that  anyone can  publish  electronic  content on a Web site and offer it for
sale.  Since its  inception,  WINPublish  has  registered  over 400  publishers.
WINPurchase  permits  consumers  to purchase  electronic  content  that has been
published  through  WINPublish.  WINPublish and WINPurchase  transactions may be
executed  using the WaveMeter  server without the need to install a WaveMeter at
the consumer's site.  WINPublish and WINPurchase,  however, are fully compatible
with the use of the  hardware  version of the  WaveMeter.  The Company  believes
that, while the volume of transactions  processed to date by the Wave System has
been limited,  the operation of the WaveMeter server  demonstrates the viability
of the Wave System and therefore enhances the ability of Wave to market the Wave
System to the leading  electronic  content  distributors  on the Web by offering
them a standard platform for commerce in electronic  content that is designed to
be compatible with the Internet,  CD-ROM and developing  distribution media such
as broadband.

     Wave  has  focused  on  promoting  the  acceptance  of the Wave  System  by
electronic  content  owners.  The initial  target  market is  entertainment  and
educational  software  developers and distributors.  Wave believes that if it is
able to  incorporate  the  rental  or  rent-to-own  functionality  into the Wave
System,  the  Wave  System  will  provide  the home  consumer  with a new way of
acquiring  interactive  content and can offer electronic  content developers and
distributors  benefits  similar to those  provided  by video  rental in the film
industry.  The Company has invested  heavily in  developing  relationships  with
entertainment and educational software providers. No assurance can be given that
any or all of these  companies  will be  successful  in  developing or marketing
products that apply the Wave System technology or that are Wave-enabled.

Competition

         The Company operates in a highly competitive and fragmented environment
that is  characterized  by rapidly  evolving  technology.  Many of the Company's
competitors and potential  competitors have substantially  greater financial and
technical  resources  than  the  Company.   Also,  many  current  and  potential
competitors have greater name recognition and more extensive customer bases that
could be leveraged,  thereby  gaining market share or product  acceptance to the
Company's  detriment.  The Wave System  competes with  conventional  information
delivery systems, such as on-line services, subscription services on CD-ROM, and
services on the  Internet.  However,  the  Company  believes  that its  metering
capability is competitive  with other  electronic  content delivery systems in a
number of  applications  due to its  superior  protection  against  unauthorized
usage,  accurate and detailed  information  on content  usage,  and  transparent
operation. Further, provided that the Company is successful in incorporating the
rental and rent-to-own  functionality into the Wave System, the Company believes
that  it will be  competitive  with  existing  distribution  systems,  including
traditional  retail outlets for entertainment and educational  software,  due to
its ability to offer these innovative merchandising mechanisms.

         The Company is aware of other metering  systems which compete  directly
with Wave, and other current and evolving  technologies that provide some of the
functionality of the Wave System.  There are other companies that have developed
or are in the process of developing  technologies that are, or in the future may
be,  the basis for  competitive  products  in the  field of  electronic  content
distribution. Some of those technologies may have an entirely different approach
or means of accomplishing the desired effects of the products being developed by
the Company.  There can be no assurance that either  existing or new competitors
will not develop products that are superior to or that otherwise achieve greater
market acceptance than the Company's products.

         The  Wave  System  is  subject  to   competition   from   producers  of
hardware-based  controllers such as dongles and software unlocking systems.  The
Company will compete with  well-established  producers of dongle-based  software
unlocking systems such as Rainbow  Technologies,  Inc. The Company also competes
with developers of software  unlocking  systems such as Portland  Software.  The
Company believes that the Wave System is superior to existing hardware-based and
software  unlocking  systems in several ways.  These systems  control the use of
electronic  content but are very limited in their  ability to measure and record
usage  information.  The Company  believes that the Wave System offers  superior
protection  from  unauthorized  usage,  low operating costs (because it does not
require  constant  communication  with  and  authorization  from  a  centralized
processor), and fast operation that is convenient and essentially transparent to
the end user.  Both hardware  controllers and software  unlocking  systems offer
only part of the  functionality  of the Wave System.  Distinct from the existing
software unlocking systems,  WaveNet provides centralized back-office support to
owners of electronic content.

         Many large  information  industry  players  are forming  alliances  and
attempting to  capitalize on the  information  delivery  options  offered by the
Internet.  In  electronic  content  delivery via the  Internet,  the Wave System
competes with electronic commerce payment technologies  developed and offered by
IBM infoMarket(R)  Service,  Broadvision Inc., Connect,  Inc., CyberCash,  Inc.,
DigiCash and Open Market,  Inc.  However,  the Company believes that many of the
electronic  commerce  payment  technologies  may be used as acceptable  currency
through the Wave System and may be  complementary  to,  rather than  competitive
with,  the Wave System.  The Company is also aware of other  companies,  such as
TestDrive Corporation, Release Software Corporation and IBM Cryptolopes(R), that
provide  electronic   content  encryption   functionality  for  transmission  of
electronic content over the Internet.  The Company believes that the Wave System
is superior to currently  available  electronic content encryption  technologies
due to the high  level of  security  and  usage  reporting  capabilities  of the
WaveMeter.

         The Company believes that the  interoperability of the Wave System with
currently  available  and  developing  distribution  media makes the Wave System
attractive to both distributors and consumers of electronic  content. A consumer
with an installed WaveMeter will be able to purchase  Wave-enabled  content from
sources on CD-ROM  and/or the  Internet,  as well as from  sources  distributing
electronic  content on other  developing  media such as broadband.  In addition,
with the  incorporation  of the rental and rent-to-own  functionality,  the Wave
System will offer  greater  merchandising  flexibility  than is  possible  using
currently available  electronic  commerce  solutions.  There can be no assurance
that the Wave System will achieve the broad-based  acceptance  necessary to make
the system a viable competitor with currently existing and developing electronic
commerce solutions.

International Market

         The Company's  technologies  are controlled under various United States
export control laws and regulations and will require export licenses for certain
exports  outside of the United States and Canada.  The Company has received full
export  license from the U.S.  Department of Commerce for the sale and export of
the Company's  single-key DES products.  The Company has also received an export
license  for its  triple-key  DES  products  under the  provisions  of a License
Exception  KMI  granted  by the  Bureau  of  Export  Administration  of the U.S.
Department  of Commerce.  There can be no  assurance  that the Company will have
patent  protection  or that it will not  infringe  patents  of third  parties in
foreign  jurisdictions.  Because  electronic  monitoring and the transmission of
audited usage and financial information on end users or payment instructions may
be subject to varying statutory or regulatory controls in foreign jurisdictions,
there can be no  assurance  that the use of all portions of the Wave System will
be permitted in any particular foreign jurisdiction.

Proprietary Rights and Licenses and Intellectual Property

         The  Company's  success  depends,  in part,  on its ability to enjoy or
obtain  protection  for its products and  technologies  under United  States and
foreign  patent laws,  copyright laws and other  intellectual  property laws, to
preserve its trade secrets and to operate  without  infringing  the  proprietary
rights of third parties.  There can be no assurance that any issued patent owned
or licensed by the Company  affords  adequate  protection to the Company or will
not be challenged,  invalidated,  infringed or circumvented.  Furthermore, there
can be no assurance  that the  Company's  activities  will not infringe  patents
owned by others.

         In addition,  the Company may be required to obtain licenses to patents
or other proprietary rights of third parties. No assurance can be given that any
licenses  required  under any such patents or  proprietary  rights would be made
available  on terms  acceptable  to the  Company,  if at all.  If the Company is
required to and does not obtain such  licenses it would be  prevented  from,  or
encounter  delays  in  the  development  and  marketing  of,  its  products  and
technologies  while it attempted  to design  around such patents or other rights
and there can be no assurance that such attempts would be successful. Failure to
obtain such licenses or to design around such patents or other rights would have
a material adverse effect on the Company.

         The Company holds  non-exclusive  patent rights relating to the metered
use of  encrypted  data in local memory  under a limited  license (the  "License
Agreement") from Titan Corporation ("Titan") to a patent (the "Licensed Patent")
jointly held by Titan and a third party. This License  Agreement  restricts Wave
from  metering  information  produced and used solely by a government  entity or
producing  products  that meter  this  information.  In  addition,  the  License
Agreement  is subject to the rights of the joint owner of the  Licensed  Patent,
who has the right to  exploit,  or to license  to third  parties,  the  Licensed
Patent,  including in a manner  competitive  with the  Company.  There can be no
assurance that the joint owner of the Licensed  Patent will not compete with the
Company or license the Licensed  Patent to a competitor of the Company,  or that
the  Company's  business  will not  exceed the scope of the  License  Agreement.
Pursuant  to the License  Agreement,  the  Company is  obligated  to pay certain
royalties to Titan.  Pursuant to the License Agreement,  the Company has granted
to  Titan  the  exclusive  right  to use  the  Company's  patents  for  products
distributed to government  entities.  On February 28, 1997 the Company and Titan
executed an addendum to the  License  Agreement  whereby the Company  received a
sole license to the Licensed  Patent to develop and  distribute  products to the
in-home  consumer  microcomputer  market  segment.  Under this  addendum  to the
License  Agreement,  Titan waived any and all defaults by Wave under the License
Agreement occurring prior to February 28, 1997.

         The Company is aware of four United  States  patents  (the "Third Party
Patents")  each having some claims that are similar to some of the claims in the
Licensed Patent. Based upon information  currently known to the Company, some of
the claims of both the Licensed Patent and the Third Party Patents cover certain
material aspects of the Company's technology.  Therefore,  the commercialization
of the Company's  technology would be subject to the rights of the holder of the
Third Party  Patents  unless the Company is able to  invalidate  or license such
claims.  Also,  the holder of the Third Party Patents or a licensee of the Third
Party Patents could seek to  invalidate  such claims of the Licensed  Patent and
therefore  be  able to  commercialize  a  technology  similar  to the  Company's
technology.  In either case,  in order to invalidate  the other  party's  patent
rights,  the party claiming  invalidity might need to prove that it invented the
claimed subject matter prior to the other party.  There can be no assurance that
the Company would be successful in  invalidating  such claims of the Third Party
Patents or that the holder of the Third Party Patents or a licensee of the Third
Party  Patents  would  not be  successful  in  invalidating  such  claims of the
Licensed  Patent.  There also can be no assurance  that the Third Party  Patents
could be proven to be invalid on any other basis.  Any proceeding  involving the
validity of the Licensed  Patent and the Third Party Patents would be protracted
and costly.  In any suit  contesting the validity of a patent,  the patent being
contested  would be entitled to a  presumption  of validity  and the  contesting
party would be required to  demonstrate  invalidity  of such patent by clear and
convincing evidence.


         If the Third  Party  Patents are not  invalid  insofar as their  claims
relate to the  Company's  technology,  then the Company  would require a license
from the holder of the Third Party Patents to  commercialize  its technology and
make,  use,  or sell  products or practice  methods,  or license  others to sell
products or use methods,  utilizing the technology in the United States.  Due to
the  uncertainty  as to whether  the Third Party  Patents  could be proved to be
invalid, the Company has engaged in preliminary  negotiations with the holder of
the Third Party Patents to obtain a license under the Third Party  Patents.  The
negotiations  have  so far  not  produced  any  agreement  and  there  can be no
assurance that a license will be obtainable on acceptable  terms, if at all. The
inability to obtain a license, if needed, on commercially reasonable terms would
have a  material  adverse  effect  on the  Company's  business  and  its  future
operations.


     The  Company  has been  issued  three  United  States  patents  relating to
encryption  and  to  the  Company's  proprietary   WaveMeter(R)  and  WaveNet(R)
technology.  The Company also has one patent  pending  before the United  States
Patent Office and three corresponding foreign patent applications pending before
the European Patent Office (collectively,  the "Wave Patents"). The Wave Patents
are material to protecting  certain of the Company's  technology.  The Company's
rights to the Wave  Patent  derive  from a  license,  amended  and  restated  in
February 1994, from Mr. Peter J. Sprague,  Chairman and Chief Executive  Officer
of the  Company,  of his  rights  in the  Wave  Patents  (the  "Amended  License
Agreement"),  and  several  agreements  with  former  officers  of  the  Company
regarding  their  rights in the Wave  Patents.  The  Amended  License  Agreement
provides for royalty payments to be made to Mr. Peter J. Sprague and Mr. John R.
Michener,  a former  officer  of the  Company,  in the  aggregate  amount of two
percent of gross  revenues  less certain  adjustments  as defined in the Amended
License  Agreement.  The royalty  payment is to be apportioned 75 percent to Mr.
Peter J. Sprague and 25 percent to Mr. John R. Michener. Payment of royalties is
secured by a security interest in and to the Wave Patents.  The Company believes
that the agreements as a whole provide it with  exclusive  rights under the Wave
Patents.  There can be no assurance that the Company will enjoy exclusive rights
to the Wave Patents under such agreements.

         On  January  26,  1996,  the  Company   received   notice  from  E-Data
Corporation  (formerly  Interactive  Gift  Express,  Inc.),  claiming  that  the
Company's practice of its technology infringes U.S. and foreign patents owned by
E-Data  Corporation,  and offering to license  such patents to the Company.  The
Company is currently  obtaining  information needed to investigate the merits of
this  claim.   The  Company  believes  that  there  is  a  viable  argument  for
non-infringement.  The patents owned by E-Data  Corporation  are currently being
litigated by third parties. The Company is not involved in these proceedings.

         The Company relies on trade secrets and proprietary know-how,  which it
protects, in part, by confidentiality agreements with its employees and contract
partners.  However, there can be no assurance that the Company's confidentiality
agreements will not be breached or that the Company would have adequate remedies
for any breach.  There can be no assurance that the Company's trade secrets will
not otherwise become known or be independently discovered by competitors.

         The  Company  also  relies on  copyright  to prevent  the  unauthorized
duplication  of its  software and  hardware  products.  The Company has and will
continue to protect its  software and its  copyright  interest  therein  through
agreements with its  consultants.  The Company also plans to seek protection for
its  semiconductor  integrated  circuit  designs under mask work laws.  Existing
copyright  and mask work laws afford only limited  protection,  particularly  in
certain  jurisdictions  outside the United  States where the Company may seek to
market its products and services.  There can be no assurance  that the copyright
laws or mask work laws will adequately protect the Company's technology.

         The Company has  registered  trademark  and service mark  registrations
with the United States Patent and  Trademark  Office for the marks  WaveMeter(R)
and WaveNet(R)  and intends to apply for  additional  name and logo marks in the
United  States and foreign  jurisdictions  as  appropriate.  No assurance can be
given that federal  registration of any of these trademarks in the United States
will be granted.  The Company has abandoned its prior applications for DataWave,
InfoWave, and WaveTrac.

Research and Development

     The Wave System incorporates semiconductor, encryption/decryption, software
transaction  processing and other  technologies  in which the Company has made a
substantial investment in research and development.  The Company expects that it
will be required to continue to make  substantial  investments  in the design of
the WaveMeter, WaveNet and software interfaces. For the years ended December 31,
1997, 1996, and 1995, the Company expended $2,146,127, $3,309,022 and $3,324,735
respectively,  on research and development activities (which amounts include the
value of stock  issued).  In addition to its ongoing  research  and  development
activities, in July 1997 the Company licensed technology and in-process research
and development from Aladdin  Knowledge  Systems for cash and warrants valued at
$3.89  million.  From its inception in February 1988 through  December 1997, the
Company expended $14,745,813.

         The  success  of the  Wave  System  depends  to a large  extent  on the
Company's  ability to adapt the Wave System for use with various methods for the
distribution  of  electronic  content,  the  ability of the Wave  technology  to
interface with various platform environments, and the ability of the Wave System
to  work in many  application  environments.  Incorporation  of  Aladdin's  Hasp
technology  furthered these efforts and illustrates the adaptive  capabilites of
the Wave System.  The Company believes that a significant  portion of its future
research  and  development  expenditures  will be used to adapt the Wave  System
accordingly.

         The  Company  will  also  continue  to expend a  significant  amount of
resources on the  development of new  iterations of the  WaveMeter.  The Company
believes  that by  providing  various  means of  linking  the  WaveMeter  to the
customer's computer or network, the Company will be more likely to achieve broad
acceptance of the Wave System.  The Company is currently  developing other forms
of the WaveMeter to target other market needs.

         Wave is now focusing increased  resources on developing the operational
infrastructure of the Company. Greater emphasis is placed on developing internal
production and fulfillment  systems and marketing  infrastructure  to distribute
WaveMeters. The Company will also increase the resources available to WaveNet to
adapt to changing  market  requirements.  The Company plans to expand WaveNet to
handle  more end users,  to develop  interfaces  for new kinds of  partners,  to
implement more sophisticated  pricing methodologies and to add greater financial
system flexibility.

Employees

         As of December 31, 1997, the Company  employed 41 full-time  employees,
25 of whom are  involved  in  marketing  and  administration  and 16 of whom are
involved  in  research  and  development.  The  Company  believes  its  employee
relations are satisfactory.


Item 2.           Properties

         The Company  leases a 10,748  square foot  facility  for its  executive
offices  and to house the WaveNet  installation,  administration,  and  customer
support  operations  in Lee,  Massachusetts  at a monthly  rent of $5,598 with a
monthly  charge of $2,123 for common costs.  The Lee,  Massachusetts  lease will
expire during  February  2001. The Company leases offices in New York, New York,
at a monthly rent of $6,769.  The lease is scheduled to expire in June 1999. The
Company  leases a 6,400  square  foot  facility  in  Princeton,  New Jersey at a
monthly  base rent of $3,733  with a monthly  payment for taxes,  insurance  and
maintenance reimbursements and improvements which currently totals approximately
$1,653 per month.  This lease is scheduled to expire during  January  2001.  The
Company's  principal  research and  development  activities are conducted at the
Princeton facility. The Company leases a 2,730 square foot facility in San Jose,
California  for $5,050 per month.  The San Jose,  California  lease will  expire
during January 1999.


Item 3.           Legal Proceedings

         On June 27, 1997 a complaint  alleging breach of contract,  among other
related claims, was filed against the Company by Carl A. Artopeous and Artopeous
Capital  Management  (collectively,  "Artopeous")  with the Sacramento  Superior
Court in Sacramento,  California in connection  with the engagement of Artopeous
by the Company to arrange financing.  The action has been removed to the Federal
Court, Eastern District of California.  Wave filed its answer in December, 1997;
responses to its document requests are due in early April, 1998.

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

         Not Applicable.



<PAGE>



                                     PART II

Item 5.           Market for Registrant's Common Equity and Related Stockholder
                  Matters

     The Company made its initial public  offering on August 31, 1994 at a price
to the public of $5.00 per share.  Until October 3, 1997, the Company's  Class A
Common  Stock had been traded on The Nasdaq  National  Market tier of The Nasdaq
Stock  Market.  From October 3, 1997 to October 24, 1997 the  Company's  Class A
Common Stock was traded on The Nasdaq  SmallCap  Market.  The Company's  Class A
Common Stock now trades on The OTC Bulletin Board under the symbol: WAVX. Except
as provided below,  the following table sets forth,  for the periods  indicated,
the high and low closing sales prices per share for the Company's Class A Common
Stock as reported by The Nasdaq National Market. For the period from October 24,
1997 to December  31, 1997 the  following  table sets forth the high and low bid
quotations  for the  Company's  Class A Common  Stock  obtained  from  Bloomberg
Information Services,  Inc. Such quotations reflect inter-dealer prices, without
retail  mark-up,  mark-down or  commission,  and may not  necessarily  represent
actual  transactions.  There is no established  trading market for the Company's
Class B Common Stock.

                                                            High     Low
Year Ended December 31, 1997
  First Quarter (January 1, 1997-March 31, 1997)........    $3.00   $1.56
  Second Quarter (April 1, 1997-June 30, 1997)..........    $1.81   $1.25
  Third Quarter (July 1, 1997-September 30, 1997).......    $2.00   $0.94
  Fourth Quarter (October 1, 1997-October 23, 1997).....    $1.94   $1.06
  Fourth Quarter (October 24, 1997-December 31, 1997)...    $2.00   $0.63

                                                             High    Low
Year Ended December 31, 1996
  First Quarter (January 1, 1996-March 31, 1996)........    $4.44   $2.63
  Second Quarter (April 1, 1996-June 30, 1996)..........     3.81    1.88
  Third Quarter (July 1, 1996-September 30, 1996).......     2.56    1.19
  Fourth Quarter (October 1, 1996-December 31, 1996)....     3.53    1.00


     As of March 25, 1998, there were approximately 217 holders of the Company's
Class A Common  Stock.  As of such date,  there were 92 holders of the Company's
Class B Common Stock.


     The Company has never  declared or paid any cash  dividends  on its capital
stock.  The  Company  currently  anticipates  that it  will  retain  all  future
earnings,  if any, to fund the  development  and growth of its business and does
not anticipate  paying any cash dividends on its Common Stock in the foreseeable
future.

Recent Sales of Unregistered Securities

     On March 6, 1998 the Company  issued 150,000 shares of newly created Series
G Convertible  Preferred Stock, par value $.01 ("Series G Convertible  Preferred
Stock")  at a  price  of $20 per  share,  for an  aggregate  purchase  price  of
$3,000,000.  The shares  were sold to one (1)  accredited  investor  pursuant to
Regulation D promulgated under the Act. The Series G Convertible Preferred Stock
is  convertible  into  Class A Common  Stock,  par value  $.01  ("Class A Common
Stock") at an effective  conversion  price of the lower of (a) $1.12 and (b) 80%
of the average of the five (5) lowest trading prices of the Class A Common Stock
during  (x) a day on which  the Class A Common  Stock is  traded  on The  Nasdaq
National Market or The Nasdaq SmallCap Market or principal  national  securities
exchange or market on which the Class A Common Stock has been listed,  or (y) if
the Class A Common  Stock is not  listed on The  Nasdaq  National  Market or The
Nasdaq SmallCap Market or any stock exchange or market, a day on which the Class
A Common Stock is traded in the over-the-counter  market, as reported by the OTC
Bulletin  Board,  or (z) if the  Class A Common  Stock is not  quoted on the OTC
Bulletin  Board,  a day on which  the  Class A Common  Stock  is  quoted  in the
over-the-counter   market  as  reported  by  the   National   Quotation   Bureau
Incorporated (or any similar  organization or agency succeeding its functions of
reporting  prices)  ("Trading  Days"),  as  reported  by  Bloomberg  Information
Services,  Inc.  during the ten (10)  Trading  Days  immediately  preceding  the
Conversion  Date, as defined in the  Certificate  of Designation of the Series G
Convertible  Preferred Stock. In addition to the Series G Convertible  Preferred
Stock, the Company also issued warrants to purchase a total of 225,000 shares of
Class A Common Stock at an exercise price of $1.38 per share, exerciseable until
October 9, 2002.


     On October  9, 1997 the  Company  issued  112,500  shares of newly  created
Series F  Convertible  Preferred  Stock,  par value $.01  ("Series F Convertible
Preferred Stock"),  at a price of $20 per share, for an aggregate purchase price
of $2,250,000.  The shares were sold to one (1) accredited  investor pursuant to
Regulation D promulgated under the Act. The Series F Convertible Preferred Stock
is convertible into the Class A Common Stock at an effective conversion price of
the lower of (a) $1.05 and (b) 80% of the average of the five (5) lowest trading
prices of the Class A Common  Stock during (x) a day on which the Class A Common
Stock is traded on The Nasdaq  National  Market or The Nasdaq SmallCap Market or
principal  national  securities  exchange  or market on which the Class A Common
Stock has been  listed,  or (y) if the Class A Common Stock is not listed on The
Nasdaq  National  Market or The Nasdaq  SmallCap Market or any stock exchange or
market,   a  day  on  which  the   Class  A  Common   Stock  is  traded  in  the
over-the-counter  market,  as reported by the OTC Bulletin  Board, or (z) if the
Class A Common Stock is not quoted on the OTC Bulletin Board, a day on which the
Class A Common Stock is quoted in the over-the-counter market as reported by the
National  Quotation Bureau  Incorporated (or any similar  organization or agency
succeeding its functions of reporting  prices)  ("Trading Days"), as reported by
Bloomberg  Information   Services,   Inc.  during  the  ten  (10)  Trading  Days
immediately  preceding the  Conversion  Date, as defined in the  Certificate  of
Designation  of the Series F  Convertible  Preferred  Stock.  In addition to the
Series F  Convertible  Preferred  Stock,  the Company  also  issued  warrants to
purchase a total of 168,750  shares of Class A Common Stock at an exercise price
of $1.26 per share, exerciseable until October 9, 2002. As of December 31, 1997,
all of the shares of the Series F Preferred stock have been converted into Class
A Common Stock

     On September 16, 1997,  the Company  issued 800,000 shares of the Company's
Class A Common Stock,  and warrants to purchase 160,000 shares of Class A Common
Stock,  which may be  exercised  at an  exercise  price  equal to $1.00,  for an
aggregate  purchase price of $800,000 pursuant to Regulation D promulgated under
the  Securities  Act of 1933,  as amended  (the  "Act"),  to six (6)  accredited
investors.

     On May 30, 1997 the Company  issued 80,000 shares of newly created Series D
Convertible  Preferred  Stock, at a price of $20 per share,  for an aggregate of
$1,600,000.  The shares  were sold to one (1)  accredited  investor  pursuant to
Regulation D promulgated under the Act. The Series D Convertible Preferred Stock
is  convertible  into the Class A Common  Stock of the  Company at an  effective
conversion  price of the lower of (i) $1.35,  or (ii) 80% of the average closing
bid price on the Nasdaq  National  Market System of the Company's Class A Common
Stock  for  the  five  (5)  trading  days  immediately  preceding  the  Date  of
Conversion,   defined  in  the  Certificate  of  Designation  of  the  Series  D
Convertible  Preferred Stock. In addition to the Series D Convertible  Preferred
Stock, the Company also issued warrants to purchase a total of 120,000 shares of
Class A Common Stock at an exercise price of $1.62 per share,  exercisable until
May 30,  2002.  As of  December  31,  1997,  all of the  shares of the  Series D
Preferred Stock have been converted into Class A Common Stock.



<PAGE>



                                                       -15-

Item 6.           Selected Financial Data

                          Statement of Operations Data
<TABLE>
<CAPTION>

                                                                                                             Period from
                                                                                                              February 12,
                                                                                                                 1988
                                                                                                              (inception)
                                                                                                                through
                                                       Year ended December 31                                December 31
                              1997              1996              1995            1994            1993           1997
                         -----------------------------------------------------------------------------------------------
<S>                     <C>                <C>              <C>            <C>             <C>             <C>

Net Revenues             $     10,712      $     1,458       $     -        $     -         $     -        $     12,170
                         ------------      ------------      ----------     -----------     ------------   ------------
Operating expenses:
Selling, general and
   administrative           7,983,151        5,560,620       4,080,185      2,432,283        2,251,094       27,436,506
Write-off of Goodwill         769,886             -                -              -               -             769,886
Aladdin Technology
   License Expense          3,889,000             -                -              -               -           3,889,000
Research and
   development              2,146,127        3,309,022       3,324,735      1,761,366        1,655,386       14,745,813
                           ----------       ----------       ----------     ----------        ---------      -----------
                           14,788,164        8,869,642       7,404,920      4,193,649        3,906,480       46,841,205
                           ----------       ----------      ----------     ----------       ----------      -----------
Other income
   (expense):
Technology License
   Revenue                  1,000,000            -                 -              -               -           1,000,000

Net interest and other
   income (expense)           (120,342)        184,369         572,054        (77,852)         (52,854)         504,572
                           -----------      ----------      ----------      ---------       ----------      -----------
      Net loss             (13,897,794)     (8,683,815)     (6,832,866)    (4,271,501)      (3,959,334)     (45,324,463)
Accrued dividends on
   preferred stock             809,982         199,614          40,600         39,484           38,467         1,134,530
                           -----------      ----------      -----------    -----------      -----------     -------------
Assured incremental
   yield                    1,673,000          670,965           -              -                             2,343,965
                         ------------       ----------     -----------    -----------      -----------      ------------
Net loss to common
   stockholders          $(16,380,776)     $(9,554,394)    $(6,873,466)   $(4,310,985)     $(3,997,801)    $(48,802,958)
                         =============     ============    ===========    ===========      ===========      ============
Weighted average
   number of common
   shares outstanding
   during the period
                           20,943,748       14,956,584      13,794,373     10,503,621        8,659,841        9,777,559

Loss per common share
                                $(.78)           $(.64)          $(.50)         $(.41)           $(.46)          $(4.99)
                         ============     ============    ============    ===========      ===========     ============


<PAGE>

</TABLE>
<TABLE>
<CAPTION>


                                                                   Balance Sheet Data
                                                                 Year ended December 31
                                 -------------------------------------------------------------------------------
                                    1997             1996             1995              1994            1993
                                 -----------     -----------     -----------       -----------       -----------
<S>                              <C>             <C>             <C>               <C>              <C>
Working capital                    (669,041)       3,197,519       5,458,512        12,463,502       (1,453,950)
   (deficiency)
Total assets                      1,678,213        6,237,219       7,754,042        13,766,864          918,303
Current liabilities               1,427,762          937,163       1,210,778           867,145        1,996,250
Long-term liabilities               522,124          465,500               -                 -                -
Series A Cumulative
   Redeemable Preferred
   Stock                            471,601          432,334         390,534           349,934          310,450
Series B Cumulative
   Convertible Preferred
   Stock                                 -0-         195,520               -                 -                -
Series C Cumulative
   Convertible Preferred
   Stock                                 -0-       2,647,742               -                 -                -
Deficit accumulated
   during the development
   stage                        (45,324,463)     (31,426,669)    (22,742,854)      (15,909,988)     (11,638,487)
Total stockholders'
   equity (deficiency)             (743,274)       1,558,960       6,152,730        12,549,785       (1,388,397)

</TABLE>


Item 7.           Management's  Discussion and Analysis of Financial Condition
                  and Results of Operations

Overview

     Wave Systems  Corp.  ("Wave" or the  "Company")  has completed a transition
from a company focused principally on research and development of new technology
to a  company  focused  on  the  commercialization  of  its  technology  through
licensing  and product  sales.  Since its  inception  in  February of 1988,  the
Company has devoted  substantially all of its efforts and resources to research,
feasibility studies, design,  development and market testing of the Wave System.
During  this  period,  the  Company  designed  and  successfully  developed  its
proprietary  integrated  circuit  technology,   WaveMeter,   WaveNet  and  other
necessary  components  of the  Wave  System.  During  1996 the  Company  devoted
substantial  efforts and resources to designing and  developing  the  technology
required to make the Wave System  compatible with the distribution of electronic
content on the Web. Concurrent with its research and development activities, the
Company has devoted increased  resources to market development and other related
activities.  During  1997 the  Company  established  relationships  with IBM and
Aladdin  Knowledge  Systems,  Ltd. as well electronic  content companies such as
Psygnosis,  GT Interactive Software Corp., and Red Storm Entertainment Corp. The
Company also  received a license fee of $1 million  pursuant to a joint  venture
and licensing  agreement with Internet  Technology Group, PLC ("ITG"),  a United
Kingdom  company.  The Company also has set the groundwork for the acceptance of
the Wave System in Europe with ITG by entering  into a joint venture with ITG to
promote the use of the Wave System in Europe.  From inception through December 3
1997,  the Company has realized only minimal  operating  revenues,  and does not
anticipate  significant  revenues in the near future.  There are numerous  risks
that could adversely affect the Company's efforts to achieve profitability.

Results of Operations

Years Ended December 31, 1997 and 1996

         For the years ended December 31, 1997 and December 31, 1996 the Company
had only minimal operating revenues.

     Selling,  general and  administrative  expenses for the year ended December
31, 1997 were  $7,983,151 as compared with  $5,560,620 for 1996. The increase in
selling,  general and  administrative  expenses was  primarily  attributable  to
development  and marketing of new  applications  of the Company's  technology as
well as  accrued  expenses  related  to the ITG Joint  Venture  Agreement,  and
bonuses and salary increases.

     In the third quarter of 1997, the Company wrote off approximately  $770,000
of Goodwill  recorded for the Win acquisition  because the Company was uncertain
as to  whether  the  anticipated  future  operations  of the  business  would be
sufficient to justify the carrying value.

     Research and development expenses for the year ended December 31, 1997 were
$2,146,127 as compared with  $3,309,022  for 1996.  The decrease in research and
development  expenses is  attributable  in part to the  agreement  with  Aladdin
whereby Wave licensed  Aladdin's Hasp technology for a share in content revenues
as well as cash and warrants totalling $3,889,600.  More generally, the decrease
in research and  development  is  attributable  to the shift in the focus of the
Company from research and  development  to  commercialization  and marketing and
personnel  adjustments  consequent thereto.

     In July of 1997,  the Company  entered into a  joint-venture  with Internet
Technology  Group,  PLC  (ITG),  a United  Kingdom  Internet  service  provider.
Pursuant to the joint venture agreement,  the Company will receive a license fee
of up to $5 million in exchange for the joint venture's right to market the Wave
technology in European and Middle Eastern  markets.  During the third quarter of
1997,  the Company  received  $1.0 million from the  joint-venture  representing
partial payment of the license fee, with the remaining  payments to be made upon
the Company's attaining certain milestones related to the number of Wave Meters
distributed.  The amount received was recorded as deferred license fee income in
the  third  quarter  as it  was  uncertain  whether  the  Company  had  met  the
contractual  requirements  required in order to have  earned the first  payment.
During the fourth  quarter  of 1997,  the  Company  met these  requirements  and
recorded the $1 million as a license fee. Also, the Company accrued  $490,000 in
the fourth  quarter for expenses  related to the  Company's  obligation  to
assist  the joint-venture  in  setting  up the Wave  system  in the  designated
markets.  These  costs are  included  in  selling,  general  and  administrative
expense.

     Net interest  expense for the year ended  December 31, 1997 was $120,342 as
compared  with net  interest  income of $184,369  for 1996.  Interest  income of
$55,282 for the year ended  December 31, 1997 was  attributable  to the interest
earned on proceeds  from the  issuance  of  convertible  preferred  stock of the
Company in May of 1996.  Interest income of $194,766 for the year ended December
31, 1996 was  attributable  to the interest earned on proceeds from the issuance
of convertible  preferred  stock of the Company in May of 1996. The Company held
no marketable securities at December 31, 1997.

         Due to the  reasons  set  forth  above,  the  Company's  net  loss  was
$13,897.794  for the year ended  December 31, 1997, as compared with  $8,683,815
for 1996.

Years Ended December 31, 1996 and 1995

         For the year ended  December  31,  1996 the  Company  had only  minimal
operating  revenues.  For the year ended  December 31, 1995,  the Company had no
operating revenues.

         Selling,  general  and  administrative  expenses  for  the  year  ended
December 31, 1996 were  $5,560,620,  as compared with  $4,080,185  for 1995. The
increase  in  selling,   general  and  administrative   expenses  was  primarily
attributable to an increase in personnel and other related costs associated with
the development and marketing of new applications of the Company's technology.

         Research and development  expenses for the year ended December 31, 1996
were  $3,309,022 as compared with  $3,324,735 for 1995. The increase in research
and development expenses consisted primarily of costs associated with
the  design and  development  of the  Company's  ASIC,  including  non-recurring
engineering costs and prototype purchases, the design and development of WaveNet
and the development and implementation of WINPublish and WINPurchase.

         Net interest  income for the year ended  December 31, 1996 was $184,369
as compared with net interest  income of $559,334 for 1995.  Interest  income of
$194,766 for the year ended December 31, 1996 was  attributable  to the interest
earned on  marketable  securities  purchased  with proceeds from the issuance of
convertible  preferred stock of the Company in May of 1996.  Interest expense of
$10,397 for the year ended  December  31,  1996 was  primarily  attributable  to
short-term working capital loans.

         Due to the  reasons  set  forth  above,  the  Company's  net  loss  was
$8,683,815 for the year ended December 31, 1996, as compared with $6,832,866 for
1995.

Liquidity and Capital Resources

     The  Company  has  experienced  net  losses  and  negative  cash  flow from
operations  since its  inception,  and,  as of  December  31, 1997 had a deficit
accumulated  during the  development  stage of  approximately  $45 million.  The
Company has  financed  its  operations  through  December  31, 1997  principally
through the private placement of Class B Common Stock for an aggregate amount of
$6,201,931 (before deduction of expenses incurred in connection therewith),  the
issuance of  $2,873,250  in aggregate  principal  amount of its 10%  Convertible
Notes and 15%  Notes (of which  $2,098,250  was  converted  into  Class B Common
Stock),  the sale of 3,728,200  shares of its Class A Common Stock in an initial
public  offering  raising  approximately  $15,711,000  after all  expenses,  the
private placement of 800,000 shares of Class A Common Stock and warrants raising
$800,000 (before  deduction of expenses incurred in connection  therewith),  and
the private placements of convertible preferred stock for an aggregate of amount
of $10,350,000 (before deduction of expenses incurred in connection  therewith).
In  addition,  the Company has  attempted  to reduce cash flow  requirements  by
compensating key employees, consultants, suppliers and other vendors with Common
Stock and options to purchase Common Stock.

     At December 31, 1997,  the Company had  approximately  $759,000 in cash and
cash  equivalents.  The Company held no  marketable  securities  at December 31,
1997. At December 31, 1996, the Company had approximately $4,064,000 in cash and
cash  equivalents.  The Company held no  marketable  securities  at December 31,
1996. The decrease in cash and cash  equivalents is attributable to the net cash
used in  operations,  partially  offset by the issuance of preferred  and common
stock of the  Company.  At December 31,  1997,  the Company had working  capital
deficiency of approximately  $669,041.  The Company expects to incur substantial
additional  expenses resulting in significant losses at least through the period
ending December 31, 1998 due to minimal revenues  associated with initial market
entry,  continued  research and development costs as well as increased sales and
marketing  expenses  associated  with market  testing and roll-out.  The Company
anticipates that its existing capital  resources will be adequate to satisfy its
capital  requirements into the second quarter. In order to continue  operations,
however,  the Company  will need to raise  additional  funds  through  public or
private  financings.  In March,  1998 the Company issued 150,000 shares of newly
created  Series  G  Convertible  Preferred  Stock  for  an  aggregate  price  of
$3,000,000. The Company has no current commitment to obtain additional funds and
is unable to state the amount or source of such additional funds.

         Significant  uncertainty  currently exists with respect to the adequacy
of current  funds to support the Company's  activities.  This  uncertainty  will
continue   until  a  positive  cash  flow  from   operations  can  be  achieved.
Additionally,  the Company is uncertain as to the availability of financing from
other sources to fund any cash  deficiencies.  These  uncertainties  raise doubt
about the Company's ability to continue as a going concern.

         The Company is currently evaluating financing options and may therefore
elect to raise  additional  capital,  from time to time,  through equity or debt
financings  in  order  to  capitalize  on  business   opportunities  and  market
conditions  and insure the continued  development  of the Company's  technology,
products and services.

         The  Company   presently  has  no  material   commitments  for  capital
expenditures.

As  of  December  31,  1997,  the  Company  had  available  net  operating  loss
carryforwards  for Federal income tax purposes of  approximately  $36.9 million.
Because of the "change in  ownership"  provisions of the Tax Reform Act of 1986,
the  Company's  net  operating  loss  carryforwards  may be subject to an annual
limitation on the utilization of these  carryforwards  against taxable income in
future  periods if a  cumulative  change in ownership of more than 50 percent of
the  Company  occurs  within any  three-year  period.  The  Company  has made no
determination  concerning  whether  there has been such a  cumulative  change in
ownership. However, the Company believes that it is likely that such a change in
ownership  occurred  prior to or following the  completion of its initial public
offering.

         In June  1997,  the FASB  issued  SFAS 130,   "Reporting  Comprehensive
Income," which establishes  standards for reporting and display of comprehensive
income and its components in a full set of general-purpose financial statements.
Under this concept, all revenues,  expenses,  gains and losses recognized during
the period are included in income,  regardless of whether they are considered to
be results of operations of the period.  SFAS 130,  which becomes  effective for
the Company in its year ending  December  31,  1998,  is not  expected to have a
material impact on the consolidated financial statements of the Company.

         In June 1997, the FASB issued SFAS 131,  "Disclosures about Segments of
an Enterprise and Related  Information," which establishes standards for the way
that public business  enterprises  report selected  information  about operating
segments in annual  financial  statements  and requires  that those  enterprises
report  selected  information  about  operating  segments  in interim  financial
reports to shareholders.  It also establishes  standards for related disclosures
about products and services,  geographic  areas and major  customers.  SFAS 131,
which becomes effective for the Company in its year ending December 31, 1998, is
currently not expected to have a material  impact on the Company's  consolidated
financial statements and footnote disclosures.

Year 2000 Issues

         The Company is in the process of evaluating  its computer  software and
databases to determine whether or not modifications  will be required to prevent
problems  related  to the year  2000.  At this  time,  it is not  expected  that
modifying or replacing the Company's software and databases will have a material
financial effect on the Company's financial position or results of operations in
any given year.

Item 7A.          Quantitative and Qualitative Disclosure about Market Risk

         Not applicable.


Item 8.           Financial Statements and Supplementary Data

         The  consolidated  financial  statements,  the notes  thereto,  and the
independent auditors' report thereon are presented beginning at page F-1 of this
Form 10-K and are hereby incorporated by reference into this Item 8.


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

         Not Applicable.

                                    PART III


Item 10. Directors and Executive Officers of the Registrant

                           Directors of the Registrant
<TABLE>
<CAPTION>

                        Business   Experience   and  Principal
                        Occupation  or    Employment    During
                        Past   5  Years;  Positions  held with
Name             Age    Company; Other Directorships            Director Since
<S>             <C>     <C>                                         <C>

Peter J.        58      Chairman  of the  Company  since  1988      1991
Sprague(1)(4)           and Chief Executive  Officer    of the
                        Company  since   July   1991; Chairman
                        of National Semiconductor  Corporation
                        from  1965 until May 1995; Director of
                        Enlightened Software,     Inc.     and
                        Pantepec International, Inc.;  Trustee
                        of  the  Strang    Clinic;      Member
                        of    Academy     of     Distinguished
                        Entrepreneurs,  Babson  College.

John E. Bagalay, 64    Managing   Director     of    Community      1993
Jr., Ph.D.(1)          Technology  Fund,   a  venture  capital
(2)(4)                 affiliate  of Boston University,  since
                       September   1989;   General  Counsel of
                       Lower  Colorado  River  Authority  from
                       October 1984 to September 1988;  former
                       General  Counsel   of   Texas  Commerce
                       Bancshares,  Inc.   and  Houston  First
                       Financial  Group;  Director of Seragen,
                       Inc.,  Cytogen,      Inc.,      Hymedix
                       Inc. and    several      privately-held
                       corporations;   President    and    CEO
                       of    Cytogen Corporation from  January
                       1998,  CFO    since     October   1997;
                       Managing Director of Boston  University
                       Venture  Capital  Fund  from 1989-1997;
                       Senior  Advisor to Chancellor,   Boston
                       University from January 1998.

Philippe         48    Manager of Financiere  Wagram  Poncelet      1993
Bertin(3)              (direct   marketing;    media)    since
                       December  1991; Manager  of Midial  S.A.
                       (consumer goods) from  1984 until 1991;
                       Manager of  FINOVELEC    since  October
                       1997.

George Gilder(4) 58    Chairman  of  the  Executive  Committee      1993
                       of  the  Company  since  1996;   Senior
                       Fellow  at  the    Discovery  Institute
                       in Seattle, Washington; author of  nine
                       books, including Life After Television,
                       Microcosm,  The  Spirit  of  Enterprise
                       and Wealth and  Poverty;   contributing
                       editor to   Forbes   Magazine; Director
                       and  President   of  Gilder  Technology
                       Group,  Inc.   (publisher  of   monthly
                       technology reports);  former   chairman
                       of   the  Lehrman  Institute   Economic
                       Roundtable; former   Program   Director
                       for  the Manhattan Institute; recipient
                       of     White    House      award    for
                       Entrepreneurial Excellence from
                       President Reagan.

John E.          68    Chairman  and Chief  Executive  Officer      1988
McConnaughy,Jr.        of    JEMC     Corporation     (private
(1)(2)(3)(4)           investments);   Chairman   and    Chief
                       Executive      Officer   of     Peabody
                       International    Corporation        (an
                       environmental  services  company)  from
                       1969 through 1985; Chairman  and  Chief
                       Executive  Officer of GEO International
                       Corporation  (a nondestructive testing,
                       screen printing  and oil field services
                       company which was spun-of from Peabody)
                       from  February  1981 to October   1992;
                       Director  of    Riddell    Sports Inc.,
                       Levcor  International,   Inc., Transact
                       International,  Inc., De-Vlieg Bullard,
                       Inc.  and   Mego  Financial  Corp.  Mr.
                       McConnaughy  is  also a  member  of the
                       Board of Trustees  of the Strang Clinic
                       and the Chairman  of the  Board  of the
                       Harlem School of the Arts.

Steven           33    President  and Chief Operating  Officer          1997
Sprague                of  the  Company   since   May    1996;
                       President of Wave  Interactive  Network
                       from  June  1995  to December 30, 1996;
                       Vice   President  of  Operations of the
                       Company  from April 1994 to June  1995;
                       employee  of  the  Company in the areas
                       of  operations  and  strategic planning
                       from   November  1992  to  April  1994;
                       consultant  to the Company  from March
                       1992 to  November  1992;  President  of
                       Tech  Support,   Incorporated (hardware
                       technical  support   information     on
                       CD-ROM)from June 1992 to November 1992;
                       sole proprietor of   SKS  Environmental
                       Sales  (manufacturers'   representative
                       for  water   treatment  companies) from
                       June 1991 to  November  1992.

</TABLE>

(1) Member of Nominating Committee.
(2) Member of Compensation Committee.
(3) Member of Audit Committee
(4) Member of Executive Committee


     Executive  Officers of the Registrant

     The executive  officers of the Company are Mr. Peter J.  Sprague,  Chairman
and  Chief  Executive  Officer  and Mr.  Steven  Sprague,  President  and  Chief
Operating Officer.

     All  officers  are elected  annually  at the first  meeting of the Board of
Directors  following the annual meeting of the stockholders,  and are subject to
removal at any time by the Board of Directors.



             Section 16(a) Beneficial Ownership Reporting Compliance

     Section  16(a) of the  Securities  Exchange  Act of 1934,  as amended  (the
"Exchange  Act") requires the Company's  directors and executive  officers,  and
persons  owning more than ten  percent of a  registered  class of the  Company's
equity securities,  to file with the Securities and Exchange  Commission reports
of ownership and changes in ownership of equity securities of the Company.  Such
persons are also required to furnish the Company with copies of all such forms.

     Based  solely  upon a review of the copies of such forms  furnished  to the
Company and, in certain cases,  written  representations  that no Form 5 filings
were required,  the Company believes that, with respect to the 1997 fiscal year,
all required  Section 16(a)  filings were made,  except that (i) the Forms 5 for
Mr. Philippe Bertin, a director of the Company, and Mr. Steven Sprague, director
and President of the Company,  were filed late; and (ii) the Form 5 for Mr. Gene
Ray, a director  of the  Company  in 1997,  was filed late and later  amended to
correct the number of derivative  securities  beneficially  owned as of December
31, 1997 from 20,000 to 42,000.


Item 11.          Executive Compensation

         Summary Compensation Table

     The following table sets forth information with respect to the compensation
paid or awarded by the Company to the Chief Executive Officer and the only other
executive officer whose cash compensation exceeded $100,000  (collectively,  the
"Named Executive Officers") for services rendered in all capacities during 1995,
1996 and 1997.
<TABLE>
<CAPTION>

                                    Long Term
                               Compensation Awards
                                 Annual Compensation       Number of Shares
Name and Principal                                             Underlying
    Position                 Year    Salary($)   Bonus($)      Options(#)
-------------------          -----  ---------  -----------    ------------
<S>                          <C>      <C>      <C>              <C>
Peter J. Sprague(1)          1997    $160,000  $  100,000        10,000
   Chairman and Chief        1996    $160,000  $  50,000          -0-
   Executive Officer         1995    $160,000  $   -0-            1,995

Steven Sprague(2)            1997    $150,000  $  117,500         -0-
   President and             1996    $131,666  $   -0-          150,000
   Chief Operating Officer   1995    $110,000  $   -0-            1,995


</TABLE>


(1) Mr.  Peter  Sprague  received  a bonus of  $100,000  for 1997;  $50,000  was
    received  in cash and  $50,000 was applied to reduce his debt to the Company
    (see Item 13).

(2)  Mr. Steven Sprague was elected President and Chief Operating Officer on May
     23, 1996 and was not previously an executive  officer during 1996. Prior to
     that,  Mr. Steven  Sprague was Vice  President of Operations of the Company
     from April 1994 to June 1995 and  employee  of the  Company in the areas of
     operations and strategic planning from November 1992 to April 1994.


         Option Grants Table

     The  following  table  sets forth  certain  information  regarding  options
granted  during the fiscal  year ended  December  31, 1997 by the Company to the
Named Executive Officers.
<TABLE> <CAPTION>


                                                                             Potential Realizable Value
                 Number of      % of Total                                   at Assumed Annual Rates of
                   Shares         Options                                    Stock Price Appreciation For
                 Underlying     Granted to       Exercise                          Option Term (1)
                  Options        Employees        Price      Expiration      ---------------------------
Name             Granted (#)    Fiscal Year     ($/Share)      Date           5% ($)         10% ($)
----             -----------    -----------     ---------    ---------        -------        -------
<S>                  <C>            <C>           <C>        <C>              <C>            <C>
Peter J. Sprague     10,000          4.9           $1.94     7/17/07          13,200         32,500
Steven Sprague          -0-         -0-            -            -               -0-             -0-
--------------
</TABLE>

(1)  The potential realizable value of the options reported above was calculated
     by assuming  5% and 10%  compounded  annual  rates of  appreciation  of the
     common stock from the date of grant of the options until the  expiration of
     the  options,  based  upon the  market  price on the date of  grant.  These
     assumed annual rates of appreciation were used in compliance with the rules
     of the Securities and Exchange  Commission and are not intended to forecast
     future price appreciation of the common stock.

         Fiscal Year End Option Value Table

     The following table sets forth  information  regarding the aggregate number
and value of options  held by the Named  Executive  Officers as at December  31,
1997. No options were exercised by the Named Executive Officers during 1997.
<TABLE>
<CAPTION>
                                              Number of Shares
                                       Underlying Unexercised Options                Value of Unexercised
                                           at December 31, 1997(#)                   In-The-Money Options
                                                                                  at December 31, 1997($)(1)
Name                                 Exercisable        Unexercisable        Exercisable         Unexercisable
---------                           -------------       -------------       -------------        -------------
<S>                                      <C>                 <C>             <C>                 <C>
Peter J. Sprague.................        331,330             10,665          $         46        $          23
Steven Sprague...................         94,530            100,665          $         47        $          23

</TABLE>
(1) The last reported  bid price for the Company's  Class A Common Stock on the
OTC  Bulletin  Board  on  December  31,  1997 was  $1.125  per  share.  Value is
calculated on the basis of the difference between the respective option exercise
prices and $1.125, multiplied by the number of shares of common stock underlying
the respective options.


         Compensation of Directors

     Directors  presently  receive no cash compensation for serving on the Board
of Directors. Under the Company's Non-Employee Directors Stock Option Plan, each
director  who is not an  employee of the  Company  receives  an annual  grant of
options to purchase  10,000 shares of Class A Common Stock at fair market value.
The  options  are  granted  upon  re-election  after the  annual  meeting of the
stockholders and vest 25% after each three-month period following grant. Options
terminate upon the earliest to occur of (i) subject to (ii) below,  three months
after the optionee  ceases to be a director of the Company,  (ii) one year after
the death or disability  of the optionee,  and (iii) ten years after the date of
grant.  If there is a change of control of the Company,  all  outstanding  stock
options will become immediately exercisable.


Item 12.         Security Ownership of Certain Beneficial Owners and Management

     The  following  table  sets  forth  certain   information   concerning  the
beneficial  ownership  of the  Company's  Class A and Class B Common Stock as of
March 25, 1998 (except as otherwise  noted) by (i) each stockholder who is known
by the Company to own  beneficially  more than five  percent of the  outstanding
Class A or Class B Common Stock,  (ii) each director of the Company,  (iii) each
of the executive officers of the Company named in the Summary Compensation Table
above, and (iv) all directors and executive  officers of the Company as a group.
Holders  of Class A  Common  Stock  are  entitled  to one vote per  share on all
matters submitted to a vote of the stockholders of the Company. Holders of Class
B Common Stock are entitled to one vote per share on all matters  submitted to a
vote of the stockholders,  except that holders of Class B Common Stock will have
five votes per share in cases  where one or more  directors  are  nominated  for
election by persons other than the Company's  Board of Directors and where there
is a vote on any merger, consolidation or other similar transaction which is not
recommended by the Company's Board of Directors. In addition, holders of Class B
Common  Stock will have five votes per share on all matters  submitted to a vote
of the  stockholders  in the event that any person or group of persons  acquires
beneficial  ownership of 20% or more of the outstanding voting securities of the
Company.  Shares of Class B Common Stock are convertible  into shares of Class A
Common Stock on a one-for-one basis at the option of the holder.

<TABLE>
<CAPTION>
                                                                                            Percent
                                                                                             of All
                             Number of Shares               Number of Shares   Percent    Outstanding
                             of Class A Common  Percent of  of Class B Common    of          Common
 Beneficial Owner(1)          Stock Owned(2)      Class        Stock Owned      Class       Stock(3)
 -------------------          --------------     --------     -------------    --------    --------
<S>                           <C>                  <C>          <C>                <C>         <C>
Peter J. Sprague(4)               1,995             *           1,873,834          41.4         7.0
Steven Sprague(5)               152,195             *             190,659           4.4         1.3
John E. Bagalay, Jr.(6)          43,500             *                   0           *           *
Philippe Bertin(7)               43,500             *                   0           *           *
George Gilder(8)                 76,833             *               2,000           *           *
John E. McConnaughy, Jr.(9)      56,030             *             335,000           8.0         1.5
Aladdin Knowledge Sys. (10)   4,537,973            17.3                 0           *          14.9
Financiere Wagram Poncelet            0             *             442,857          11.0         1.8
All executive officers and
directors as a group
(6 persons)(11)                 373,403            1.7          2,401,493          52.5        10.2

</TABLE>

*Less than one percent.

     (1) Each individual or entity has sole voting and investment power,  except
as otherwise indicated.

     (2) Does not  include  shares  of Class A Common  Stock  issuable  upon the
conversion of Class B Common Stock.

     (3) In  circumstances  where  the Class B Common  Stock has five  votes per
share,  the  percentages  of total  voting  power would be as follows:  Peter J.
Sprague,  24.2%;  Steven  Sprague,  2.9%;  John E.  Bagalay,  Jr., less than 1%;
Philippe Bertin, less than 1%; George Gilder, less than 1%; John E. McConnaughy,
Jr., 4.5%; Aladdin Knowledge Systems, 11.7%;  Financiere Wagram Poncelet,  6.0%;
and all Executive Officers and Directors as a group, 32.6%.

     (4)  Includes  331,995  shares  which  are  subject  to  options  presently
exercisable or exercisable  within 60 days. Also includes 320,000 shares held in
trust for the benefit of Mr. Sprague's adult children, and for which Mr. Sprague
is a trustee.

     (5)  Includes  145,195  shares  which  are  subject  to  options  presently
exercisable or exercisable within 60 days.

     (6)  Includes  39,500  shares  which  are  subject  to  options   presently
exercisable or exercisable within 60 days.

     (7)  Includes  39,500  shares  which  are  subject  to  options   presently
exercisable or exercisable within 60 days.

     (8)  Includes  72,833  shares  which  are  subject  to  options   presently
exercisable or exercisable within 60 days.

     (9)  Includes  52,030  shares  which  are  subject  to  options   presently
exercisable or exercisable within 60 days.

     (10)  Includes  4,037,973  shares  which are  subject to options  presently
exercisable or exercisable within 60 days.

     (11)  Includes  681,043  shares  which are  subject  to  options  presently
exercisable or exercisable within 60 days.




Item 13.         Certain Relationships and Related Transactions

Note Receivable from Director/Officer

     On  November  16,  1992,  the  Company  made a personal  loan to Mr.  Peter
J.Sprague,  Chairman and Chief Executive Officer of the Company, as evidenced by
a note for $150,000, which sum was due and payable to the Company on January 16,
1993 and which bore interest at the rate of ten percent (10%) per annum.  On the
due date, the note was canceled and the total amount owed was "rolled-over" into
a subsequent note, dated May 12, 1993 for $150,000,  plus accrued interest.  The
note is due on demand by the Company and accrues interest at the rate of 10% per
annum.  On April 22,  1993,  the Company  made an  additional  loan to Mr. Peter
Sprague for $23,175 as evidenced by a subsequent note, which is due on demand by
the Company and which  bears  interest at a rate of 10% per annum.  All of these
loans were made to Mr. Sprague for personal  reasons.  As part of Mr.  Sprague's
$100,000 bonus for 1997,  $50,000 was applied  against his  indebtedness  to the
Company.  As  of  December  31,  1997,  Mr.  Sprague's  aggregate   indebtedness
(including accrued interest) to the Company under the notes totaled $212,024. No
demand has been made as of the date hereof. The notes are secured by a pledge of
67,000 shares of Class B Common Stock.

Compensation to Steven Sprague

         Steven Sprague received  aggregate  compensation of $267,500,  $131,666
and  $110,000  for  services  rendered  to the  Company in 1997,  1996 and 1995,
respectively.  Steven  Sprague is the son of Mr. Peter J. Sprague,  the Chairman
and Chief Executive Officer of the Company.

Transactions Involving Michael Sprague

         In 1997,  Wave  paid  $182,209  to  Enterprise  Engineering  Associates
("EEA"), during which time Mr. Michael Sprague was an employee of EEA. On August
1, 1997,  Michael  Sprague  became an employee of Wave,  at an annual  salary of
$110,000.  Michael Sprague is the son of Mr. Peter J. Sprague,  the Chairman and
Chief Executive Officer of the Company.

Amended and Restated License Agreement and Assignment

         Pursuant to an Amended and Restated License  Agreement,  dated February
14, 1994, and related Patent  Assignment  and Security  Agreement,  Mr. Peter J.
Sprague  assigned  his interest in a patent for the metering and usage of serial
data  information  to the  Company  in  exchange  for a  non-terminable  royalty
interest. The Company has agreed to payment of royalties to Mr. Sprague of 2% of
the gross  revenues  (less  actual  amounts  paid to  information,  database and
content providers,  hardware  manufacturers and suppliers,  search and retrieval
software suppliers,  consolidators of information and network providers) derived
from the  Company's  technology  based on the patent.  The royalty  payments are
allocated 75% to Mr. Sprague and 25% to a former officer of the Company, and are
secured by a security interest in and to the patent.


License and Cross-License Agreement

         On May 1, 1992, the Company entered into a Joint Technology Development
Agreement and License and  Cross-License  Agreement  with The Titan  Corporation
whereby  Titan  granted  to the  Company  license  rights to the use of  certain
patents which are co-owned by Titan. Dr. Gene W. Ray, a director of the Company,
is a  director,  President  and Chief  Executive  Officer of Titan.  The Company
granted  to Titan  the  exclusive  right to make  for,  sell in,  and lease in a
"Retained Market," as defined in the agreement,  the subject matter described in
any Company patent.  The Retained Market is defined  generally as the market for
"Government  Information,"  as  defined  in  the  agreement,  used  solely  by a
government  entity, and the market for products used to access such information.
On February  28, 1997 the Company and Titan  executed an addendum to the License
and  Cross-License  Agreement whereby the Company received a sole license to the
licensed  patent to develop and  distribute  products  to the  in-home  consumer
microcomputer   market   segment.   Under  this  addendum  to  the  License  and
Cross-License Agreement,  Titan waived any and all defaults by the Company under
the License and Cross-License Agreement occurring prior to February 28, 1997.

<PAGE>


                                                      PART IV


Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K

14 (a) (1)  Financial Statements:

                       Consolidated Financial Statements
                           December 31, 1997 and 1996
                   (With Independent Auditors' Report Thereon)


<TABLE>
<CAPTION>
                                                                                                       Page(s)

<S>                                                                                                      <C>
Index to Consolidated Financial Statements                                                               F-1

Independent Auditors' Report                                                                             F-2

Consolidated Balance Sheets as of December 31, 1997 and 1996                                             F-3

Consolidated  Statements of Operations  for each of the years ended December 31,
   1997, 1996 and 1995 and for the period from February 12,
   1988 (inception) through December 31, 1997                                                            F-4

Consolidated  Statements of  Stockholders'  Equity  (Deficiency) for each of the
   years ended December 31, 1997, 1996 and 1995 and for the period from
   February 12, 1988 (inception) through December 31, 1997                                               F-5

Consolidated  Statements of Cash Flows for each of the years ended  December 31,
   1997, 1996 and 1995 and for the period from
   February 12, 1988 (inception) through December 31, 1997                                              F-13

Notes to Consolidated Financial Statements                                                              F-15

</TABLE>

(a) (2)  Financial Statement Schedules:
   All  schedules  have been  omitted  since they are either not required or not
applicable.

(a) (3)  Exhibits


Exhibit No.                                          Description of Exhibit

     3.1  Restated  Certificate of Incorporation of Registrant  (incorporated by
          reference to Exhibit 3.1 of the Registrant's Registration Statement on
          Form S-1, File No. 33-75286)

     3.2  Bylaws of Registrant  (incorporated by reference to Exhibit 3.2 of the
          Registrant'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 the Registrant'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
          the Registrant's Registration Statement on Form S-1, File No.
          33-75286)

     4.3  Certificate of Designation of Series B Preferred Stock of Wave Systems
          Corp.  as filed with the  Delaware  Secretary of State on May 24, 1996
          (incorporated by reference to Exhibit 3.1 of the Registrant's  Current
          Report on Form 8-K filed on May 30, 1996, File No. 0-24752)

     4.4  Certificate of Designation of Series C Convertible  Preferred Stock of
          Wave Systems  Corp.  as filed with the Delaware  Secretary of State on
          December  27, 1996  (incorporated  by  reference to Exhibit 3.1 of the
          Registrant'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 of
          Wave Systems  Corp.  as filed with the Delaware  Secretary of State on
          December  27, 1996  (incorporated  by  reference to Exhibit 3.1 of the
          Registrant'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 Systems  Corp.  as filed with the Delaware  Secretary of State on
          October 9, 1997  (incorporated  by  reference  to  Exhibit  3.1 of the
          Registrant's  Current  Report on Form 8-K filed on October  15,  1997,
          File No. 0-24752)

     4.7  Certificate of Designation of Series G Convertible  Preferred Stock of
          Wave Systems  Corp.  as filed with the Delaware  Secretary of State on
          March  5,  1998  (incorporated  by  reference  to  exhibit  3.1 of the
          Registrant's  Current Report on Form 8-K filed on March 19, 1998, File
          No. 0-24752)

   +10.1  Joint  Technology  Development  Agreement,  dated  as of May 1,  1992,
          between The Titan  Corporation and  Cryptologics  International,  Inc.
          (incorporated  by  reference  to  Exhibit  10.2  of  the  Registrant's
          Registration Statement on Form S-1, File No. 33-75286)

   +10.2  License   and   Cross-License   Agreement,   dated  as of May 1, 1992,
          between The Titan  Corporation and  Cryptologics  International,  Inc.
          (incorporated  by  reference  to  Exhibit  10.3  of  the  Registrant's
          Registration Statement on Form S-1, File No. 33-75286)

     10.3 Amendment to License and Cross-License  Agreement,  dated as of August
          27,  1993,  between  The  Titan  Corporation  and Wave  Systems  Corp.
          (incorporated  by  reference  to  Exhibit  10.4  of  the  Registrant's
          Registration Statement on Form S-1, File No. 33-75286)

     10.4 Amended and Restated  License  Agreement,  dated February 14, 1994, by
          and among Wave Systems  Corp.,  Peter J. Sprague and John R.  Michener
          (incorporated  by  reference  to  Exhibit  10.5  of  the  Registrant's
          Registration Statement on Form S-1, File No. 33-75286)

   +10.5  Wave Systems Corp. 1994 Stock Option Plan  (incorporated  by reference
          to Exhibit  10.6 of the  Registrant's  Registration  Statement on Form
          S-1, File No. 33-75286)

   +10.6  Wave  Systems   Corp.   Non-Employee   Directors   Stock  Option  Plan
          (incorporated  by  reference  to  Exhibit  10.7  of  the  Registrant's
          Registration Statement on Form S-1, File No. 33-75286)

     10.7 Regulation S Securities  Subscription  Agreement,  dated as of May 29,
          1996  (incorporated  by reference  to Exhibit 4.1 of the  Registrant's
          Current Report on Form 8-K filed on May 30, 1996, File No. 0-24752)

     10.8 Purchase Agreement between Wave Systems Corp. and JNC Opportunity Fund
          Ltd.,  dated as of December  27, 1996  (incorporated  by  reference to
          Exhibit 4.1 of the  Registrant's  Current  Report on Form 8-K filed on
          January 8, 1997, File No. 0-24752)

     10.9 Registration  Rights  Agreement  between  Wave Systems  Corp.  and JNC
          Opportunity Fund Ltd., dated as of December 27, 1996  (incorporated by
          reference to Exhibit 4.2 of the  Registrant's  Current  Report on Form
          8-K filed on January 8, 1997, File No. 0-24752)

   10.10  Purchase Agreement between Wave Systems Corp. and JNC Opportunity Fund
          Ltd.,  dated as of May 30, 1997  (incorporated by reference to Exhibit
          4.1 of the  Registrant's  Current  Report on Form 8-K filed on June 3,
          1997, File No. 0-24752)

   10.11  Registration  Rights  Agreement  between  Wave Systems  Corp.  and JNC
          Opportunity  Fund  Ltd.,  dated as of May 30,  1997  (incorporated  by
          reference to Exhibit 4.2 of the  Registrant's  Current  Report on Form
          8-K filed on June 30, 1997, File No. 0-24752)

   10.12  Purchase  Agreement between Wave Systems Corp. and Combination,  Inc.,
          dated as of October 9, 1997  (incorporated by reference to Exhibit 4.1
          of the  Registrant's  Current  Report on Form 8-K filed on October 15,
          1997, File No. 0-24752)

   10.13  Registration   Rights   Agreement   between  Wave  Systems  Corp.  and
          Combination, dated as of October 9, 1997 (incorporated by reference to
          Exhibit 4.2 of the  Registrant's  Current  Report on Form 8-K filed on
          October 15, 1997, File No. 0-24752)

   10.14  Purchase  Agreement  between Wave Systems Corp. and Combination  Inc.,
          dated as of March 6, 1998 (incorporated by reference to Exhibit 4.1 of
          Registrant's  Current Report on Form 8-K filed on March 19, 1998 file
          No. 0-24752)

   10.15  Registration   Rights   Agreement   between  Wave  Systems  Corp.  and
          Combination Inc., dated as of March 6, 1998 (incorporated by reference
          to Exhibit 4.2 of the Registrant's Current Report on Form 8-K filed on
          March 19, 1998, file No. 0-24752)

   10.16  Addendum to License and  Cross-License  Agreement,  dated February 28,
          1997,   between  The  Titan   Corporation   and  Wave  Systems   Corp.
          (incorporated  by  reference  to  Exhibit  10.10  of the  Registrant's
          Current  Report  on Form  10-K  filed  on  March  24,  1997,  file No.
          0-24752).

   23.1   Consent of Independent Auditors - KPMG Peat Marwick LLP

+Confidential treatment has been granted as to portions of this exhibit.
+Management contract or compensatory plan.

     (b) The company filed a Form 8-K on October 15, 1997 in connection with the
         sale of its Series F Convertible Preferred Stock to Combination Inc.

<PAGE>




                                   SIGNATURES

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

Dated:  March 31, 1998
                               WAVE SYSTEMS CORP.

                                     By:      /s/ Peter J. Sprague
                                     -----------------------------
                                     Name:    Peter J. Sprague
                                     Title:   Chairman, Chief Executive Officer
                                     (Principal Financial Officer and Duly
                                     Authorized Officer of the Registrant)

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

 Signature                            Title                            Date
/s/ Peter J. Sprague
------------------------
Peter J. Sprague         Chairman and Chief Executive Officer     March 31, 1998
                      (Principal Financial Officer and Duly
/s/ Steven Sprague      Authorized Officer of the Registrant)
------------------------
Steven Sprague        President, Chief Operating Officer and      March 31, 1998
                                     Director
/s/ John E. Bagalay, Jr.
------------------------
John E. Bagalay, Jr.                 Director                     March 31, 1998

/s/ Philippe Bertin
------------------------
Philippe Bertin                      Director                     March 31, 1998

/s/George Gilder
------------------------
George Gilder                        Director                     March 31, 1998

/s/John E. McConnaughy, Jr.
------------------------
John E. McConnaughy, Jr.             Director                     March 31, 1998

<PAGE>
                                      F-1

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

                        Consolidated Financial Statements

                           December 31, 1997 and 1996

                   (With Independent Auditors' Report Thereon)



                   Index to Consolidated Financial Statements

<TABLE>
<CAPTION>
                                                                                                       Page(s)

<S>                                                                                                      <C>
Independent Auditors' Report                                                                             F-2

Consolidated Balance Sheets as of December 31, 1997 and 1996                                             F-3

Consolidated  Statements of Operations  for each of the years ended December 31,
   1997, 1996 and 1995 and for the period from February 12,
   1988 (inception) through December 31, 1997                                                            F-4

Consolidated  Statements of  Stockholders'  Equity  (Deficiency) for each of the
   years ended December 31, 1997, 1996 and 1995 and for the period from
   February 12, 1988 (inception) through December 31, 1997                                               F-5

Consolidated  Statements of Cash Flows for each of the years ended  December 31,
   1997, 1996 and 1995 and for the period from
   February 12, 1988 (inception) through December 31, 1997                                              F-13

Notes to Consolidated Financial Statements                                                              F-15

</TABLE>


<PAGE>

                                       F-2

                          INDEPENDENT AUDITORS' REPORT



The Board of Directors and Stockholders
Wave Systems Corp.:


We have audited the consolidated  financial statements of Wave Systems Corp. and
subsidiaries (a development  stage  corporation)  as listed in the  accompanying
index.  These  consolidated  financial  statements are the responsibility of the
Company's  management.  Our  responsibility  is to  express  an opinion on these
consolidated financial statements based on our audits.

We  conducted  our  audits  in  accordance  with  generally   accepted  auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated  financial statements referred to above present
fairly, in all material  respects,  the financial position of Wave Systems Corp.
and  subsidiaries  as of December  31,  1997 and 1996,  and the results of their
operations and their cash flows for each of the years in the  three-year  period
ended  December  31,  1997 and for the period  from  February  12, 1988 (date of
inception) to December 31, 1997 in conformity with generally accepted accounting
principles.

The accompanying  consolidated  financial statements have been prepared assuming
that Wave Systems Corp. and  subsidiaries  will continue as a going concern.  As
discussed in note 1 to the consolidated  financial  statements,  the Company has
suffered recurring losses from operations since inception that raise substantial
doubt about the entity's  ability to continue as a going  concern.  Management's
plans in regard to these matters are also described in note 1. The  consolidated
financial  statements do not include any adjustments  that might result from the
outcome of this uncertainty.

                                                 KPMG PEAT MARWICK LLP




Boston, Massachusetts
March 27, 1998


<PAGE>



                                       F-3


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

                           Consolidated Balance Sheets

                           December 31, 1997 and 1996
 <TABLE>
 <CAPTION>




          Assets                                                                                       1997             1996

<S>                                                                                             <C>                    <C>
Current assets:
   Cash and cash equivalents                                                                    $      758,721         4,064,324
   Prepaid expenses and other receivables                                                                   -             70,358
                                                                                                   -------------    -------------

          Total current assets                                                                         758,721         4,134,682

Property and equipment, less accumulated depreciation of
   $964,184 in 1997 and $622,356 in 1996                                                               849,276           934,798
Goodwill, net of accumulated amortization of $39,686 in 1996                                                -            912,752
Other assets                                                                                            70,216           254,987
                                                                                                   -------------     -------------
                                                                                                 $   1,678,213         6,237,219
                                                                                                   =============     =============

   Liabilities and Stockholders' equity (deficiency)

Current liabilities:
   Accounts payable and accrued expenses                                                          $  1,427,762           937,163
   Note payable                                                                                        522,124           465,500
                                                                                                  ------------      ------------
             Total Current Liabilities                                                               1,949,886         1,402,663
                                                                                                  ------------      ------------
Series A Cumulative Redeemable Preferred Stock, $.0l par value.
   360 shares issued and outstanding in 1997 and 1996; involuntary
   liquidation value, $471,601                                                                         471,601           432,334
Series B Preferred Stock, $.0l par value. 20 shares issued and
   outstanding in 1996                                                                                      -            195,520
Series C Convertible Preferred Stock $.0l par value. 150,000
   shares issued and outstanding in 1996                                                                    -          2,647,742
                                                                                                  ------------       -----------

          Total preferred stock                                                                        471,601         3,275,596
                                                                                                  ------------       -----------

Stockholders' equity:
   Preferred stock, $.0l par value. Authorized 2,000,000 shares;
     360 shares issued and outstanding as Series A Cumulative
     Redeemable Preferred Stock                                                                             -                 -
   Common stock, $.0l par value. Authorized 25,000,000 shares as Class A;
     issued and outstanding 22,874,639 in 1997 and 11,582,086 in 1996                                  228,747           115,821
   Common stock, $.01 par value. Authorized 13,000,000 shares as
     Class B; issued and outstanding 4,421,953 in 1997 and 6,208,141 in 1996                            44,220            62,081
   Capital in excess of par value                                                                   44,520,246        33,052,432
   Deficit accumulated during the development stage                                                (45,324,463)      (31,426,669)
   Less:  Note receivable from stockholder, including accrued interest
     of $88,849 in 1997 and $71,530 in 1996                                                           (212,024)         (244,705)
                                                                                                  ------------      ------------

          Total stockholders' equity (deficiency)                                                     (743,274)        1,558,960
                                                                                                  ------------       -----------

 Commitments and contingencies
                                                                                                 $   1,678,213         6,237,219
                                                                                                   ===========       ===========


See accompanying notes to consolidated financial statements.


</TABLE>
<TABLE>
<CAPTION>




                                       F-4

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

                      Consolidated Statements of Operations

                     Years ended December 31, 1997, 1996 and
                     1995 and period from February 12, 1988
                               (date of inception)
                            through December 31, 1997



                                                                                                             Period from
                                                                                                          February 12, 1988
                                                                                                         (date of inception)
                                                                                                               through
                                                                                                            December 31,
                                                           1997             1996              1995              1997
                                                           ----             ----              ----              ----

<S>                                                <C>                  <C>                <C>            <C>
Net revenue                                        $        10,712             1,458               -             12,170
                                                     -------------      ------------      -------------    -------------

Operating expenses:
   Selling, general and administrative                   7,983,151         5,560,620        4,080,185        27,436,506
   Write-off of goodwill                                   769,886                -                -            769,886
   Aladdin license and in process
      research and development expense                   3,889,000                -                -          3,889,000
   Research and development                              2,146,127         3,309,022        3,324,735        14,745,813
                                                       -----------       -----------      -----------        ----------

                                                        14,788,164         8,869,642        7,404,920        46,841,205
                                                        ----------       -----------      -----------        ----------

Other income (expense):
   License fee                                           1,000,000                -                -          1,000,000
   Interest income                                          55,282           194,766          560,875         1,058,332
   Interest expense                                       (175,624)          (10,397)          (1,541)         (566,480)
   Other income                                                 -                 -            12,720            12,720
                                                      ------------      ------------     ------------     -------------

                                                           879,658           184,369          572,054         1,504,572
                                                      ------------      ------------     ------------       -----------

          Net loss                                     (13,897,794)       (8,683,815)      (6,832,866)      (45,324,463)

Accrued dividends on preferred stock (including
   accretion of assured incremental yield on preferred
   stock of $1,673,000 in 1997 and $670,965 in 1996)     2,482,982           870,579           40,600         3,478,495
                                                       -----------      ------------    -------------       -----------

          Net loss to common stockholders            $ (16,380,776)       (9,554,394)      (6,873,466)      (48,802,958)
                                                    ===============       ===========      ===========        ==========

Weighted average number of common shares
   outstanding during the period                        20,943,748        14,956,584       13,794,373         9,777,559
Loss per common share                                $        (.78)             (.64)            (.50)            (4.99)
                                                   ================       ============     ============      ============


See accompanying notes to consolidated financial statements.

</TABLE>
<TABLE>
<CAPTION>

                                       F-5

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

          Consolidated Statements of Stockholders' Equity (Deficiency)

     Period from February 12, 1988 (date of inception) to December 31, 1997
                                                                                                                 Deficit
                                                                                                               accumulated
                                                        Class A                 Class B           Capital      during the
                                                      common stock            common stock      in excess of    development
                                                    Shares     Amount     Shares       Amount     par value        stage
                                                   ---------  ---------  ---------    --------   -----------    -----------
<S>                                                   <C>         <C>    <C>          <C>           <C>          <C>
Shares issued to founders at $.003 per share           -           -     4,680,000     46,800       (31,200)        -
Shares issued at $1.25 per share, net of
   expenses of $36,574 from September through
   November 1988                                       -           -       300,000      3,000       335,426         -
Net loss for period ended December 31, 1988            -           -         -            -            -         (326,832)
                                                   ---------  ---------  ---------    ---------  -----------    -----------
Balance at December 31, 1988                           -           -     4,980,000     49,800       304,226      (326,832)
Shares issued at $1.25 per share, net of
   expenses of $68,750, from January through
   December 1989                                       -           -       270,000      2,700       266,050         -
Shares issued at $1.25 per share in July 1989 as
   compensation for services rendered                  -           -      1,920            19         2,381         -
Shares issued by principal stockholders at $1.25
   per share in December 1989 as compensation
   for services rendered                               -           -         -            -         374,000         -
Net loss for year ended December 31, 1989              -           -         -            -            -         (982,186)
                                                   ---------  ---------  ---------    ---------  -----------    -----------
Balance at December 31, 1989                           -           -     5,251,920     52,519       946,657    (1,309,018)
Shares issued by principal stockholder at $1.25                                                                     -
   per share in March 1990 as compensation for
   services rendered                                   -           -         -            -          56,250
Shares issued by principal stockholder at   $.50
   per share in March 1990 as compensation for
   services rendered                                   -           -         -            -          60,000         -
Shares issued at $1.67 per share in May 1990 as
   compensation for services rendered                  -           -        6,000          60         9,940         -
Shares issued at $1.67 per share, net of
   expenses of $5,000 in March, April,
   November and December 1990                          -           -      390,000       3,900       641,100         -
Net loss for year ended December 31, 1990              -           -         -            -            -       (1,178,129)
                                                   ---------  ---------  ---------    ---------  -----------    -----------
Balance at December 31, 1990                           -           -     5,647,920     56,479      1,713,947   (2,487,147)
Shares issued at $1.67 per share from March
   through November 1991                               -           -     315,000        3,150       521,850         -
Shares issued at $1.67 per share in November
   1991 as compensation for services rendered          -           -     19,800           198        32,802         -
Net loss for year ended December 31, 1991              -           -         -            -            -       (1,009,368)
                                                   ---------  ---------  ---------    ---------  -----------    -----------
Balance at December 31, 1991 (carried forward)         -           -     5,982,720     59,827      2,268,599   (3,496,515)


</TABLE>


<PAGE>

<TABLE>
<CAPTION>


                                       F-6

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

          Consolidated Statements of Stockholders' Equity (Deficiency)

     Period from February 12, 1988 (date of inception) to December 31, 1997




                                                                     Note
                                                                  receivable
                                                     Deferred        from
                                                   compensation   stockholder      Total

<S>                                                   <C>             <C>         <C>
Shares issued to founders at $.003 per share            -              -          15,600
Shares issued at $1.25 per share, net of
   expenses of $36,574 from September through
   November 1988                                        -              -         338,426
Net loss for period ended December 31, 1988             -              -        (326,832)
                                                      -----          -----  -------------
Balance at December 31, 1988                            -              -          27,194
Shares issued at $1.25 per share, net of
   expenses of $68,750, from January through
   December 1989                                        -              -         268,750
Shares issued at $1.25 per share in July 1989 as
   compensation for services rendered                   -              -           2,400
Shares issued by principal stockholders at $1.25
   per share in December 1989 as compensation
   for services rendered                                -              -         374,000
Net loss for year ended December 31, 1989               -              -        (982,186)
                                                      -----          -----  -------------
Balance at December 31, 1989                            -              -        (309,842)
Shares issued by principal stockholder at $1.25
   per share in March 1990 as compensation for
   services rendered                                    -              -          56,250
Shares issued by principal stockholder at   $.50
   per share in March 1990 as compensation for
   services rendered                                    -              -          60,000
Shares issued at $1.67 per share in May 1990 as
   compensation for services rendered                   -              -          10,000
Shares issued at $1.67 per share, net of
   expenses of $5,000 in March, April,
    November and December 1990                          -              -         645,000
Net loss for year ended December 31, 1990               -              -      (1,178,129)
                                                      -----          -----  -------------
Balance at December 31, 1990                            -              -        (716,721)
Shares issued at $1.67 per share from March
   through November 1991                                -              -         525,000
Shares issued at $1.67 per share in November
   1991 as compensation for services rendered           -              -         33,000
Net loss for year ended December 31, 1991               -              -     (1,009,368)

                                                      -----          -----  -------------
Balance at December 31, 1991 (carried forward)          -              -     (1,168,089)
</TABLE>
<TABLE>
<CAPTION>
<PAGE>
                                       F-7

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

   Consolidated Statements of Stockholders' Equity (Deficiency) - (Continued)
                                                                                                                Deficit
                                                                                                               accumulated
                                                         Class A                Class B          Capital in    during the
                                                      common stock            common stock        excess of    development
                                                   Shares      Amount      Shares     Amount      par value       stage
                                                 ----------  ----------  ----------  ----------  ----------   -----------
<S>                                                  <C>     <C>         <C>          <C>        <C>          <C>
Balance at December 31, 1991 (brought forward)        -      $    -      5,982,720    $59,827    2,268,599    (3,496,515)
Shares issued at $1.67 per share from January
   through October 1992                               -           -        708,000      7,080    1,172,920          -
Shares issued at $1.67 per share in May 1992 in
   connection with License and Cross-License
   Agreement                                          -           -        674,976      6,750    1,118,210          -
Shares issued at $1.67 per share in May 1992 as
   compensation for services rendered                 -           -         18,000        180      29,820           -
Shares issued at $2.50 per share in May and
   November 1992 as compensation for services
   rendered                                           -           -        771,000      7,710    1,919,790          -
Shares issued at $2.50 per share, net of
   expenses of $7,500, in November and
   December 1992                                      -           -        323,001      3,230     796,773           -
Shares issued by principal stockholder in
   December 1992 at $2.50 per share as
   compensation for services rendered                 -           -          -           -         75,000           -
Shares canceled in October and December 1992          -           -        (75,000)      (750)        750           -
Issuance of stock options at $.003 exercise
   price per share in June 1992                       -           -          -           -        798,400           -
Amortization of deferred compensation                 -           -          -           -            -             -
Accrued dividends on preferred stock                  -           -          -           -         (6,383)          -
Note received from stockholder and accrual of
   interest thereon                                   -           -          -           -            -             -
Net loss for year ended December 31, 1992             -           -          -           -            -       (4,182,638)
                                                 ----------  ----------  ----------  ----------  ----------   -----------
Balance at December 31, 1992 (carried forward)         -           -      8,402,697     84,027    8,173,879    (7,679,153)


</TABLE>
<PAGE>
<TABLE>
<CAPTION>

                                       F-8


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

   Consolidated Statements of Stockholders' Equity (Deficiency) - (Continued)

                                                                           Note
                                                                        receivable
                                                           Deferred        from
                                                         compensation   stockholder      Total
                                                         ------------   ------------  ------------
<S>                                                          <C>            <C>       <C>
Balance at December 31, 1991 (brought forward)                -              -        (1,168,089)
Shares issued at $1.67 per share from January
   through October 1992                                       -              -         1,180,000
Shares issued at $1.67 per share in May 1992 in
   connection with License and Cross-License
   Agreement                                                  -              -         1,124,960
Shares issued at $1.67 per share in May 1992 as
   compensation for services rendered                         -              -            30,000
Shares issued at $2.50 per share in May and
   November 1992 as compensation for services
   rendered                                                   -              -         1,927,500
Shares issued at $2.50 per share, net of
   expenses of $7,500, in November and December 1992          -              -           800,003
Shares issued by principal stockholder in
   December 1992 at $2.50 per share as
   compensation for services rendered                         -              -            75,000
Shares canceled in October and December 1992                  -              -             -
Issuance of stock options at $.003 exercise
   price per share in June 1992                           (398,660)          -           399,740
Amortization of deferred compensation                      155,455           -           155,455
Accrued dividends on preferred stock                          -              -            (6,383)
Note received from stockholder and accrual of
   interest thereon                                           -          (152,974)      (152,974)
Net loss for year ended December 31, 1992                     -              -        (4,182,638)
                                                         ------------   ------------  ------------
Balance at December 31, 1992 (carried forward)            (243,205)      (152,974)       182,574

</TABLE>
<PAGE>
<TABLE>
<CAPTION>


                                       F-9


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

   Consolidated Statements of Stockholders' Equity (Deficiency) - (Continued)

                                                                                                                 Deficit
                                                                                                               accumulated
                                                        Class A                 Class B           Capital in    during the
                                                     common stock             common stock         excess of   development
                                                  Shares      Amount     Shares       Amount       par value      stage
                                                 ----------  ----------  ----------  ----------  ----------   -------------
<S>                                                 <C>     <C>         <C>          <C>           <C>         <C>
Balance at December 31, 1992 (brought forward)       -      $    -      8,402,697    $84,027       8,173,879   (7,679,153)
Shares issued at $1.67 per share in February
   1993                                              -           -         30,000        300          49,800        -
Shares issued at $3.50 per share, net of
   expenses of $82,427, from April through
   December 1993                                     -           -        550,359      5,504       1,838,294        -
Shares issued at $3.50 per share from May to
   December 1993 as compensation  for services
   rendered, for the acquisition of property
   and equipment and as additional interest on
   borrowings                                        -           -         73,319        733         255,884        -
Issuance of warrants to purchase Class B
   common stock from September to December
   1993 in conjunction with the issuance of
   convertible debt                                  -           -          -            -            72,893        -
Amortization of deferred compensation                -           -          -            -             -            -
Accrued dividends on preferred stock                 -           -          -            -           (38,467)       -
Note received from stockholder and accrual of
   interest thereon                                  -           -          -            -             -            -
Net loss for year ended December 31, 1993            -           -          -            -             -       (3,959,334)
                                                ----------  ----------  ----------   ----------   ----------  -------------
Balance at December 31, 1993                         -           -      9,056,375      90,564     10,352,283   (11,638,487)
Shares issued at $3.50 per share in January
   and February 1994                                 -           -         95,715         957        334,046      -
Shares issued at $3.50 per share in February
   1994 as additional interest on borrowings         -           -          5,700          57         19,893        -
Issuance of warrants to purchase Class B
   common stock in January and February
    1994 in conjunction with the issuance
    of convertible debt                              -           -          -            -           115,234        -
Accrued dividends on preferred stock                 -           -          -            -           (39,484)       -
Accrual of interest on note receivable from
   stockholder                                       -           -          -            -             -            -
Sale of warrants to underwriter in September
   1994                                              -           -          -            -                 4        -
   Conversion of notes payable                       -           -        599,507      5,995       2,079,131        -
Shares issued at $5.00 per share in initial
   public offering in September 1994, net of
   expenses of $2,929,835                        3,728,200    37,282        -            -        15,673,883        -
   Net loss for year ended December 31, 1994         -           -          -            -             -       (4,271,501)
                                                ----------  ----------  ----------   ----------   ----------  -------------
   Balance at December 31, 1994 (carried         3,728,200    37,282    9,757,297     97,573      28,534,990   (15,909,988)
   forward)


</TABLE>


<PAGE>
<TABLE>
<CAPTION>

                                      F-10


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

   Consolidated Statements of Stockholders' Equity (Deficiency) - (Continued)

                                                                              Note
                                                                           receivable
                                                              Deferred        from
                                                            compensation   stockholder      Total
<S>                                                          <C>            <C>             <C>
Balance at December 31, 1992 (brought forward)               (243,205)      (152,974)       182,574
Shares issued at $1.67 per share in February
   1993                                                           -             -            50,100
Shares issued at $3.50 per share, net of
   expenses of $82,427, from April through
   December 1993                                                  -             -         1,843,798
Shares issued at $3.50 per share from May to
   December 1993 as compensation  for services
   rendered, for the acquisition of property
   and equipment and as additional interest on
   borrowings                                                     -             -           256,617
Issuance of warrants to purchase Class B
   common stock from September to December
   1993 in conjunction with the issuance of
   convertible debt                                               -             -            72,893
Amortization of deferred compensation                         243,205           -           243,205
Accrued dividends on preferred stock                              -             -           (38,467)
Note received from stockholder and accrual of
   interest thereon                                               -           (39,783)       (39,783)
Net loss for year ended December 31, 1993                         -             -         (3,959,334)
                                                              -----------    -----------  -----------
Balance at December 31, 1993                                      -          (192,757)    (1,388,397)
Shares issued at $3.50 per share in January
   and February 1994                                              -             -            335,003
Shares issued at $3.50 per share in February
   1994 as additional interest on borrowings                      -             -             19,950
Issuance of warrants to purchase Class B
   common stock in January and February 1994
   in conjunction with the issuance of convertible
   debt                                                           -             -            115,234
Accrued dividends on preferred stock                              -             -            (39,484)
Accrual of interest on note receivable from
   stockholder                                                    -           (17,315)       (17,315)
Sale of warrants to underwriter in September
   1994                                                           -             -                  4
   Conversion of notes payable                                    -             -          2,085,126
Shares issued at $5.00 per share in initial
   public offering in September 1994, net of
   expenses of $2,929,835                                         -             -         15,711,165
   Net loss for year ended December 31, 1994                      -             -         (4,271,501)
                                                              -----------    -----------  -----------
   Balance at December 31, 1994 (carried forward)                 -          (210,072)    12,549,785
                                                              -----------    -----------  -----------










</TABLE>
<PAGE>

                                      F-11


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

   Consolidated Statements of Stockholders' Equity (Deficiency) - (Continued)



 <TABLE>
<CAPTION>
                                                                                                                   Deficit
                                                                                                                 accumulated
                                                        Class A                  Class B           Capital in    during the
                                                     common stock             common stock          excess of    development
                                                   Shares     Amount      Shares        Amount      par value       stage
                                                 ---------   ---------  ---------      ---------   ----------   ------------
<S>                                              <C>         <C>        <C>            <C>         <C>          <C>
Balance at December 31, 1994 (brought forward)   3,728,200   $37,282    9,757,297      $97,573     28,534,990   (15,909,988)
Shares issued at prices ranging from $1.00 per
   share to $3.13 per share as compensation for
   services rendered                               31,559        315         -            -            57,184         -
Exercise of options to purchase Class B stock        -           -        681,700        6,817        429,413         -
Accrued dividends on preferred stock                 -           -           -            -           (40,600)        -
Accrual of interest on note receivable from
   stockholder                                       -           -           -            -             -             -
Exchange of Class B stock for Class A stock      2,855,859    28,559   (2,855,859)     (28,559)         -             -
Net loss for the year ended December 31, 1995        -           -           -            -             -        (6,832,866)
                                                 ---------   ---------  ---------      ---------   ----------   ------------
Balance at December 31, 1995                     6,615,618    66,156    7,583,138       75,831     28,980,987   (22,742,854)
Exercise of options to purchase Class A stock      214,091     2,141         -            -           420,366         -
Shares issued at prices ranging from $2.06 per
   share to $3.44 per share as compensation for
   services rendered                               42,077        421         -            -           123,029          -
Issuance of unregistered Class B common stock
   to acquire Wave Interactive Network valued
   at approximately $.98 per share                    -           -       375,000        3,750        364,688         -
Issuance of warrants to purchase unregistered
   shares of
   Class A common stock in conjunction with          -           -           -            -           283,455        -
   the issuance
   of convertible debt and preferred stock
Conversion of Class B Preferred Stock            2,960,303    29,603         -            -         3,078,921         -
Accrual of interest on note receivable               -           -           -            -             -             -
Accrued dividends on preferred stock                 -           -           -            -          (199,014)        -
Exchange of Class B stock for Class A stock      1,749,997    17,500    (1,749,997)    (17,500)         -             -
Net loss for the year ended December 31, 1996        -           -           -            -             -        (8,683,815)
                                                 ----------  ---------  ---------      ---------   ----------   ------------
Balance at December 31, 1996                     11,582,086  115,821    6,208,141       62,081     33,052,432   (31,426,669)
                                                 ----------  ---------  ---------      ---------   ----------   ------------
Exercise of options to purchase Class A
   and B common stock                               70,326       703       10,330          104        139,081         -
Shares issued at prices ranging from $1.00
   per share to $3.00 per share as
   compensation for services rendered              126,885      1,269        -            -           304,227         -
Conversion of preferred stock into common stock  7,998,860     79,989        -            -         6,703,028         -
Issuance of Class A common stock and warrants
   to purchase Class A common stock to Aladdin     500,000      5,000        -            -         3,834,000         -
Issuance of Class A common stock and warrants
   to purchase Class A common stock                799,964      8,000        -            -           792,000         -
Reduction in note receivable                         -           -           -            -             -             -
Accrual of interest on note receivable               -           -           -            -             -             -
Issuance of warrants to purchase Class A
   common stock in conjunction with the
   issuance of Preferred Stock                       -           -           -            -           386,462         -
Accrued dividend on preferred stock including
   accretion of assured incremental yield            -           -           -            -        (1,372,984)        -
Assured incremental yield on issuance of
   Series F convertible preferred stock
   and debt                                          -           -           -            -           682,000         -
Net loss                                             -           -           -            -             -       (13,897,794)
Exchange of Class B stock for Class A stock      1,796,518    17,965    (1,796,518)    (17,965)         -             -
                                                 ----------  ---------  ---------      ---------   ----------   ------------
Balance at December 31, 1997                     22,874,639  228,747     4,421,953      44,220     44,520,246   (45,324,463)
                                                 ==========  =========  =========      =========   ==========   ============
</TABLE>
<PAGE>
<TABLE>
<CAPTION>

                                      F-12

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

   Consolidated Statements of Stockholders' Equity (Deficiency) - (Continued)


                                                      Note
                                                   receivable
                                      Deferred        from
                                    compensation   stockholder      Total
                                    ------------   -----------   -----------
<S>                                     <C>         <C>          <C>
Balance at December 31, 1994             -          (210,072)    12,549,785
(brought forward)
Shares issued at prices ranging
   from $1.00 per share to $3.13
   per share as compensation for
   services rendered                     -              -            57,499
Exercise of options to purchase
   Class B stock                         -              -           436,230
Accrued dividends on preferred
   stock                                 -              -           (40,600)
Accrual of interest on note
   receivable from stockholder           -           (17,318)       (17,318)
Exchange of Class B stock for
   Class A stock                         -              -             -
Net loss for the year ended
   December 31, 1995                     -              -        (6,832,866)
                                     -----------   -----------   -----------
Balance at December 31, 1995             -          (227,390)     6,152,730
Exercise of options to purchase
   Class A stock                         -              -           422,507
Shares issued at prices ranging
   from $2.06 per share to $3.44
    per share as compensation for
    services rendered                    -              -           123,450
Issuance of unregistered Class B
   common stock to acquire
   Wave Interactive Network
   valued at approximately
   $.98 per share                        -              -           368,438
Issuance of warrants to purchase
   unregistered shares of Class
   A common stock in conjunction
    with the issuance of convertible
   debt and preferred stock              -              -           283,455
Conversion of Class B Preferred
   Stock                                 -              -         3,108,524
Accrual of interest on note
   receivable                            -           (17,315)       (17,315)
Accrued dividends on preferred
   stock                                 -              -          (199,014)
Exchange of Class B stock for
Class A stock                            -              -             -
Net loss for the year ended
 December 31, 1996                       -              -        (8,683,815)
                                     -----------   -----------   -----------
  Balance at December 31, 1996           -          (244,705)     1,558,960
                                     -----------   -----------   -----------
Exercise of options to purchase          -              -           139,888
   Class A and B common stock
Shares issued at prices ranging
   from $1.00 per share
   to $3.00 per share as                 -              -           305,496
   compensation for services
   rendered
Conversion of preferred stock            -              -         6,783,017
   into common stock
Issuance of Class A common stock
   and warrants to purchase
   Class A common stock
   to Aladdin                            -              -         3,839,000
Issuance of Class A common stock
   and warrants to purchase Class A
   common stock                          -              -           800,000
Reduction in note receivable             -            50,000         50,000
Accrual of interest on note
   receivable                            -           (17,319)       (17,319)
Issuance of warrants to purchase
   Class A common stock
   in conjunction with the
   issuance of Preferred Stock           -              -           386,462
Accrued dividend on preferred
   stock including accretion
   of assured incremental yield          -              -        (1,372,984)
Assured incremental yield on
   issuance of Series F
   convertible preferred stock
   and debt                              -              -           682,000
Net loss                                 -              -        (13,897,794)
Exchange of Class B stock for
Class A stock                            -              -               -
                                     -----------   -----------   -----------
Balance at December 31, 1997             -          (212,024)      (743,274)
                                     ===========   ===========   ===========


See accompanying notes to consolidated financial statements.
</TABLE>


<PAGE>
<TABLE>
<CAPTION>




                                      F-13


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

                      Consolidated Statements of Cash Flows

            Years ended December 31, 1997, 1996, 1995 and the Period
     From February 12, 1988 (Date of Inception) through December 31, 1997



                                                                                                             Period from
                                                                                                          February 12, 1988
                                                                                                         (date of inception)
                                                                                                               through
                                                                                                            December 31,
                                                           1997             1996              1995              1997
                                                           ----             ----              ----              ----
<S>                                                  <C>                  <C>              <C>              <C>
Cash flows from operating activities:
   Net loss                                          $ (13,897,794)       (8,683,815)      (6,832,866)      (45,324,463)
   Adjustments to reconcile net loss to net cash
    used in operating activities:
     Write-off of goodwill                                 769,886                -                -            769,886
     Depreciation and amortization                         486,693           316,829          177,393         1,187,368
     Reserve for note from affiliate                            -          1,004,934          668,000         1,672,934
     Accrued interest on marketable securities                  -             48,617          (48,617)         (106,962)
     Noncash expenses:
       Accretion of assured incremental yield on
          convertible debt                                 119,000                -                -            119,000
       Common stock issued in connection with
          License and Cross-License Agreement                   -                 -                -          1,124,960
       Common stock issued for services rendered
          and additional interest on borrowings            305,496            40,938           57,499         2,677,058
       Issuance of warrants to Aladdin                   2,939,000                -                -          2,939,000
       Accrued interest on note payable                     56,624             9,500               -             66,124
       Preferred stock issued for services rendered             -                 -                -            265,600
       Compensation associated with issuance of
          stock options                                         -                 -                -            399,740
       Amortization of deferred compensation                    -                 -                -            398,660
       Amortization of discount on notes payable                -                 -                -            166,253
       Common stock issued by principal stockholder
          for services rendered                                 -                 -                -            565,250
     Changes in assets and liabilities:
       Increase in accrued interest on note receivable     (17,319)          (17,315)         (17,318)          (88,850)
       Increase (decrease) in prepaid expenses and
          other receivables                                 70,358            64,413          (70,602)               -
       Increase in other assets                            184,771           (53,346)         (88,114)          (85,132)
       (Decrease) increase in accounts payable and
          accrued expenses                                 490,599          (191,103)         343,633         1,565,274
                                                      ------------        ----------     ------------       -----------

          Net cash used in operating activities         (8,492,686)       (7,460,348)      (5,810,992)      (31,688,300)
                                                       -----------         ---------      -----------        ----------


                                                                                                          (Continued)

</TABLE>

<PAGE>

<TABLE>
<CAPTION>


                                      F-14


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

                Consolidated Statements of Cash Flows, Continued




                                                                                                             Period from
                                                                                                          February 12, 1988
                                                                                                         (date of inception)
                                                                                                               through
                                                                                                            December 31,
                                                           1997             1996              1995              1997
                                                           ----             ----              ----              ----
<S>                                                       <C>             <C>             <C>              <C>
Cash flows from investing activities:
   Acquisition of property and equipment                  (256,306)         (252,439)        (814,205)       (1,807,118)
   Short-term loans to affiliate                                -         (1,004,934)        (668,000)       (1,672,934)
   Organizational costs                                         -                 -                -            (14,966)
   Purchase of marketable securities-held to maturity           -         (2,945,458)     (16,601,235)      (27,546,769)
   Maturity of marketable securities-held to maturity           -          6,843,041       20,810,690        27,653,731
                                                      ------------       -----------       ----------        ----------
          Net cash provided by (used in) investing
            activities                                    (256,306)        2,640,210        2,727,250        (3,388,056)
                                                      ------------       -----------      -----------       -----------
Cash flows from financing activities:
   Net proceeds from issuance of common stock            1,839,888           422,507          436,230        24,409,471
   Net proceeds from issuance of preferred stock
     and warrants                                        3,553,501         5,950,027               -          9,505,527
   Sale of warrants                                             -                 -                -                  4
   Note receivable from stockholder                         50,000                -                -           (123,175)
   Proceeds from notes payable and warrants to
     stockholders                                               -                 -                -          2,083,972
   Repayments of notes payable to stockholders                  -                 -                -         (1,069,972)
   Proceeds from notes payable and warrants                     -                 -                -          1,284,250
   Repayments of note payable                                   -                 -                -           (255,000)
   Advances from stockholder                                    -                 -                -            227,598
   Repayments of advances from stockholder                      -                 -                -           (227,598)
                                                         ---------         ---------       ----------        -----------

          Net cash provided by financing activities      5,443,389         6,372,534          436,230        35,835,077
                                                         ---------         ---------       ----------        -----------
Net increase (decrease) in cash and cash equivalents    (3,305,603)        1,552,396       (2,647,512)          758,721
Cash and cash equivalents at beginning of period         4,064,324         2,511,928        5,159,440                -
                                                         ---------         ---------       ----------        -----------
Cash and cash equivalents at end of period            $    758,721         4,064,324        2,511,928           758,721
                                                        ==========         =========       ==========        ===========


See accompanying notes to consolidated financial statements.

</TABLE>

<PAGE>

                                      F-15


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

                   Notes to Consolidated Financial Statements

      December 31, 1997, 1996, 1995 and The Period From February 12, 1988
                 (Date Of Inception) Through December 31, 1997



     (1) Organization and Basis of Preparation

          Wave  Systems  Corp.  (the  "Company"  or  "Wave")  is  engaged in the
     research and  development  of a proprietary  system (the "Wave System") for
     use with a  computer,  that  measures,  controls,  and  records  the use of
     electronic  content.  The  Company is also  engaged  in  various  research,
     development  and  marketing  efforts to  commercialize  the Wave  System to
     provide more efficient and flexible  pricing (e.g.,  pay per use or rent to
     own) and  greater  security  on the usage of the  electronic  content.  The
     Company is in the  development  stage and,  accordingly,  the  accompanying
     consolidated  financial statements are presented in a format prescribed for
     a development stage enterprise.

          The  Company  has  incurred  significant  losses in current  and prior
     periods.  Management  intends to  continue to devote  resources  toward the
     research,  development  and  marketing of its products in order to generate
     future revenues from licensing and product sales. In addition,  the Company
     is actively  pursuing  additional short- and long-term  financing  sources,
     including debt and equity financing.  Although  management believes that it
     can  successfully  research,  develop  and market its  products  and obtain
     additional financing,  there can be no assurance that it will be able to do
     so.

(2) Significant Accounting Policies

     (a) Principles of Consolidation

          The consolidated financial statements include the financial statements
     of Wave; a wholly owned subsidiary,  Harvard International Medical Library,
     Inc.,  doing business as MedWave;  a majority  owned  inactive  subsidiary,
     Network News Corp.,  ("NNC"); and a wholly owned inactive  subsidiary.  All
     significant  intercompany balances and transactions have been eliminated in
     consolidation.

     (b) Use of Estimates

          The  preparation of financial  statements in conformity with generally
     accepted  accounting  principles  requires management to make estimates and
     assumptions  that affect the reported amounts of assets and liabilities and
     disclosure  of  contingent  assets  and  liabilities  at  the  date  of the
     financial  statements  and the  reported  amounts  of  expenses  during the
     reporting period. Actual results could differ from those estimates.

     (c) Cash Equivalents

          For purpose of the consolidated  statements of cash flows, the Company
     considers all highly liquid  instruments with a maturity of three months or
     less to be cash equivalents.

     (d) Property and Equipment

          Property and equipment,  including  computer  software,  are stated at
     cost.   Depreciation  is  computed  using  the  straight-line  method  over
     estimated useful lives of five years.



<PAGE>



                                      F-16


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

            Notes to Consolidated Financial Statements - (Continued)





     (e) Goodwill

          Goodwill,  which represents the excess of purchase price over the fair
     value of net assets  acquired,  is amortized on a straight-line  basis over
     the period expected to be benefited of five years. The Company assesses the
     recoverability  of  this  intangible  asset  by  determining   whether  the
     amortization  of the  goodwill  balance  over  its  remaining  life  can be
     recovered through  undiscounted  future operating cash flows of the related
     acquired operation. The amount of goodwill impairment,  if any, is measured
     based on projected  discounted future operating cash flows using a discount
     rate reflecting the Company's  average cost of funds. The assessment of the
     recoverability  of goodwill is impacted if estimated  future operating cash
     flows are not  achieved.  During  the third  quarter of 1997,  the  Company
     wrote-off  goodwill  related  to the WIN  acquisition  as it was  uncertain
     whether the current and expected  future results of operations of WIN would
     be sufficient to support its carrying value.

     (f) Income Taxes

          The Company  accounts for income  taxes under the asset and  liability
     method. As such, deferred tax assets and liabilities are recognized for the
     future tax consequences  attributable to differences  between the financial
     statement  carrying  amounts of existing  assets and  liabilities and their
     respective  tax  bases and  operating  loss and tax  credit  carryforwards.
     Deferred tax assets and  liabilities  are measured  using enacted tax rates
     expected to apply to taxable  income in the years in which those  temporary
     differences are expected to be recovered or settled. The effect on deferred
     tax assets and liabilities of a change in tax rates is recognized in income
     in the period that includes the enactment date.

     (g) Stock Option

          Plan The Company  accounts for its stock  option  plans in  accordance
     with the provisions of Accounting  Principles Board ("APB") Opinion No. 25,
     Accounting for Stock Issued to Employees, and related  interpretations.  As
     such,  compensation  expense is  recorded  on the date of grant only if the
     current market price of the underlying stock exceeds the exercise price. On
     January 1, 1996, the Company adopted the disclosure provisions of Statement
     of Financial  Accounting  Standards ("SFAS") No. 123,  Accounting for Stock
     Based  Compensation and accordingly,  provides pro forma net income and pro
     forma earnings per share footnote disclosures for employee stock options as
     if the fair value-based method defined in SFAS No. 123 had been applied.

     (h) Research and Development

          Research and development costs are expensed as incurred.



<PAGE>



                                      F-17


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

            Notes to Consolidated Financial Statements - (Continued)





     (i) Loss Per Share

          During the fourth  quarter of 1997 the Company  adopted  Statement  of
     Financial  Accounting  Standards No. 128 ("SFAS 128"),  Earnings Per Share.
     Pursuant to SFAS 128,  basic net loss per common share has been  calculated
     based  upon  the  weighted   average  number  of  shares  of  common  stock
     outstanding  during the  period.  No effect has been given to common  stock
     equivalents or convertible  preferred stock or debt in the diluted loss per
     common share as they are all anti-dilutive.  Included in net loss to common
     stockholders is the accretion of the assured  incremental  yield related to
     the ability of the Series B, C, D and F preferred  stockholders  to acquire
     common stock upon conversion at a discount.  The assured  incremental yield
     is being accreted as a dividend over the periods from the dates of issuance
     of the preferred stock to the earliest eligible dates for conversion.

     (j) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of

          The Company  reviews its  long-lived  assets and certain  identifiable
     intangibles  for  impairment  whenever  events or changes in  circumstances
     indicate  that the  carrying  amount  of an asset  may not be  recoverable.
     Recoverability of assets to be held and used is measured by a comparison of
     the  carrying  amount of an asset to future net cash flows  expected  to be
     generated by the asset.  If such assets are considered to be impaired,  the
     impairment to be recognized is measured by the amount by which the carrying
     amount of the  assets  exceed the fair  value of the  assets.  Assets to be
     disposed of are reported at the lower of the carrying  amount or fair value
     less costs to sell.

     (k) Reclassifications

          Certain  reclassifications  have  been  made to the 1996  consolidated
     financial statements to conform to the 1997 presentation.

(3) Related Party Transactions

     (a) Note Receivable from Stockholder

          A  stockholder,  the  Chairman  and  Chief  Executive  Officer  of the
     Company,  was  indebted  to the  Company  at  December  31,  1997 under two
     promissory notes totaling  $212,024,  including  accrued  interest,  due on
     demand.  During 1997, $50,000 of the Chairman and Chief Executive Officer's
     bonus was used to reduce the principal owned.

          The notes are  secured by a pledge of 67,000  shares of Class B common
     stock held by the stockholder  and officer.  The notes bear interest at 10%
     per annum.  The notes and  accrued  interest  thereon  have been shown as a
     deduction  from  stockholders'  equity  in  the  accompanying  consolidated
     financial statements.

     (b) Payment to Employer of Related Party

          In  1997,  the  Company  paid  $182,209  to  Enterprise   Engineering
     Associates  ("EEA"),  during which time Mr. Michael Sprague was an employee
     of EEA. On August 1, 1997,  Michael  Sprague became an employee of Wave, at
     an annual  salary of $110,000.  Michael  Sprague is the son of the Chairman
     and Chief Executive Officer of the Company.
<PAGE>



                                      F-18


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

             Notes to Consolidated Financial Statements, (Continued)




   (b) Acquisition and Dispositions

          In November 1995, the Company entered into a transaction  with certain
     individuals whereby shares in its newly-formed subsidiary, Wave Interactive
     Network,  Inc. ("WIN"), were transferred in exchange for a demand note. The
     amount of the demand note was based on the level of funding provided to WIN
     by the Company during 1995. The demand note from WIN accrued  interest at a
     rate of Prime plus 1% and, subject to certain  limitations  associated with
     WIN's  ability  to  raise  additional  capital,  was  convertible  into  an
     undiluted  20% of the  common  shares  of WIN at the  option  of Wave.  The
     Company  retained  a 1%  ownership  in WIN and  transferred  the  remaining
     ownership to certain individuals, including former employees. Approximately
     65% of the ownership was transferred to Steven  Sprague,  President and CEO
     of WIN, and three other children of Mr. Peter J. Sprague,  Chairman and CEO
     of Wave.  The note was fully reserved as its  collectibility  was dependent
     upon WIN's ability to raise additional  capital.  In addition,  the Company
     entered into a separate  commercial  agreement  that,  among other  things,
     granted  certain  distribution  rights to WIN in exchange for royalties and
     other consideration.

          During 1996,  the Company  continued to finance the  operations of WIN
     through  additional  demand notes with terms similar to the original demand
     note.  The  additional  notes  amounting  to  $1,004,000  were  also  fully
     reserved.  On December  30, 1996,  effective  as of October 18,  1996,  the
     Company  entered  into a merger  agreement  with WIN  whereby  the  Company
     exchanged, for all of the outstanding WIN common stock that it did not own,
     375,000 shares of Class B common stock. These Class B shares are restricted
     securities within the meaning of Rule 144 of the Securities Act of 1933, as
     amended (the "Act").  Additionally,  based on the attainment of a specified
     milestone,  the  shareholders  of WIN are entitled to receive an additional
     325,000  shares of the  Company's  Class B common  stock.  The Company also
     issued a 10% convertible note and a warrant to refinance a convertible note
     obligation  of WIN  amounting to  approximately  $456,000,  which  included
     accrued interest to October 18, 1996, and an outstanding warrant.  Included
     in the results of operations  are WIN's  operations  from October 18, 1996.
     This acquisition has been accounted for by the purchase method.

          The purchase price of $952,438 was  determined  based on the estimated
     fair  value  of  the  consideration  given  to  the  WIN  shareholders  and
     noteholders.  Due to its  restricted  nature,  the Class B common stock was
     valued at a  discount  of 25% from the  market  value of the Class A common
     stock as of October 18, 1996. The  convertible  note was valued at its face
     amount as any discount  attributable to the  incremental  yield imbedded in
     the conversion feature was assumed to be offset by the restricted nature of
     the Class A common  stock into which the note is  convertible.  The warrant
     was valued at $128,000,  its estimated fair value,  using the  BlackScholes
     model and assuming:

                    Expected Life 5 years
                    Interest Rate 6.25%
                    Volatility  124%
                    Dividend Yield 0.0%

          The entire  purchase price was allocated to goodwill as WIN had no net
     tangible  assets.  Subsequently,  in 1997,  the Company  determined  it was
     uncertain  whether the current and expected future results of operations of
     WIN would be adequate to support the goodwill capitalization, and wrote-off
     the goodwill as impaired. If the contingent  consideration is issued, value
     ascribed to such consideration will be expensed.
<PAGE>

                                      F-19

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

             Notes to Consolidated Financial Statements, (Continued)


<TABLE>
<CAPTION>

(4) Property and Equipment
   Property and equipment as of December 31 consisted of the following:
                                                                                1997              1996
                                                                                ----              ----

<S>                                                                       <C>                <C>
       Equipment                                                            $ 1,297,702         1,094,036
       Furniture, fixtures and improvements                                     389,530           350,744
       Computer software                                                        128,228           112,374
                                                                             ----------        ----------
                                                                              1,815,460         1,557,154
       Less: Accumulated depreciation                                           966,184           622,356
                                                                             ----------        ----------
          Total                                                            $    849,276           934,798
                                                                            ===========       ===========

</TABLE>


          Depreciation   expense  on   property   and   equipment   amounted  to
     approximately $344,000, $272,000, $172,000 and $966,000 for the years ended
     December 31, 1997, 1996, and 1995 and for the period from inception through
     December 31, 1997, respectively.

(5) Notes Payable

          In connection  with the  acquisition  of WIN, the Company issued a 10%
     convertible  note  amounting to $456,000  and a warrant to refinance  WIN's
     obligation  to a WIN  noteholder.  The note is  convertible  any time after
     April 1, 1997 and will become due,  including  accrued interest of $66,125,
     on April 18, 1998. The note is  convertible  into a number of the Company's
     unregistered  Class A common stock for a period  beginning on April 1, 1997
     and ending  April 18, 1998  calculated  as the greater of (a) the number of
     shares that would be acquired at 80% of the fair market  value of the Class
     A common  stock or (b) 250,000  shares plus 2,000 shares for each month the
     note is outstanding.

(6) Accounts Payable and Accrued Expenses
   Accounts  payable and accrued  expenses  as of December 31  consisted  of the
following:
<TABLE>
<CAPTION>
                                                                                              1997               1996
                                                                                              ----               ----
<S>                                                                                      <C>                    <C>
       Accrual of costs related to the ITG agreement                                        $ 490,000                -
       Accounts payable                                                                       298,486           403,447
       Accrued consulting and professional fees                                               264,495           409,562
       Accrued payroll and related costs                                                      318,403           111,340
       Other accrued liabilities                                                               56,378            12,814
                                                                                          -----------       -----------

          Total                                                                           $ 1,427,762           937,163
                                                                                            =========         =========
</TABLE>

(7) Capital Stock

          (a) Redeemable  Preferred  Stock

     The Company has authorized 2,000,000 shares of preferred stock having a par
value of $.0l per share. On October 19, 1992, the Board of Directors  designated
and  issued  360  shares of this  preferred  stock of the  Company  as "Series A
Cumulative Redeemable Preferred Stock" ("Series A Preferred Stock").

                                   (Continued)

<PAGE>
                                      F-20


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

             Notes to Consolidated Financial Statements, (Continued)





          The Series A Preferred  Stock was issued in settlement of compensation
     owed to a former  officer  of the  Company  for  services  provided  to the
     Company.  The holder of the Series A Preferred Stock is entitled to receive
     a dividend at the rate of $60 per share per annum,  when and as declared by
     the Board of Directors of the Company.  Dividends are  cumulative  from the
     date of original issue, and payable upon redemption.

          No  dividends  may be  declared  upon the common  stock of the Company
     unless full cumulative  dividends on the Series A Preferred Stock have been
     declared and a sum  sufficient  for the payment  thereof has been set apart
     for such  payment.  The stock is  non-voting  and  redeemable at $1,000 per
     share,  plus  accumulated  dividends,  at any  time  at the  option  of the
     Company.  The stock is subject to mandatory  redemption five years from the
     date of  issuance,  or  October  1997.  Because  the  dividend  rate on the
     Preferred Stock was below market rates, the stock was discounted to yield a
     market  rate of 12% at the time of  issuance,  resulting  in a discount  of
     $94,400.  Dividends of $39,267  (including  amortization of the discount of
     $17,667),  $41,800 (including amortization of the discount of $20,200), and
     $40,600  (including  amortization  of the  discount of  $18,998)  have been
     accrued for the years ended December 31, 1997, 1996 and 1995, respectively.
     The holder has not  notified  the  Company of his  intention  to redeem the
     stock.  The Company  continues to accrue  dividends  until  receipt of such
     intention.

          In May of 1996, the Company raised  $3,214,026,  net of issuance costs
     of  $285,974,  through  the  placement  of 350 shares of Series B Preferred
     Stock  ("Series  B  Preferred  Stock")  pursuant  to  Regulation  S of  the
     Securities  Act of 1933 ("the  Act").  The Series B  Preferred  Stock has a
     stated value of $10,000 per share,  which accrues dividends for liquidation
     and conversion  purposes at 6% per annum, and ranks senior to the Company's
     common stock and Series C Convertible  Preferred Stock ("Series C Preferred
     Stock")  and junior to the Series A  Preferred  Stock.  Series B  Preferred
     Stock was  convertible  by the holder,  in  increments,  into the Company's
     Class A common stock.  The Series B Preferred  Stock was convertible at the
     lesser  of 110%  of the  average  closing  bid  price  for  the  five  days
     immediately  preceding  the issue date or 85% of the  average  closing  bid
     price for the five days immediately  preceding the conversion date.  During
     1996, 330 shares of the Company's  Series B Preferred  Stock were converted
     into  2,960,303  shares  of the  Company's  Class A  common  stock  and the
     remaining  20 shares  of Series B  preferred  were  converted  in 1997 into
     117,240 shares of the Company's Class A common stock.

          In December of 1996,  the Company  raised  $2,634,037  net of issuance
     costs of  $365,963  ($101,964  of which  related to the value  ascribed  to
     warrants  issued)  through  the  placement  of  150,000  shares of Series C
     Preferred Stock pursuant to Regulation D of the Act. The Series C Preferred
     Stock has a stated value of $20 per share,  which accrues dividends payable
     quarterly in cash at 6% per annum.

                                   (Continued)


<PAGE>



                                      F-21


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

             Notes to Consolidated Financial Statements, (Continued)





          The Series C Preferred  Stock  ranks  senior to the  Company's  common
     stock and junior to the Series A and B Preferred Stock.  Series C Preferred
     Stock was  convertible  by the holder,  in  increments,  into the Company's
     Class A common  stock based on the market  price of the  Company's  Class A
     common stock at the time of conversion.

          The Series C Preferred  Stock was  convertible  at the lesser of $2.31
     per share or 80%,  as  adjusted,  of the  average  of the fair value of the
     Class A common stock for the five days prior to the conversion date. During
     1997 all of the  Series C  preferred  stock was  converted  into  2,850,439
     shares of the Company's Class A common stock.

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

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

   (b) Convertible Preferred Stock

          In October 1997 the Company raised  approximately  $1,850,000,  net of
     issuance costs of $397,000 ($224,000 of which related to the value ascribed
     to warrants  issued),  though the private placement 112,500 shares of newly
     created  Series F  Convertible  Preferred  Stock.  The Series F Convertible
     Preferred  Stock  has a  stated  value  of $20  per  share,  which  accrued
     dividends payable quarterly in cash at 6%.

          The Series F  Convertible  Preferred  Stock was  convertible  into the
     Class A Common Stock at an effective  conversion  price of the lower of (a)
     $1.05 and (b) 80% of the average of the five (5) lowest  trading  prices of
     Class A Common Stock. During 1997 all of the Series F Convertible Preferred
     Stock was converted into 2,961,086  shares of the Company's  Class A Common
     Stock.

   (c) Common Stock

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

                                   (Continued)


<PAGE>



                                      F-22


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

             Notes to Consolidated Financial Statements, (Continued)





          Two principal  stockholders  did not acquire the full amount of shares
     to which they were entitled.  Most of the additional  proportionate  shares
     that these  stockholders would have been credited with were offered instead
     to certain officers, employees and stockholders for $.003 per share. To the
     extent that these rights were offered to the  individuals  in  compensation
     for services  rendered to the Company,  compensation  expense  equal to the
     difference  between the estimated fair value as of the date of issuance and
     the purchase  price of the stock was recorded.  The estimated fair value of
     the common stock was  determined  based on sales to third  parties near the
     date of  issuance.  Compensation  expense  associated  with the issuance of
     these  shares of  $430,250 is  included  in the  accompanying  consolidated
     statement of operations for the period from inception to December 31, 1997.

          In May and November,  1992, the Company issued 770,000 shares of Class
     B restricted common stock to certain  employees,  officers and stockholders
     of the Company for a purchase price of $.003 per share, payable in the form
     of services to the Company.

          As these  shares  were  issued  for  services  rendered,  compensation
     expense of $1,927,500 was recorded representing the estimated fair value of
     $2.50 per share at the date of  issuance,  the price at which  common stock
     was sold to third parties near the time of issuance.

          In February 1995, the Company agreed to grant 36,000 shares of Class A
     common stock, 12,000 of which were issued in 1995 with the remainder issued
     in 1996, to two consultants and six non-employee  directors as compensation
     for  services  rendered.   Expenses  of  $112,500  were  recorded  in  1995
     representing  the stock's  fair value of $3.13 per share at the time of the
     agreement to grant.

          In July 1995,  the  Company  issued  19,559  shares to two  vendors in
     payment for services rendered.  Costs of $20,000 were recorded representing
     the  stock's  fair value of  approximately  $1.00 per share at the time the
     services were rendered.

          In July and August 1996, the Company issued 15,000 and 3,077 shares of
     Class A common  stock  to two  consultants  as  compensation  for  services
     rendered.  Expenses of $40,938 have been recorded  representing the stock's
     fair value of $2.06 and $3.44 per share,  respectively,  at their  dates of
     issuance.

          During 1997 the Company issued 126,885 shares of the Company's Class A
     common stock to vendors or for the settlement of  liabilities.  Expenses of
     $305,496 have been recorded representing the stocks' fair value at the date
     of issuance.


                                   (Continued)


<PAGE>



                                      F-23


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

             Notes to Consolidated Financial Statements, (Continued)





          During  1997 the  Company  sold  approximately  800,000  shares of the
     Company's  Class A common stock and warrants to purchase  160,000 shares of
     the Company's  Class A common stock,  which may be exercised at an exercise
     price of $1.00, for an aggregate purchase price of $800,000.

          During 1997 the Company issued 500,000 shares of the Company's Class A
     common stock in connection with a license  agreement with Aladdin Knowledge
     Systems,  Ltd. for its proprietary  persistent encryption  technology.  The
     shares  were  issued  at their  fair  value  on the date of
     issuance.

   (d) Recapitalization

          In January  1994,  the Board of  Directors  authorized  the Company to
     amend and restate the Company's Certificate of Incorporation to reflect the
     authorization of 25,000,000 shares of a newly created Class A common stock,
     which   stock  has  voting   rights  of  one  vote  per   share,   and  the
     reclassification  of the then  current  outstanding  shares of common stock
     into Class B common stock. In June 1994, the Board of Directors  authorized
     that the Class B common  stock  will have one vote per share,  except  that
     Class B common  stock will have five votes per share in cases  where one or
     more  directors  are  nominated  for  election  by  persons  other than the
     Company's  Board of  Directors  and  where  there is a vote on any  merger,
     consolidation or other similar transaction, which is not recommended by the
     Company's  Board of Directors.  In addition,  the Class B common stock will
     have  five  votes  per  share  on all  matters  submitted  to a vote of the
     stockholders  in the event  that any  person or group of  persons  acquires
     beneficial ownership of 20% or more of the outstanding voting securities of
     the Company. The Class B common stock is convertible into shares of Class A
     common  stock at any time.  The  classes  of common  stock are alike in all
     other respects.

(8) Options and Warrants

          1991 Plan

          In September 1991, the Board of Directors authorized the establishment
     of a stock  option plan (the "1991  Plan").  The total  number of shares of
     Class B common stock  subject to the Plan is 2,700,000.  Options  terminate
     upon  the  earlier  of the date of the  expiration  of the  option  or upon
     termination  of  the  employment  relationship  between  the  Company  or a
     subsidiary and the optionee for any reason other than death,  disability or
     retirement.

          Employees are entitled to exercise  their options on dates  determined
     by the Compensation Committee of the Board of Directors. Vesting provisions
     for  options  granted  generally  range from  immediate  vesting to prorata
     vesting over a three-year period.  Options granted under the 1991 Plan may,
     in the  discretion  of the  Compensation  Committee,  include  the right to
     acquire a reload option.  A reload option  provides for the automatic grant
     of a new  option at the  then-current  market  price in  exchange  for each
     previously  owned  share  tendered  by  an  employee  in a  stock-for-stock
     exercise.

          Subsequent  to January  1994 no  further  options,  other than  reload
     options,  may be granted under the 1991 Plan. All options outstanding under
     the 1991 Plan continue in full force and effect  subject to their  original
     terms. (Continued)


<PAGE>



                                      F-24


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

             Notes to Consolidated Financial Statements, (Continued)





          Other Options

          In 1993,  in  connection  with an investment  banking  agreement,  the
     Company  granted  options to purchase 30,000 shares of Class B common stock
     at an exercise  price of $1.67 per share,  and  options to purchase  14,286
     shares of Class B common stock at an exercise price of $3.50 per share. The
     options vested  immediately and are exercisable for a period of seven years
     from the date of issuance.

          1994 Plans

          In January 1994, the Board of Directors  authorized the  establishment
     of the 1994  Employee  Stock  Option  Plan (the "1994  Plan").  The initial
     number  of  shares  of Class A common  stock  subject  to the 1994 Plan was
     1,000,000.  The  terms of the 1994  Plan are  similar  to those of the 1991
     Plan. Options are granted with exercise prices that approximate fair market
     value at the date of grant. In May 1996, the Board of Directors approved an
     amendment  to the  Company's  1994 Plan to increase the number of shares of
     Class A common stock reserved for issuance thereunder to 2,000,000 shares.

          In January 1994, the Board of Directors  authorized the  establishment
     of the Non-Employee  Directors Stock Option Plan (the  "Directors'  Plan").
     The  total  number  of  shares  of  Class A  common  stock  subject  to the
     Directors' Plan was 200,000. Pursuant to the Directors' Plan, each director
     who was not an employee of the Company received an initial grant of options
     to purchase  12,000 shares of Class A common stock at an exercise  price of
     $3.50 per share.

          Any person  subsequently  elected as a director who is not an employee
     of the Company will receive an initial grant of options to purchase  12,000
     shares of Class A common  stock on the day he or she is elected a director.
     In addition, on the day immediately following each of the dates on which an
     incumbent director is reelected,  he or she received an additional grant of
     options to purchase 2,000 shares of Class A common stock.

          In February 1995, the Board of Directors authorized certain changes to
     the  Directors'  Plan.  The annual option grant for directors was increased
     from a total of 2,000  shares of Class A common  stock to 10,000  shares of
     Class A  common  stock.  In July  1995,  the  stockholders  of the  Company
     authorized  an  increase  to the  total  number of  shares  subject  to the
     Directors' Plan from 200,000 shares to 500,000 shares.  Options to purchase
     a total of 110,000 and 100,000  shares of Class A common stock at $ 1.94 to
     $ 3.09 and $3.09 per share, were issued in 1997 and 1996, respectively,  to
     nonemployee directors.

          Initial  option grants under the  Directors'  Plan vest one-third upon
     grant, and one-third on each of the first and second anniversaries.  Annual
     option grants vest 25% after each three-month period following grant.

       (Continued)


<PAGE>



                                      F-25


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

             Notes to Consolidated Financial Statements, (Continued)





          Options under the Directors'  Plan are exercisable for a period of ten
     years from the date of grant. Options may not be exercised after the option
     holder ceases to be a director of the Company,  except that in the event of
     death or disability of the option holder, the option may be exercised for a
     period of one year after the date of death or disability, and, in the event
     of  retirement  of the option  holder,  the option may be  exercised  for a
     period of three months after the date of retirement.

          At December  31, 1997,  there were  approximately  953,000  additional
     shares   available   for  grant   under  the  1994  Plan.   The  per  share
     weighted-average  fair value of stock options granted during 1997, 1996 and
     1995 was  $1.58,  $2.65  and  $2.22 on the  dates of grant  using the Black
     Scholes   option-pricing   model   with  the   following   weighted-average
     assumptions:

                                1997              1996              1995
                                ----              ----              ----

       Expected Life (Years)      10               10                10
       Interest Rate             6.5%             6.4%              5.6%
       Volatility                111%             124%              135%
       Dividend Yield              0%               0%                0%

          The Company  applies APB  Opinion No. 25 in  accounting  for its Plans
     and,  accordingly,  no  compensation  cost has been  recognized  for  stock
     options  granted  to  employees  at  fair  market  value  in the  financial
     statements.

          Had the Company  determined  compensation cost based on the fair value
     at the grant dates for its stock  options under SFAS No. 123, the Company's
     net loss  would  have been  increased  to the pro forma  amounts  indicated
     below:

<TABLE>
<CAPTION>

                                                                1997              1996             1995
                                                                ----              ----             ----
<S>                                                        <C>                 <C>                <C>
     Net loss - as reported                                 $ (13,897,794)      (8,683,815)       (6,832,866)
     Net loss - pro forma                                   $ (15,300,187)     (10,025,517)       (7,102,627)
     Net loss to common stockholders - as reported          $ (16,380,776)      (9,554,394)       (6,873,466)
     Net loss to common shareholders - pro forma            $ (17,783,169)     (10,896,096)       (7,143,227)
     Loss per common share - as reported                    $        (.78)            (.64)             (.50)
     Loss per common share - pro forma                      $        (.85)            (.73)             (.52)

</TABLE>

          Pro forma net loss  reflects  only options  granted in 1997,  1996 and
     1995. Therefore, the full impact of calculating compensation cost for stock
     options  under  SFAS No.  123 is not  reflected  in the pro  forma net loss
     amounts  presented  above because  compensation  cost is reflected over the
     options' vesting periods and compensation cost for options granted prior to
     January 1, 1995 are not considered.

                                   (Continued)


<PAGE>



                                      F-26


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

             Notes to Consolidated Financial Statements, (Continued)


<TABLE>
<CAPTION>



Summary of Option Activity

   A summary of option activity through December 31, 1997 follows:

                                  Class A and B shares  Weighted average
                                    subject to option    exercise price

<S>                                    <C>                    <C>
Balance at January 1, 1991                      -              $  -
Options granted                             30,000             1.67
                                       -----------

Balance at December 31, 1991                30,000             1.67
Options granted                            816,750             1.18
                                        ----------

Balance at December 31, 1992               846,750             1.20
Options granted                            949,186             3.10
                                        ----------

Balance at December 31, 1993             1,795,936             2.20
Options granted                            310,200             3.05
Options canceled                          (108,500)            3.38
                                        ----------

Balance at December 31, 1994             1,997,636             2.27
Options granted                            777,850             2.22
Options canceled                          (349,205)            2.11
Options exercised                         (681,700)             .64
                                        ----------

Balance at December 31, 1995             1,744,581             2.92
Options granted                          1,342,075             2.65
Options canceled                          (503,879)            3.20
Options exercised                         (214,091)            1.97
                                        ----------

Balance at December 31, 1996             2,368,686             2.79
Options granted                            316,010             1.58
Options canceled                          (669,580)
Options exercised                          (70,326)            1.90
                                       -----------

Balance at December 31, 1997             1,944,790             2.73
                                         =========
</TABLE>

          At  December  31,  1997,  there  were  approximately  988,000  options
     exercisable at prices ranging from $1.06 to $7.06.

                                   (Continued)


<PAGE>



                                      F-27


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

             Notes to Consolidated Financial Statements, (Continued)





The following table summarizes  information  about stock options  outstanding at
December 31, 1997:
<TABLE>
<CAPTION>

                                                              Weighted
                                            Weighted           average
                                             average          remaining
Range of           Number        Number     exercise         contractual
exercise prices  outstanding   exercisable    price             life
<S>                <C>           <C>          <C>            <C>
   $1.06            131,250         6417       $1.06          9.9 years

   1.09 - 1.67     440,260       203,063       1.30           7.4 years

   1.94 - 2.31     134,810        23,400       2.04           8.2 years

   2.50 - 2.97     154,690       118,603       2.61           6.5 years

   3.06 - 3.50     924,000       559,339       3.31           7.2 years

   3.81             87,000        29,000       3.81           8.1 years

   7.06             72,780        48,522       7.06           7.6 years
</TABLE>

   Warrants

          In 1993 and 1994,  the Company  issued  warrants to acquire a total of
     151,600  shares of Class B common  stock at $3.50 per share in  conjunction
     with sales of Class B common stock to  individuals  and  institutions.  All
     warrants  are  exercisable  for a  period  of five  years  from the date of
     issuance.

          In 1993 and 1994,  the Company  issued  warrants to acquire a total of
     376,253  shares of Class B common  stock at $3.50 per share in  conjunction
     with the issuance of its 10% Convertible Notes which have since been repaid
     and in 1994,  the  Company  issued  warrants  to  acquire a total of 46,799
     shares of Class B common stock at $6.00 per share in  conjunction  with the
     issuance of its 15% Notes, also which have since been repaid.  All warrants
     are exercisable for a period of five years from their dates of issuance.

          Under  the  terms  of  the  Company's  initial  public  offering,  the
     underwriter  acquired warrants to purchase 360,000 Class A common shares at
     a price of $6.50 per share for nominal  consideration.  These  warrants are
     exercisable for four years commencing in September 1995.

          As a result  of the  successful  placement  of 350  shares of Series B
     Preferred  Stock,  a consultant  from Digital Media Group,  Inc. was issued
     warrants by the Company to purchase 30,000 Class A common shares at a price
     of $3.09 per share. These warrants are exercisable for ten years commencing
     in March 1996.

                                   (Continued)


<PAGE>



                                      F-28


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

             Notes to Consolidated Financial Statements, (Continued)





          Due to the  successful  placement of 150,000  shares of the  Company's
     Series C Convertible  Stock,  Wharton Capital Partners Ltd. and The Shemano
     Group,  Inc., two financial  consulting  firms, were issued warrants by the
     Company to purchase  37,500 Class A common  shares each at a price of $2.54
     per share. These warrants expire on December 27, 1999.

          In  connection  with the  acquisition  of WIN,  the  Company  issued a
     warrant that allows the holder the ability to purchase  unregistered shares
     of the Company's  Class A common stock at a price of $1.25 per share at the
     earlier of the  conversion of a note or April 18, 1998 for a period of five
     years.  The number of shares  able to be  purchased  under this  warrant is
     based on a formula of $170,000  divided by 80% of the fair market  value of
     the Class A common stock at the time of conversion.

          As a result  of the  successful  placement  of  80,000  shares  of the
     Company's Series D Preferred  Stock, JNC Opportunity  Fund, the acquirer of
     the  placement,   received   80,000  warrants  to  purchase  the  Company's
     unregistered  Class A Common Stock,  and financial  consultants,  primarily
     Wharton Capital Partners, received a total of 40,000 warrants. The warrants
     have an exercise price of $1.62, and expire on May 30, 2002.

          As a result  of the  successful  placement  of  112,500  shares of the
     Company's Series F Preferred Stock,  Combination  Inc., the acquirer of the
     placement, received 112,500 warrants to purchase the Company's unregistered
     Class  A  Common  Stock,  and  Wharton  Capital  Partners  received  56,250
     warrants.  The  warrants  have an  exercise  price of $1.26,  and expire on
     October 9, 2002.

          In  connection  with the private  placement of  approximately  800,000
     shares of the Company's  Class A Common Stock,  the Company  issued 160,000
     warrants to purchase  shares of the Company's  unregistered  Class A Common
     Stock at an exercise price of $1.00.  The warrants  expire on September 16,
     2000.

          In connection with a technology  license  agreement with Aladdin,  the
     Company  issued two  warrants on July 18, 1997 to  purchase  the  Company's
     Class A Common Stock.  The first warrant is  excerciseable in 100,000 share
     lots, and provides the holder with the right to acquire 2,185,437 shares of
     the  Company's  unregistered  Class A Common Stock at an exercise  price of
     $1.70 per share.  The first  warrant  has a life of two  years.  The second
     warrant  provides the holder with the right to acquire 7% of the  Company's
     Class A Common Stock on a fully diluted basis for the average closing price
     for the 15 trading days prior to exercise. The warrant must be exercised in
     its entirety and expires at the end of three years.

                                   (Continued)


<PAGE>



                                      F-29


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

             Notes to Consolidated Financial Statements, (Continued)





     A summary of warrants  outstanding at December 31, 1997,  based upon a year
     end price of the Class A common stock of $1.125 per share, follows:
<TABLE>
<CAPTION>

                                                Range of
                     Class A and B shares       exercise     Expiration
 Year of issuance     subject to warrants        prices         Term

<S>                       <C>               <C>              <C>
   1993                     249,529         $     3.50         5 years
   1994                     685,123           3.50 - 6.50    4-5 years
   1996                      30,000               3.09        10 years
   1996                      75,000               2.54         3 years
   1996                     188,889               1.25         5 years
   1997                     120,000               1.62         5 years
                            168,750               1.26         5 years
                            160,000               1.00         3 years
                          2,185,437               1.70         2 years
                          ---------
                          3,862,728
</TABLE>

     At December 31, 1997, warrants to acquire  approximately 3.5 million shares
of Class A and Class B common stock were exercisable.

     The above information table does not  include  the  Aladdin  warrant  to
purchase 7% of the Company due to its variable nature.

(9) Licensing Agreements
   (a) Licensed Patents

          In February  1994,  the Company  entered  into an Amended and Restated
     License Agreement (the "Agreement") with Mr. Peter J. Sprague, the Chairman
     and Chief Executive Officer of the Company,  and Mr. John Michener,  then a
     shareholder and officer of the Company,  whereby the Company was granted an
     exclusive license to make, have made, use, lease, sell or otherwise perform
     services covered by certain licensed patents (the "Licensed Patents") which
     are a fundamental part of the Company's  product.  The Agreement amends and
     restates  certain license  agreements  entered into by the Company prior to
     February 1994.

          The  Agreement  provides  for  royalty  payments  to be  made  to  the
     licensors  in the  aggregate  amount  of two  percent  of the  total  gross
     revenues derived by the Company and any sublicensee of the Company from the
     exploitation of the Licensed Patents,  less any amounts paid, if any to (i)
     information  and  database  providers  for  information  distributed  to or
     through  the  Company  or its  sublicensees,  and  to  (ii)  the  Company's
     sublicensees  for  manufacturing  the product or  performing  the  services
     covered by the Licensed Patents. Royalty payments are payable quarterly and
     are to be apportioned 75% to Mr. Sprague and 25% to Mr. Michener.

                                   (Continued)


<PAGE>



                                      F-30


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

             Notes to Consolidated Financial Statements, (Continued)





          Payment of royalties  is secured by a security  interest in and to the
     Licensed  Patents.  Mr.  Sprague  assigned  all of his  right,  title,  and
     interest in the Licensed Patents to the Company.

          The Company  believes  that the  agreements as a whole provide it with
     exclusive rights under the Wave Patents. There can be no assurance that the
     Company will enjoy  exclusive  rights to the Licensed  patents  under these
     agreements.

   (b) Aladdin License Agreement

          During the third  quarter of 1997 the Company  entered  into a license
     agreement with Aladdin  Knowledge  Systems,  Ltd.  ("Aladdin"),  an Israeli
     company,  for technology and in-process research and development related to
     Aladdin's proprietary  persistent encryption system. Under the terms of the
     Aladdin license  agreement,  the company is prohibited from using any other
     encryption  technology for the first five years.  This  technology  will be
     incorporated  into the  Wave  System  to  facilitate  pay-per-view  content
     distribution.

          The Company  acquired the license for this  technology in exchange for
     $950,000 plus two warrants to purchase the  Company's  Class A common stock
     valued at approximately $2.9 million. The cost of this license was expensed
     as  research  and  development  costs.  Aladdin  also is provided a royalty
     payment of 5% to 9% of the Company's net content revenues.

          In connection with this agreement, Aladdin acquired an equity position
     in the Company by purchasing 500,000 shares of the Company's Class A common
     stock for $900,000,  which approximated the fair market value of the shares
     on the date of purchase.


(10) License and Cross-License Agreements

          On  May  1,  1992,  the  Company  entered  into  a  Joint   Technology
     Development Agreement and License and Cross-License Agreement ("License and
     Cross-License  Agreement")  with The Titan  Corporation  ("Titan")  whereby
     Titan granted to the Company  license rights to the use of certain  patents
     which are co-owned or licensed by Titan.  The Company  granted to Titan the
     exclusive right to make for, sell in, and lease in a "Retained  Market," as
     defined in the  agreement,  the  subject  matter  described  in any Company
     patent.  The  Retained  Market  is  defined  generally  as the  market  for
     "Government  Information,"  as defined in the  agreement,  used solely by a
     government  entity,  and  the  market  for  products  used to  access  such
     information.  The Company  issued to Titan 674,976 shares of Class B common
     stock in return for the  license  to Titan's  patents.  These  shares  were
     valued at $1.67 per share (total  $1,124,960),  the estimated fair value of
     the shares at the time of issuance (based on the price at which shares were
     sold to third  parties  near the time of  issuance),  and were  included in
     research and development expense in the accompanying consolidated statement
     of operations  for the period from  February 12, 1988 through  December 31,
     1996.

          The License and Cross-License  Agreement  provides for royalties to be
     paid by the Company to Titan based upon the  Company's  "Net  Revenues," as
     defined in the  agreement.  Net  Revenues  are defined  generally  as gross
     product  revenues less amounts paid to information  providers and data base
     providers for  information  provided to the Company for use in its products
     and services. Royalties are payable on a quarterly basis.

                                   (Continued)


<PAGE>



                                      F-31


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

             Notes to Consolidated Financial Statements, (Continued)





          The License and Cross-License Agreement also provides for royalties to
     be  paid  to the  Company  by  Titan  based  upon  Titan's  "Allocable  Net
     Revenues,"  as  defined  in  the  agreement.  Allocable  Net  Revenues  are
     generally defined as that portion that a Company patent or information adds
     to Titan's  gross  amounts  invoiced  to  purchasers  for all  products  or
     information  services  making  use of a  Company  patent  or  know-how  and
     information. Royalties are payable on a quarterly basis.

          The License and  Cross-License  Agreement  specifies certain events of
     termination, some of which have already occurred but which have been waived
     or extended by Titan.

          A director of the Company,  who resigned  from the Board at the end of
     1997, is also the President,  Chief  Executive  Officer,  and a director of
     Titan. Pursuant to the terms of a related stockholders agreement, Titan has
     the right to designate a member of the Company's  Board of Directors for as
     long as Titan continues to own at least 50% of the shares originally issued
     to Titan.  As of December 31, 1997, no royalties have been earned by Titan.
     On February  28,  1997,  the Company and Titan  executed an addendum to the
     License  Agreement  whereby the Company  received a sole license to Titan's
     patent  to  develop  and  distribute   products  to  the  in-home  consumer
     microcomputers  market  segment.  Under  this  addendum,  Titan  waived all
     defaults  previously  incurred  by Wave as well  as  extended  the  license
     agreement to expire at the time the patents expire.

(11) Revenue Sharing Agreements With Partners

          The  Company  has,  and  intends to continue  to,  enter into  revenue
     sharing arrangements with information providers,  software developers,  and
     hardware  and systems  manufacturers  such as IBM  discussed  below.  These
     revenue  sharing  arrangements  will  be  negotiated  between  each  of the
     partners  and  the  Company.   It  is  anticipated   that  revenue  sharing
     arrangements  will vary according to the market in which the Wave system is
     adopted and from which  revenues  are  derived.  Generally,  a  significant
     portion of the revenue  collected by the Company  will be paid  directly to
     the  information  provider or software  developer.  Once these payments are
     made the remainder of revenues will be shared between the Company and other
     partners.  There can be no assurance that the Company will be successful in
     entering into definitive  agreements with these parties,  or that the terms
     of such agreements will be favorable to the Company.

          In December  1997,  the Company  entered  into a series of  agreements
     ("the agreements") with IBM pursuant to which the Company and IBM agreed to
     explore ways to inexpensively incorporate the Company's WaveMeter chip into
     PC products and to support each other in achieving  industry-wide  adoption
     of the WaveMeter technology.  Pursuant to the agreements,  the Company must
     subsidize  the  incremental  cost  of  using  the  Wave  technology  in IBM
     products. The total subsidy is capped at $30 million. The Company must also
     share  varying  percentages  of its usage and  advertising  fee income that
     results from usage of any Wave technology  distributed by IBM. In addition,
     the Company  must  provide  user and  technical  service and support to IBM
     customers for the end-user  application of Wave  technology.  Finally,  the
     agreements  provide  for cash  payments  upon  the  attainment  of  certain
     milestones. The amount of such cash payments is based upon the appreciation
     of the  Company's  stock.  To date,  none of  these  milestones  have  been
     achieved;  therefore,  no  costs  have  been  recognized  in the  financial
     statements.

<PAGE>


                                      F-32
(12) Joint Venture

In  July of  1997,  the  Company  entered  into a  joint-venture  with  Internet
Technology Group, PLC ("ITG"),  a United Kingdom Internet service provider.  The
joint  venture  is  owned  25% by  the  Company  and  75$ by  ITG.  The  Company
contributed its technical  expertise and ITG contributed initial working capital
and the commitment to fund all future working capital  requirements of the joint
venture.  The objective of the joint venture  company,  Global Wave, Ltd., is to
promote and  commercialize  the Wave  technology in certain  European and Middle
Eastern  markets.  Pursuant to the joint  venture  agreement,  the Company  will
receive a license  fee of up to $5 million in exchange  for the joint  venture's
right to market the Wave technology in European and Middle Eastern markets. The
license  fee will be paid by ITG as part of its  commitment  to fund  the  joint
venture.  During the third  quarter of 1997,  the Company  received $1.0 million
from the joint-venture representing partial payment of the license fee, with the
remaining  payments to be made upon the Company's  attaining certain  milestones
related to the  number of Wave  Meters  distributed.  The  amount  received  was
recorded as deferred license fee income in the third quarter as it was uncertain
whether the Company had met the  contractual  requirements  required in order to
have earned the first  payment.  During the fourth  quarter of 1997, the Company
met these  requirements  and recorded the $1 million as a license fee.  Also the
Company  accrued  $490,000  in the fourth  quarter for  expenses  related to the
Company's  obligation  to assist the joint venture in setting up the Wave system
in the  designated  markets.  In January 1998,  the joint venture  agreement was
modified  to extend  the  milestone  dates and  provide  for the  payment  of an
additional $750,000 of the $5 million license fee to the Company. The payment of
$750,000 was received in January 1998. The remaining  portion of the license fee
will be paid in 1998 if the remaining  milestones are achieved;  however,  there
can be no assurance  that the remaining  milestones  will be achieved.  Also, at
this time  neither  ITG nor the joint  venture  have the  resources  to fund the
remaining payments.

The joint venture is entirely  funded through  advances from ITG and the Company
has no commitment to fund the operations of the joint venture.

The Company  accounts for its 25% interest in the joint venture  pursuant to the
equity method of  accounting.  At December 31, 1997 the Company's  investment in
the joint venture was $0 for financial reporting purposes.
<PAGE>
                                      F-33


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

             Notes to Consolidated Financial Statements, (Continued)


(13) Commitments and Contingencies

          Litigation

          The Company is party to legal proceedings  generally incidental to its
     business.  Management believes that the outcome of such litigation will not
     have a material  adverse effect on the consolidated  financial  position or
     results of operations of the Company,

          Leases

          In  December  1994,  the  Company  entered  into  an  operating  lease
     beginning  March 1995 for its offices in New York, New York,  which expired
     on  February  28,  1998.  The lease  provides  for  minimum  annual rent of
     $200,000   per  annum  plus   applicable   escalations.   The  Company  has
     subsequently terminated this lease and entered into a new lease in the same
     facility.  The  minimum  annual  rent for the new  lease  is  approximately
     $81,000 and its expiration is June 1999.  The Company also leases  premises
     in Princeton,  New Jersey; San Jose,  California;  and Lee,  Massachusetts,
     under operating  leases,  which expire on various dates through January 14,
     2001.

          Future minimum lease payments under noncancelable  operating leases as
     of December 31, 1997 are as follows:

         Year ending December 31  Operating Lease

                  1998               $ 245,151
                  1999                 107,922
                  2000                  65,280
                                      --------
                                     $ 418,353
                                     =========

          Rent expense for the years ended December 31, 1997, 1996, 1995 and for
     the  period  from   inception   through   December  31,  1997  amounted  to
     approximately $383,000, $341,000, $262,000 and $1,500,000, respectively.



<PAGE>



                                      F-34


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

             Notes to Consolidated Financial Statements, (Continued)




(14) Income Taxes

          The  Company  has net  operating  loss  carryforwards  for tax  return
     purposes  of  approximately  $36,900,000  which  expire  beginning  in 2003
     through 2012.

          Pursuant  to the Tax Reform  Act of 1986,  annual  utilization  of the
     Company's net operating loss  carryforwards  may be limited if a cumulative
     change in ownership of more than 50% occurs within a three year period. The
     Company has not determined  whether there has been such a cumulative change
     in ownership or the impact on the utilization of the loss  carryforwards if
     such change has occurred.

          The  tax  effects  of  temporary  differences  that  give  rise to the
     deferred tax asset at December 31, 1997 and 1996 are as follows:
<TABLE>
<CAPTION>

                                                                        1997              1996
<S>                                                              <C>                <C>      <C>
     Deferred tax assets:
       Net operating loss carryforwards                           $ 15,493,000        11,554,000
       License rights                                                1,307,000            45,000
                                                                    ----------     -------------
          Total gross deferred tax assets                           16,800,000        11,599,000
       Less valuation allowance                                    (16,800,000)      (11,599,000)
                                                                    ----------     -------------
          Net deferred tax asset                                   $        -                 -
                                                                    ==========      ============
</TABLE>

          The valuation allowance increased by $5,201,000 and $3,599,000, during
     the years ended December 31, 1997 and 1996, respectively.

(15) Defined Contribution Plan

          The  Company  adopted  the Wave  Systems  Corp.  401 (k)  Savings  and
     Investment Plan, a defined  contribution  plan, on January 1, 1995 to which
     substantially-all employees can contribute. Employees of the Company become
     eligible  immediately  on  employment.  The  Company has the option to make
     discretionary matching contributions; no contributions were made in 1997 or
     1996 or 1995.

(16) Disclosures  about the Fair Value of  Financial  Instruments  Cash and Cash
     Equivalents,  Accounts  Receivable,  Accounts Payable and Accrued Expenses,
     and Note Payable

          The  carrying  amounts  of these  instruments,  other  than the  note,
     approximate fair value because of their short maturities.  The note payable
     approximates its estimated fair value based on the timing of its issue.

                                   (Continued)


<PAGE>



                                      F-35


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

             Notes to Consolidated Financial Statements, (Continued)




          Limitations

          Fair value  estimates are made at a specific  point in time,  based on
     relevant market information and information about the financial instrument.
     These  estimates  are  subjective in nature and involve  uncertainties  and
     matters of  significant  judgment and therefore  cannot be determined  with
     precision, Changes in assumptions could significantly affect the estimates.

(17) Subsequent Events (unaudited)

          During  March of 1998,  the  Company  issued  150,000  shares of newly
     created  Series G  Convertible  Preferred  stock for an aggregate  purchase
     price of $3,000,000.  The Series G Convertible preferred stock is senior to
     the Company's classes of common stock, and is junior to the Company' Series
     A Redeemable  Preferred in  liquidation  rights.  The Series G  Convertible
     Preferred Stock accrues dividends at the rate of 6% per annum. The Series G
     Convertible Preferred stock is convertible into the Company's  unregistered
     Class A Common  stock at the lower of $1.12 or 80% of the  average of the 5
     lowest  closing  bids for the 10  calendar  days  prior to  conversion.  In
     addition,  the company issued warrants to the purchaser and placement agent
     for 225,000  shares of the  Company's  Class A common stock at an excercise
     price of $1.38